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Quesnay’s Tableau set out three classes of society, and showed how
transactions flowed between them. The three classes were:
(a) landowners,
(b) the farmers and farm-labourers, and
(c) others, called ‘sterile class’
According to him, only the agricultural sector produced any surplus value, the
rest only reproducing what it consumed. He anticipated Malthus’s fear of under
consumption arising from excessive savings. Net income would be reduced if
the flows in the Tableau were interrupted by delays in spending. This was the
first attempt to construct a macroeconomic input-output model of the economy.
In fact, progress in this field had to await the application of matrix algebra and
computerization. Quesnay suggested a single tax, ‘l’impôt unique’, on the net
income from land, arguing that the nation would thereby save tax-collecting
costs. Only agriculture yielded a surplus, and therefore ultimately it bears all
taxes anyway.
The Physiocrats
The Physiocrats were a group of French Enlightenment thinkers of the 1760s led
by the French court physician, François Quesnay. The founding document of
Physiocratic doctrine was Quesnay's Tableau Économique (1759). The
members of Physiocrats were Marquis de Mirabeau, Mercier de la Rivière,
Dupont de Nemours, La Trosne, the Abbé Baudeau and others. To
contemporaries, they were known simply as the économistes.
The cornerstone of the Physiocratic doctrine was Quesnay's axiom that only
agriculture yielded a surplus – known as ‘net product’. Manufacturing, the
Physiocrats argued, took up as much value as inputs into production as it created
in output, and consequently created no net product. Contrary to the
Mercantilists, the Physiocrats believed that the wealth of a nation lies not in its
stocks of gold and silver, but rather in the size of its net product.
It is at this point that the Physiocrats jumped into their laissez-faire attitude. They
called for the removal of restrictions on internal trade and labor migration, the
abolition of the corvée, the removal of state-sponsored monopolies and trading
privileges, the dismantling of the guild system, etc.
On fiscal matters, the Physiocrats famously pushed for their "single tax" on
landed property -- l'impôt unique. According to Physiocrats, any tax levied
throughout the economy will just passed from sector to sector until they fall upon
the net product. As land is the only source of wealth, then the burden of all taxes
ultimately bears down on the landowner. So instead of levying a complicated
collection of scattered taxes (which are difficult to administer and can cause
temporary distortions), it is most efficient to just go to the root and tax land rents
directly.
A general laissez-faire policy and the "single tax" were the speediest, least
distortionary and least costly ways of arriving at the natural state. The
Physiocrats believed that net product of the natural state was the maximum net
product sustainable over the long run. The policy measures advocated by the
Physiocrats went very much against the interests of the nobility and the landed
gentry. But because Quesnay was the private physician to Madame de
Pomapadour, the mistress of King Louis XV, the Physiocratic clique enjoyed a
good degree of protection in the French court. The Physiocrats became so
influential that even after the death of Pomapadour, they remain a furious
publisher of different journals and articles that promote their ideas.
Equilibrium
The term equilibrium has often to be used in economic analysis. In fact, Modern
Economics is sometimes called equilibrium analysis. Equilibrium means a state
of balance. When forces acting in opposite directions are exactly equal, the
object on which they are acting is said to be in a state of equilibrium.
Types of Equilibrium
When the word equilibrium is used to qualify the term value, then according to
Professor Schumpeter, a stable equilibrium value is an equilibrium value that if
changed by a small amount, calls into action forces that will tend to reproduce
the old value; a neutral equilibrium value is an equilibrium value that does not
know any such forces; and an unstable equilibrium value is an equilibrium value,
change in which calls forth forces which tend to move the system farther and
farther away from the equilibrium value.
There are two major theorems presented by Kenneth Arrow and Gerard Debreu
in the framework of general equilibrium:
2. It shows that the quantities of demanded goods / factors are equal to the
quantities supplied. Such a condition implies that there is a full
employment of resources.
6. The general equilibrium analysis also gives us the clue for predicting
the consequences of an economic event.
4. Last but not least, the general equilibrium analysis falls to the ground as
its star assumption of perfect competition is contrary to the actual
conditions prevailing in the real world.
