PRINCIPLES OF

MICROECONOMICS II
GE PAPER FOR ALL COURSES EXCEPT B.A. (HONS.) ECONOMICS
GE- ECONOMICS
SEMESTER-III
GENERIC ELECTIVE (GE)

DEPARTMENT OF DISTANCE AND CONTINUING EDUCATION

UNIVERSITY OF DELHI
Principles of Microeconomics II

Editors
Prof. J. Khuntia, Devender, Sarabjeet Kaur

Content Writer
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Tanu Singh, Dyuti Agrawal
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Prof. J. Khuntia, Devender

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ISBN: 978-81-19417-59-9
Ist edition: 2023
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economics@col.du.ac.in

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Principles of Microeconomics II

SYLLABUS
Principles of Microeconomics II

Syllabus Mapping

Unit I: Market Structures

Theory of a Monopoly Firm: Concept of imperfect competition; short run and Lesson 1: Monopoly
long run price and output decisions of a monopoly firm; concept of a supply (Pages 3-20);
curve under monopoly; comparison of perfect competition and monopoly, Lesson 2: Some Applications
social cost of monopoly, price discrimination; remedies for monopoly: of Monopoly
Antitrust laws, natural monopoly mperfect Competition: Monopolistic (Pages 23-38);
competition: Assumptions, SR and LR price and output determinations under Lesson 3: Monopolistic
monopolistic competition, economic efficiency and resource allocation; Competition
oligopoly: assumptions, oligopoly models, game theory, contestable markets, (Pages 39-50);
role of government. Lesson 4: Oligopoly
(Pages 51-64);
Lesson 5: Collusive Oligopoly
(Pages 65-81)

Unit II: Consumer and Producer Theory

Consumer and Producer Theory in Action: Externalities, marginal cost Lesson 6: Consumer and
pricing, internalising externalities, public goods; imperfect information: Producer Theory in Action
adverse selection, moral hazard, social choice, government inefficiency. (Pages 85-102);
Markets and Market Failure: Market adjustment to changes in demand, Lesson 7: Market Failure
efficiency of perfect competition; sources of market failure: imperfect (Pages 103-119)
markets, public goods, externalities, imperfect information; evaluating the
market mechanism.

Unit III: Income Distribution and Factor Pricing

Input markets: demand for inputs; labour markets, land markets, profit Lesson 8: Market for Factor
maximisation condition in input markets, input demand curves, distribution Inputs Demand and Supply
of Income. of Factors
(Pages 123-143);
Lesson 9: Factor Pricing
(Pages 145-164)

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 Principles of Microeconomics II

Unit IV: International Trade

Absolute advantage, comparative advantage, terms of trade, sources of Lesson 10: International Trade
comparative advantage, trade barriers, free trade/ protectionism. and Absolute Advantage
(Pages 167-186);
Lesson 11: Comparative
Advantage and Terms of Trade
(Pages 187-212);
Lesson 12: Trade Barriers and
the Debate between Free Trade
and Protectionism
(Pages 213-230)

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Principles of Microeconomics II

CONTENTS

UNIT I: MARKET STRUCTURES

LESSON 1 MONOPOLY 3–20

1.1 Introduction
1.2 Learning Objectives
1.3 Meaning and Kinds of Monopoly
1.4 Absence of Supply Curve in Monopoly
1.5 Learning Outcome
1.6 Self Assessment Questions
1.7 Recommended Readings
LESSON 2 SOME APPLICATIONS OF MONOPOLY 23–38

2.1 Learning Objectives

2.2 Introduction
2.3 Social Costs / Allocative Inefficiency of Monopoly
2.4 Comparison of Perfect Competition with Monopoly
2.5 Price Discrimination
2.6 Natural Monopoly
2.7 Antitrust Laws
2.8 Learning Outcome
2.9 Self Assessment Questions

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 Principles of Microeconomics II

LESSON 3 MONOPOLISTIC COMPETITION 39–50

3.1 Introduction
3.2 Learning Objectives
3.3 Features of Monopolistic Competition
3.4 Average and Marginal Revenue Curves under Monopolistic Competition
3.5 Equilibrium of A Firm Under Monopolistic Competition
3.6 Excess Capacity under Monopolistic Competition
3.7 Perfect vs Monopolistic Competition: A Comparison
3.8 Learning Outcomes
3.9 Recommended Readings

LESSON 4 OLIGOPOLY 51–64

4.1 Learning Objectives

4.2 Introduction
4.3 Features of Oligopoly
4.4 Behaviour of Oligopoly Firms
4.5 Equilibrium in Oligopoly
4.6 Models of Non-Collusive Oligopoly
4.7 Summary
4.8 Self Assessment Questions
4.9 Recommended Readings

LESSON 5 COLLUSIVE OLIGOPOLY 65–81

5.1 Objective
5.2 Introduction
5.3 Models of Collusive Oligopoly

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Principles of Microeconomics II