General Disequilibrium (Keynesian Theory)
In the above figure, MC curve is the marginal cost curve for the commodity.
Originally, the market is in equilibrium at price P1 with demand curve D1. Then,
for any reason, demand for that commodity decreases to D2, Neoclassical
economists tells us that the new equilibrium will be at price P3. But, in fact, the
prices do not drop quite that far, instead, prices drop to P2. Perhaps this is
because the businessmen do not know just how far they need to cut their prices,
and are cautious to avoid cutting too much. At a price P2, the seller can sell only
Qd amount of output. By producing Qd amount of output at price P2, the
producers are not maximising their short-run profit. We have ‘disequilibrium’ in
the sense that production is not on the marginal cost curve. At P2, the sellers can
sell Qd amount of output, but they cannot produce the same amount of output.
Here is a qualification. Producer might temporarily produce more that Qd, in
order to build up their inventories. But there is a limit to how much inventories
they want, so they will cut their production back to Qd eventually.
With a reduction of demand for cellular phones, any economist would expect a
reduction in the quantity of that commodity produced. Neoclassical economics
leads us to expect that the price would drop to P3 and output cut back to Qe. At
the same time, a certain number of workers would be laid off and would switch
their efforts into their second best alternatives, working in other industries,
perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the
production and layoffs would go even further, with output dropping to Qd. A
reduction in income does not only reduce the demand for cellular phones, but it
also reduces the demand for all other normal goods as well. This disequilibrium
will spread contagiously through many different goods markets, through the effect
of disequilibrium on income. So every other industry will face a reduction in
demand because of the reductions in productions in many other industries.
Utility Theory
In economics, utility is a measure of the happiness or satisfaction gained from a good or
service. The concept is applied by economists in such topics as the indifference curve,
which measures the combination of a basket of commodities that an individual or a
community requests at a given level(s) of satisfaction. The concept is also used in utility
functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract
curves. It is a central concept of welfare economics.
The doctrine of utilitarianism saw the maximisation of utility as a moral criterion for the
organisation of society. According to utilitarians, such as Jeremy Bentham (1748-1832)
and John Stuart Mill (1806-1876), society should aim to maximise the total utility of
individuals, aiming for 'the greatest happiness for the greatest number'.
Utility theory assumes that humankind is rational. That is, people maximize their utility
wherever possible. For instance, one would request more of a good if it is available and
if one has the ability to acquire that amount, if this is the rational thing to do in the
circumstances.
For this reason, neoclassical economics abandoned utility as a foundation for the
analysis of economic behaviour, in favour of an analysis based upon
preferences. This led to the development of tools such as indifference curves to
explain economic behaviour.
A utility function to describe an individual's set of preferences clearly is not unique. If the
value of the utility function were to be, for e.g., doubled, squared, or subjected to any
other strictly monotonically increasing function, it would still describe the same
preferences. With this approach to utility, known as ordinal utility it is not possible to
compare utility between individuals, or find the total utility for society as the Utilitarians
hoped to do.
Monopoly is that market form in which a single producer controls the whole supply of a
single commodity which has no close substitute.
From this definition there are two points that must be noted:
(i) (i) Single Producer: There must be only one producer who may be an
individual, a partnership firm or a joint stock company. Thus single firm
constitutes the industry. The distinction between firm and industry disappears
under conditions of monopoly.
(ii) (ii) No Close Substitute: The commodity produced by the producer must
have no closely competing substitutes, if he is to be called a monopolist. This
ensures that there is no rival of the monopolist. Therefore, the cross elasticity
of demand between the product of the monopolist and the product of any other
producer must be very low.
The Equilibrium level in monopoly is that level of output in which marginal revenue
equals marginal cost. The producer will continue producer as long as marginal revenue
exceeds the marginal cost. At the point where MR is equal to MC the profit will be
maximum and beyond this point the producer will stop producing.
Y
MC
Revenue
/ Cost
AC
P’
P L
T
E AR
MR
O M X
Output
It can be seen from the diagram that up till OM output, marginal revenue is greater than
marginal cost, but beyond OM the marginal revenue is less than marginal cost.
Therefore, the monopolist will be in equilibrium at output OM where marginal revenue is
equal to marginal cost and the profits are the greatest. The corresponding price in the
diagram is MP’ or OP. It can be seen from the diagram at output OM, while MP’ is the
average revenue, ML is the average cost, therefore, P’L is the profit per unit. Now the
total profit is equal to P’L (profit per unit) multiply by OM (total output).
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will
stop producing. In the long run, the monopolist can change the size of plant in response
to a change in demand. In the long run, he will make adjustment in the amount of the
factors, fixed and variable, so that MR equals not only to short run MC but also long run
MC.
(iii) In equilibrium position, the price (iii) In equilibrium position, the price
charged by the firm equals to MC. charged by the firm is above MC.
(iv) The firm is in long-run equilibrium at (iv) The firm is in long-run equilibrium at
the minimum point of the long-run AC the point where AC curve is still declining
curve. and has not reached the minimum point.
Y Y
MC
P P
P’ AC=MC
AC P’
L
T
T L AR
MR AR MR
O M X O M X
P’ P
L
T
AC
AR
MR MC
O M X
MPS SRS
Y D’ Y
D Price S
D
P’
P” E Q
P
LRS
P”’ S
S D
D’
D MR
O M M’ M” X O M L X
Output Output
Equilibrium Position in a Decreasing Cost Industry under Perfect Equilibrium Position under Monopoly
Competition
(a) (a) Personal: It is personal when different prices are charged for different
persons.
(b) (b) Local: It is local when the price varies according to locality.
(c) (c) According to Trade or Use: It is according to trade or use when different
prices are charged for different uses to which the commodity is put, for example,
electricity is supplied at cheaper rates for domestic than for commercial purposes.
(a) (a) When consumers have certain preferences or prejudices. Certain consumers
usually have the irrational feeling that they are paying higher prices for a good
because it is of a better quality, although actually it may be of the same quality.
Sometimes, the price differences may be so small that consumers do not consider
it worthwhile to bother about such differences.
(b) (b) When the nature of the good is such as makes it possible for the monopolist
to charge different prices. This happens particularly when the good in question is
a direct service.
(c) (c) When consumers are separated by distance or tariff barriers. A good may
be sold in one town for Re. 1 and in another town for Rs. 2. Similarly, the
monopolist can charge higher prices in a city with greater distance or a country
levying heavy import duty.
(a) (a) The elasticities of demand in different markets must be different. The
market is divided into sub-markets. The sub-market will be arranged in ascending
order of their elasticities, the higher price being charged in the least elastic market
and vice versa.
(b) (b) The costs incurred in dividing the market into sub-markets and keeping
them separate should not be so large as to neutralise the difference in demand
elasticities.
(c) (c) There should be complete agreement among the sellers otherwise the
competitors will gain by selling in the dear market.
(d) (d) When goods are sold on special orders because then the purchaser cannot
know what is being charged from others.
P1 MC
P2
P’ P”
E’ E” AR” CMR
MR’ AR’ MR”
O M1 X O M2 X O M X
Output Output Output
Price Discrimination in Monopoly
(ii) (ii) The monopolist has now to decide at what level of output he should
produce. To achieve maximum profit, hence, he will be in equilibrium at
output at which MR=MC, and MC curve cuts the MR curve from below. In
the above diagram (c) it is shown that the equilibrium of the discriminating
monopolist is established at output OM at which MC cuts CMR. The output
OM is distributed between two markets in such a way that marginal revenue in
each is equal to ME. Therefore, he will sell output OM 1 in Market A, because
only at this output marginal revenue MR’ in Market A is equal to ME (M1E’ =
ME). The same condition is applied in Market B where MR” is equal to ME
(M2E” = ME). In the above diagram, it is also shown that in Market B in
which elasticity of demand is greater, the price charged is lower than that in
Market B where the elasticity of demand is less.