5.4 Prisoner’s Dilemma

5.5 Self Assessment Questions
5.6 Game Theory: Example
5.7 Ligopoly and the Functioning of The Economy
5.8 Contestable Markets and Potential Entry
5.9 Learning Outcome
5.10 Terminal Questions

UNIT II: CONSUMER AND

PRODUCER THEORY
LESSON 6 CONSUMER AND PRODUCER THEORY IN ACTION 85–102

6.1 Learning Objectives

6.2 Cost Changes
6.3 Comparative Statics
6.4 Changes in Input Prices
6.5 Changes in Technology
6.6 Effects of Taxation on Competitive Industry
6.7 Learning Outcome
6.8 Terminal Questions
LESSON 7 MARKET FAILURE 103–119

7.1 Learning Objective

7.2 Introduction
7.3 Allocative Efficiency under Perfect Competition
7.4 Market Failure
7.5 Externalities

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 Principles of Microeconomics II

7.6 Public Goods

7.7 Self Assessment Questions
7.8 Functions of Government
7.9 Public Policy Towards Monopoly and Competition
7.10 Learning Outcome
7.11 Terminal Questions

UNIT III: INCOME DISTRIBUTION AND

FACTOR PRICING
LESSON 8 MARKET FOR FACTOR INPUTS DEMAND AND
SUPPLY OF FACTORS 123–143

8.1 Introduction
8.2 The Demand for Factors
8.3 Supply of Factors
8.4 Learning Outcome
8.5 Terminal Questions

LESSON 9 FACTOR PRICING 145–164

9.1 Learning Objectives

9.2 Introduction
9.3 Marginal Productivity Theory
9.4 Self Assessment Questions
9.5 Economic Rent
9.6 Self Assessment Questions
9.7 Learning Outcome
9.8 Terminal Questions

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Principles of Microeconomics II

UNIT IV: INTERNATIONAL TRADE

LESSON 10 INTERNATIONAL TRADE AND
ABSOLUTE ADVANTAGE 167–186

10.1 Introduction
10.2 Learning Objectives
10.3 What is trade?
10.4 Why do people trade?
10.5 Theory of Absolute Advantage
10.6 Glossary
10.7 Answer to In-Text Questions
10.8 Learning outcomes
10.9 Terminal Questions
10.10 Solutions to Terminal Questions

LESSON 11 COMPARATIVE ADVANTAGE AND TERMS OF TRADE 187–212

11.1 Introduction
11.2 Learning Objectives
11.3 Theory of Comparative Advantage
11.4 Sources of Comparative Advantage
11.5 Terms of Trade (TOT)
11.6 Types of Terms of Trade
11.7 Glossary
11.8 Answer to In-Text Questions

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 Principles of Microeconomics II

11.9 Learning Outcomes

11.10 Terminal Questions
11.11 Solutions to Terminal Questions

LESSON 12 TRADE BARRIERS AND THE DEBATE

BETWEEN FREE TRADE AND PROTECTIONISM 213–230

12.1 Introduction
12.2 Learning Objectives
12.3 Trade Barriers
12.4 Types of Trade Barriers
12.5 Free Trade versus Protectionism
12.6 Glossary
12.7 Answer to In-Text Questions
12.8 Learning Outcomes
12.9 Terminal Questions
12.10 Solutions to Terminal Questions
12.11 Recommended Readings

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UNIT I: MARKET STRUCTURES

LESSON 1 MONOPOLY
LESSON 2 SOME APPLICATIONS OF MONOPOLY
LESSON 3 MONOPOLISTIC COMPETITION
LESSON 4 OLIGOPOLY
LESSON 5 COLLUSIVE OLIGOPOLY
Monopoly

LESSON 1 NOTES

MONOPOLY
Prof. J. Khuntia
Professor
School of Open Learning
University of Delhi

Structure
1.1 Introduction
1.2 Learning Objectives
1.3 Meaning and Kinds of Monopoly
1.4 Absence of Supply Curve in Monopoly
1.5 Learning Outcome
1.6 Self Assessment Questions
1.7 Recommended Readings

1.1 INTRODUCTION

Perfect competition, as discussed earlier, represents an extreme market situation

wherein firms do not have any control over price determination. Besides this,
free entry and exit of firms, perfect knowledge about market conditions, perfect
mobility of factors and no government intervention make the competitive market
efficient and welfare maximizing. Perfect competition implies a complete absence
of monopoly power. But there could be another extreme market situation wherein
there is a complete absence of competition which is called monopoly.