Oligopoly is that market situation in which the number of firms is small but each firm in
the industry takes into consideration the reaction of the rival firms in the formulation of
price policy. The number of firms in the industry may be two or more than two but not
more than 20. Oligopoly differs from monopoly and monopolistic competition in this
that in monopoly, there is a single seller; in monopolistic competition, there is quite a
larger number of them; and in oligopoly, there are only a small number of sellers.
CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is
further classified as below:
(i) (i) Perfect or Pure Duopoly: If the duopolists in an industry are
producing identical products it is called perfect or pure duopoly.
(ii) (ii) Imperfect or Impure Duopoly: If the duopolists in an industry are
producing differentiated products it is called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes
consideration the reactions of the rival firms in formulating its own price policy it is
called oligopoly. Oligopoly is further classified as below:
Imperfect
competition:
Many producers,
Retail trade
Monopolistic competition Many real or perceived
(Gasoline, PCs, etc.)
differences in product
Advertising and
Few producers,
Steel, chemicals, etc. Some Quality rivalry,
No differences in product.
Administered prices
Oligopoly
Few producers,
Some differentiation Autos, aircraft, etc.
of products
Single producer,
Local telephone, Considerable but Advertising and
Product without close
Monopoly electricity, and gas usually regulated Service promotion
substitutes
CAUSES OF OLIGOPOLY:
1. Economies of Scale: The firms in the industry, with heavy investment, using improved technology and
reaping economies of scale in production, sales, promotion, etc, will compete and stay in the market.
2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms have
ownership of patents or control of essential raw material used in the production of an output. The heavy
expenditure on advertising by the oligopolistic industries may also be a financial barrier for the new
firms to enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately
merge and formulate a joint policy in the pricing and production of the products. The joint action of the
few big firms discourages the entry of new firms into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore, they
keep a strict watch of the price charged by rival firms in the industry. The firm generally avoid price
ware and try to create conditions of mutual interdependence.
CHARACTERISTICS OF OLIGOPOLY:
1. 1. Every seller can exercise an important influence on the price-output policies of his rivals. Every
seller is so influential that his rivals cannot ignore the likely adverse effect on them of a given change in
the price-output policy of any single manufacturer. The rival consciousness or the recognition on the
part of the seller is because of the fact of interdependence.
2. 2. The demand curve under oligopoly is indeterminate because any step taken by his rivals may
change the demand curve. It is more elastic than under simple monopoly and not perfectly elastic as
under perfect competition.
3. 3. It is often noticed that there is stability in price under oligopoly. This is because the oligopolist
avoids experimenting with price changes. He knows that if raises the price, he will lose his customers
and if he lowers it he will invite his rivals to price war.
EFFECTS OF OLIGOPOLY:
1. 1. Small output and high prices: As compared with perfect competition, oligopolist sets the prices at
higher level and output at low level.
2. 2. Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms in an
oligopolistic industry.
3. 3. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level higher than the
AC. The consumers have to pay more than it is necessary to retain the resources in the industry. In
other words, the economy’s productive capacity is not utilised in conformity with the consumers’
preferences.
4. 4. Lower efficiency: Some economists argued that there is a low level of production efficiency in
oligopoly. There is no tendency for the oligopolists to build optimum scales of plant and operate them
at the optimum rates of output. However, the Schumpeterian hypothesis states that there is high
tendency of innovation and technological advancement in oligopolistic industries. As a result, the
product cost decreases with production capacity enhancement. It will offset the loss of consumer
surplus from too high prices.
5. 5. Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may engage in
aggressive and extensive sales promotion effort by means of advertisement and by changing the design
and improving the quality of their products.
6. 6. Wider range of products: As compared with pure monopoly or pure competition, differentiated
oligopoly places at the consumers’ disposal a wider variety of commodities.
7. 7. Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to create
quality and design differentiations. Hence, from the point of view of economic welfare, oligopoly fares
fairly badly. The oligopolists push non-price competition beyond socially desirable limits.
COLLUSIVE OLIGOPOLY:
The degree of imperfect competition in a market is influenced not just by the number and size of firms but by
how they behave. When only a few firms operate in a market, they see what their rivals are doing and react.
‘Strategic interaction’ is a term that describes how each firm’s business strategy depends upon its rivals’
business behaviour.
When there are only a small number of firms in a market, they have a choice between ‘cooperative’ and ‘non-
cooperative’ behaviour:
• Firms act non-cooperatively when they act on their own without any explicit or implicit agreement with
other firms. That’s what produces ‘price wars’.
• Firms operate in a cooperative mode when they try to minimise competition between them. When firms
in an oligopoly actively cooperate with each other, they engage in ‘collusion’. Collusion is an
oligopolistic situation in which two or more firms jointly set their prices or outputs, divide the market
among them, or make other business decisions jointly.
A ‘cartel’ is an organisation of independent firms, producing similar products, which work together to raise
prices and restrict output. It is strictly illegal in Pakistan and most countries of the world for companies to
collude by jointly setting prices or dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit
Y
collusion’, which occurs when they refrain from competition without explicit agreements. When firms tacitly
Price Da MC
collude, they often quote identical (high) prices, pushing up profits and decreasing the risk of doing business.
The rewards of collusion, when it is successful, can be great. It is more illustrated in the following diagram:
AC
G
P
E
T
Da
MR
O Q X
Quantity
Equilibrium under Collusive Oligopoly
The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming that the other
firms all follow firm A’s lead in raising and lowering prices. Thus the firm’s demand curve has the same
elasticity as the industry’s DD curve. The optimum price for the collusive oligopolist is shown at point G on
DaDa just above point E. This price is identical to the monopoly price, it is well above marginal cost and earns
the colluding oligopolists a handsome monopoly profit.
(a) (a) The first choice is that the firm increases the price of the product. Each firm in the industry is fully
aware of the fact that if it increases the price of the product, it will lose most of its customers to its rival.
In such a case, the upper part of demand curve is more elastic than the part of the curve lying below the
kink.
(b) (b) The second option for the firm is to decrease the price. In case the firm lowers the price, its total
sales will increase, but it cannot push up its sales very much because the rival firms also follow suit with
a price cut. If the rival firms make larger price cut than the one which initiated it, the firm which first
started the price cut will suffer a lot and may finish up with decreased sales. The oligopolists, therefore
avoid cutting price, and try to sell their products at the prevailing market price. These firms, however,
compete with one another on the basis of quality, product design, after-sales services, advertising,
discounts, gifts, warrantees, special offers, etc.
Y
Price D
MR
P
MC
P’
T
D
MC
S
O N X
Output
The Kinky Demand Curve
MR
In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve just below the
point corresponding to the kink. During this discontinuity the marginal cost curve is drawn. This is because of
the fact that the firm is in equilibrium at output ON where the MC curve is intersecting the MR curve from
below.
Price 12 – D
10 – B
8–
6–
4– D’
2–
In the above diagram, the demand curve is made up of two segments DB and BD’. The demand curve is kinked
at point B. When the price is Rs. 10 per unit, a firm sells 120 units of output. If a firm decides to charge Rs. 12
per unit, it loses a large part of the market and its sales come down to 40 units with a loss of 80 units. In case,
the producer lowers the price to Rs. 4 per unit, its competitors in the industry will match the price cut. Its sales
with a big price cut of Rs. 6 increases the sale by only 40 units. The firm does not gain as its total revenue
decreases with the price cut.
2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the
price of the product for the entire industry. The other firms in the industry simply follow the price leader and
accept the price fixed by him and adjust their output to this price. The price leader is generally a very large or
dominant firm or a firm with the lowest cost of production. It often happens that price leadership is established
as a result of price war in which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set independently and there is usually some
understanding among the oligopolists operating in the industry. This agreement may be either tacit or explicit.
Types of Price Leadership: There are several types of price leadership. The following are the principal types:
(a) (a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the
industry. It sets the price and rest of the firms simply accepts this price.
(b) (b) Barometric price leadership, i.e., the price leadership of an old, experienced and the largest firm
assumes the role of a leader, but undertakes also to protect the interest of all firms instead of promoting
its own interests as in the case of price leadership of a dominant firm.
(c) (c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by
following aggressive price leadership. It compels other firms to follow it and accept the price fixed by
it. In case the other firms show any independence, this firm threatens them and coerces them to follow
its leadership.
Price Determination under Price Leadership: There are various models concerning price-output
determination under price leadership on the basis of certain assumptions regarding the behaviour of the price
leader and his followers. In the following case, there are few assumptions for determining price-output level
under price leadership:
(a) (a) There are only two firms A and B and firm A has a lower cost of production than the firm B.
(b) (b) The product is homogenous or identical so that the customers are indifferent as between the firms.
(c) (c) Both A and B have equal share in the market, i.e., they are facing the same demand curve which
will be the half of the total demand curve.
Y D MCb
Price &
Cost
K
P
MCa
L F
E D
MR
O N M X
Quantity
In the above diagram, MCa is the marginal cost curve of firm A and MCb is the marginal cost curve of firm B.
Since we have assumed that the firm A has a lower cost of production than the firm B, therefore, the MCa is
drawn below MCb.
Now let us take the firm A first, firm A will be maximising its profit by selling OM level of output at price MP,
because at output OM the firm A will be in equilibrium as its marginal cost is equal to marginal revenue at point
E. Whereas the firm B will be in equilibrium at point F, selling ON level of output at price NK, which is higher
than the price MP. Two firms have to charge the same price in order to survive in the industry. Therefore, the
firm B has to accept and follow the price set by firm A. This shows that firm A is the price leader and firm B is
the follower.
Since the demand curve faced by both firms is the same, therefore, the firm B will produce OM level of output
instead of ON. Since the marginal cost of firm B is greater than the marginal cost of firm A, therefore, the
profit earned by firm B will be lesser than the profit earned by firm A.
Difficulties of Price Leadership: The following are the challenges faced by a price leader:
(a) (a) It is difficult for a price leader to correctly assess the reactions of his followers.
(b) (b) The rival firms may secretly charge lower prices when they find that the leader charged unduly high
prices. Such price cutting devices are rebates, favourable credit terms, money back guarantees, after
delivery free services, easy instalment sales, etc.
(c) (c) The rivals may indulge in non-price competition. Such non-price competition devices are heavy
advertisement and sales promotion.
(d) (d) The high price set by the price leader may also attract new entrants into the industry and these new
entrants may not accept his leadership.
50
D
MR
0 2 (Q’) 4 6 8 X
Output
The Economic Waste cause by the Monopolist
In the above diagram, DD curve represents the consumers’ marginal utility at each level of output, while the
MC curve represents the opportunity cost of the devoting production to this good rather than to other industries.
For example, at Q = 3, the vertical difference between B and A represents the utility that would be gained from
a small increase to the output of Q. Adding up all the lost social utility from Q = 3 to Q = 6 gives the shaded
region ABE.
INTERVENTION STRATEGIES:
According to a Nobel Prize winner Milton Friedman, basically there are three choices – private unregulated
monopoly, private monopoly regulated by the government, or the government operation. In most market
economies of the world, the monopolists are regulated by the State. There are several methods and tools for
controlling the power misuse by monopolistic and oligopolistic firms:
1. Anti-trust Policy: Anti-trust policies are laws that prohibit certain kinds of behaviour (such as firm’s
joining together to fix prices) or curb certain market structures (such as pure monopolies and highly
concentrated oligopolies).
2. Encouraging Competition: Most generally, anticompetitive abuses can be avoided by encouraging
competition whenever possible. There are many government policies that can promote vigorous rivalry
even among large firms. In particular, it is crucial to keep the barriers to entry low.
3. Economic Regulations: Economic regulation allows specialised regulatory agencies to oversee the
prices, outputs, entry, and exit of firms in regulated industries such as public utilities and transportation.
Unlike antitrust policies, which tell businesses what not to do, regulation tells businesses what to do and
how to do.
4. Government Ownership of Monopolies: Government ownership of monopolies has been an approach
widely used. In recent years, many governments have privatised industries that were in former times
public enterprises, and encouraged other firms to enter for competition.
5. Price Control: Price control on most goods and services has been used in wartime, partly as a way of
containing inflation, partly as a way of keeping down prices in concentrated industries.
6. Taxes: Taxes have sometimes been used to alleviate the income-distribution effects. By taxing
monopolies, a government can reduce monopoly profits, thereby softening some of the socially
unacceptable effects of monopoly.
Game Theory
GAME THEORY AND OLIGOPOLY BEHAVIOUR:
Game theory analyses the way that two or more players or parties choose actions or strategies that jointly affect
each participant. In other words, game theory determines rational behaviour of players whose interests are
mutually dependent on one another’s decision. Its objective is to find mathematically complete principles
which define rational behaviour for the participants in a social economy, or to derive from them the general
characteristics of that behaviour. The theory was developed by John von Neumann (1903-1957), who was a
Hungarian born mathematician.
By game we mean any situation in which the interests of the participants conflict. While taking decision each
party must consider what probably will be the decision of the other so that he may make a choice most
profitable to himself. This what usually happens in a game of chess or cards. This is applicable to situations
arising in an oligopoly.
There are two common games, i.e., constant-sum game and zero-sum game:
• Constant-Sum Game: is the game in which the participants take share of the total gain.
• Zero-Sum Game: is the game in which the winnings of one are matched exactly by the losses of the
other.
In the following example, the dynamics of price-cutting will be analysed, so lets the game begin! Suppose
there are two rival firms in an industry, viz., Berney & Max:
Y
Max’s
Berney’s
Price matching
Max’
s
O Berney’s Price X
In the above diagram, the vertical arrows show Max’s price cuts; the horizontal arrows show Berney’s
responding strategy of matching each price cut. By tracing through the pattern of reaction and counter-reaction,
you can see that this kind of rivalry will end in mutual ruin at a zero price. Because the only price compatible
with both strategies is a price of zero; 90 percent of zero is zero. If one party cut the price, the other party will
match the price cuts, and it will continue until the price of zero is attained. Now the Berney will start ‘what-if’
analysis. What Max will do if Berney charge price A, price B, and so forth. The novel element in the duopoly
game is that the firm’s profits will depend on the rival’s strategy as well as on its own.
The useful tool for representing the interaction between two players is a two-way ‘payoff table’. A payoff table
is a means of showing the strategies and the payoffs of a game between two players. In the payoff table, a firm
can choose between the strategies listed in its rows or columns. For example, Max can choose between its two
columns and Berney can choose between its two rows. In this example, each firm decides whether to charge its
Max’s Price
normal price or to start a price war by choosing a low price:
The above payoff table shows the price war game between Berney and Max. The amounts in rupees inside the
cells show the payoffs of the two firms; that is, these are the profits earned by each firm for each of the four
outcomes. The lower left amount shows the payoff to the player on the left, i.e., Berney; the upper right shows
the payoff to the player at the top, i.e., Max. Just like Max, Berney has two choices, i.e., either to opt for
normal price or go for a price war. In cell C, the Berney plays normal price and Max plays price war. The
result is that Berney has a profit of – Rs. 100 while Max has a profit of – Rs. 10. Thinking through the best
strategies for each player leads to the dominant equilibrium in cell A, where both the players avoid price war.
Dominant Strategy: The simplest strategy in game theory is ‘dominant strategy’. This situation arises when
one player has a best strategy no matter what strategy the other player follows. The firm’s best price strategy is
to follow normal price. In the above case, charging the normal price is a dominant strategy for both firms in the
‘price-war game’. When both or all players have a dominant strategy, the outcome is said to be ‘dominant
equilibrium’ because each player is having its own dominant strategy.
Nash Equilibrium: This theory presented by a mathematician John Nash. Nash equilibrium applies to the
situation when all the participants in a game are each pursuing their best possible strategy in the knowledge of
the strategies of all other participants. For example, imagine a two-person country where both the people have
to decide the side of the road on which to drive. The payoffs are as follows:
(i) No crash: happens when both drive on the left or right. It is Nash equilibrium. There are two possible Nash
equilibria, i.e., either both driving on the left, or both driving on the right.
(ii) Crash: happens when one drives on the left and the other drives on the right. If one drives on the left and
the other drives on right, it is not Nash equilibrium because, given the choice of the other, each would change
their own policy.
Now take our previous example of Bernie and Max. Suppose each firm considers whether to have its normal
price or to raise its price toward the monopoly price and try to earn monopoly profits. It is a rivalry game,
which is shown in the following diagram:
Max’s Price
Normal – Rs. 20
Price *
In the above game, it is shown that the firms can stay at their normal price equilibrium that we found in the
price-war game, or they can try to raise their price to earn some monopoly profits.
Cell A: Each firm follows high price strategy and both firms have the highest joint profit of Rs. 300. It is the
situation where both the firms behave like a monopolist for having high prices.
Cell D: Each firm follows normal price strategy and both firms have the lowest joint profit of Rs. 20. It is the
situation of normal price equilibrium that we found in the price-war game.
Cell C: Max follows a high price strategy but Burney undercuts. So Burney takes most of the market and has
the highest profit of any situation, while Max actually loses money.
Cell B: Berney gambles on high price, but Max’s normal price means a loss for Berney.
Conclusion: In the above example of the rivalry game, Berney has a dominant strategy; it will profit more by
choosing a normal price no matter what Max does. On the other hand, Max does not have a dominant strategy
because Max would want to play normal if Berney plays normal and would want to play high if Berney plays
high. In the above game, the best policy for Max is to play normal price. This situation illustrates the basic
rule of basing your strategy on the assumptions that your opponent will act in his or her best interest. This is
Nash equilibrium. Nash equilibrium is one in which no player can improve his or her payoff given the other
player’s strategy. The Nash equilibrium is also sometimes called ‘non-cooperative equilibrium’, because each
party chooses its strategy without collusion or cooperation, choosing that strategy which is best for itself,
without regard for the welfare of society or any other party.
The Pollution Game: In many circumstances, non-cooperative behaviour leads to economic inefficiency or
social misery. One notable example is the arms race, where non-cooperative behaviour between the United
States and the (former) Soviet Union, and Pakistan and India led to massive military spending and development
of weapons of mass destruction, makes the continents unsafe. Another example of pollution game is shown in
payoff table as follows:
US Steel
High – Rs. 30
Pollution *
In the above diagram, an example of two steel manufacturing concerns, namely, US Steel and Oxy Steel,
operating in the United States is taken. In this world of unregulated firms, each individual profit-maximising
firm would prefer to pollute the earth’s environment rather than install expensive pollution-control equipment.
In such a world, if a firm behaves altruistically and cleans up its wastes, that firm will have higher production
costs, higher prices, and fewer customers. If the costs are high enough, the firm may even go bankrupt. This is
a situation in which the Nash equilibrium is inefficient. When markets or decentralised equilibria become
dangerously inefficient, governments may step in. By setting efficient regulations or emissions charges,
government can induce firms to move to outcome A, the Low pollute/Low pollute world. In that equilibrium,
the firms make the same profit as in the high-pollution world, and the earth is a healthier place to live in.
Monetary-Fiscal Game: The game theory is also important to understanding a nation’s economic policies.
Economists and politicians have argued that monetary policy and fiscal policy are skewed in an undesirable
direction; fiscal deficits are too high and reduce national saving, while monetary policy produces interest rates
that retard investments. It is customary in a modern economy to separate monetary and fiscal functions. A
country’s central bank determines the monetary policy – interest rates, and the fiscal policy – taxes and
spending – is determined by the executive and legislative branches. But the monetary and fiscal authorities
have different objectives. The central bank takes a stance that emphasises austerity and low inflation. The
fiscal authorities worry about full employment, popularity, keeping taxes low, preserving spending programs,
and getting re-elected. Thus they pick high deficits. The central bank wants minimise the inflation and chooses
high interest rates. Thus the outcome is the non-cooperative equilibrium between fiscal authorities and
monetary policy makers at cell C:
Fiscal Policy
Perhaps the best strategy of monetary fiscal game is to lower the deficits, lower interest rates and raise
investment, which was adopted by President Bill Clinton for the survival of US economy