1.2 LEARNING OBJECTIVES

• To understand the concept of monopoly

• To differentiate between different kinds of monopolies
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• To analyze the equilibrium of a monopolist firm Material 3

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 Principles of Microeconomics II

NOTES • To comprehend the relationship between price and quantity supplied

• To explain and analyze the monopoly power

1.3 MEANING AND KINDS OF MONOPOLY

Monopoly has been derived from the combination of words ‘Mono + Polein’
where ‘mono’ means single and ‘polein’ means to sell. So, monopoly can be
defined as a market structure where there is a single seller selling a product for
which there is no close substitute available and there are barriers to enter the
market. Presence of a single firm shows that there is no difference between a
firm and an industry.
Features of Monopoly: The definition of monopoly mentioned above
reveals the following characteristics of a monopolist:
1. Single Seller – In a monopoly there is just one seller of a product or
service, so there is no difference between the firm and industry. The
demand curve facing the monopolist is thus the market demand curve.
The monopolist thus fixes the price and quantity where it maximizes its
profits. However, out of the two variables that are price and quantity,
a monopolist can fix either of the variables. If it fixes the price, the
quantity is determined by the market and if it fixes the quantity to be
sold then the price is determined by the market.
2. No close Substitutes – For a monopolist to retain its position in the
long run, it is essential that the firm sells a unique product which cannot
be substituted by any other product or service.
3. No Entry – A monopolist usually earns supernormal profits in the long
run as there is no entry of the new firms in the industry. So, the profit
earned by the monopolist is not wiped out as in the case of perfect
competition where presence of supernormal profits attracts new firms
in the industry.

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Monopoly

4. Goal of Profit Maximization – The goal of a monopolist firm is to NOTES

maximize the profits. How it maximizes the profits would be discussed
under the next heading.
5. Absence of Supply Curve – In perfect competition there is a one to
one relation between price and quantity supplied. Such relation is absent
in case of a monopoly as the quantity supplied is dependent upon the
elasticity of the demand curve and shape of the marginal cost. Thus, the
same quantity can be supplied at two different prices or two different
quantities can be supplied at the same price showing that there is no
supply curve in monopoly.
Demand Curve under Monopoly
In case of a monopoly, the firm itself is the industry which means it is both the
price maker as well as price taker unlike perfect competition where industry
sets the price and all the firms are just the price takers having no freedom of
setting or changing the price. The market demand curve in case of a monopoly
is therefore the demand curve that the monopolist firm faces whereas in perfect
competition the demand curve of the firm is a straight line parallel to X axis as
given in Figure 1.1.

Diagram 1: Demand Curves under Perfect Competition and Monopoly

Fig. 1.1 Demand curves under perfect competition and monopoly

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 Principles of Microeconomics II

NOTES Total Revenue, Average Revenue and Marginal Revenue Under Monopoly
Take an imaginary revenue schedule of the monopolist as represented in Table 1.1.
Table 1.1 An imaginary revenue schedule of the monopolist

Price or Average Quantity Total Revenue Marginal

Revenue (AR) (TR) Revenue
(MR)
100 1 100 –
90 2 180 80
80 3 240 60
70 4 280 40
60 5 300 20
50 6 300 0
40 7 280 – 20
30 8 240 – 40
20 9 180 – 60
10 10 100 – 80

This schedule shows the relation between price or average revenue and
quantity in case of monopoly. It shows that as price falls quantity demanded
increases, ceteris paribus. Total revenue thus first increases, reaches its maximum
and then starts falling but it is always non-zero and positive. Average Revenue
(AR) and Marginal Revenue (MR) are falling. AR remains higher than MR as
quantity of output increases. MR is positive as long as total revenue (TR) is
increasing, when TR reaches the maximum, MR becomes zero and when TR
starts falling in absolute terms, MR becomes negative. The shapes of the TR, AR
and MR curves should be understood prior to deriving the equilibrium. Figure
1.2 is based on the values of TR, AR and MR given in Table 1.1.

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Monopoly

NOTES

Fig. 1.2 TR, AR and MR curves under Monopoly

Based on the above discussion we can say that:

i. Both AR and MR curves start from the same point on the price
(vertical) axis.
ii. Both the curves are downward sloping.
iii. Slope of MR is twice the slope of AR.
The relation between MR, AR and Elasticity of demand is mentioned in
the results given below (Figure 1.2):
i. If demand curve has unit elasticity i.e. Ed = 1, MR = 0
ii. If demand curve is relatively elastic i.e. Ed > 1, MR = Positive
iii. If demand curve is relatively inelastic i.e. Ed < 1, MR = Negative

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NOTES Equilibrium under Monopoly

The objective of a monopolist is to maximize profits. There are two approaches
to maximize profits, as given below:
1) Total Approach
2) Marginal Approach

TOTAL (REVENUE and COST) APPROACH

A monopolist earns maximum profits when the gap between Total Revenue (TR)
and Total Cost (TC) is Maximum. The condition is depicted in the Figure 1.3.
Here, TR curve starts from the origin as there is no revenue since the output is
zero and TR is inverse ‘U’ shaped because of inverse relation between price and
quantity. TC is inverse ‘S’ shaped because of Law of Variable Proportion. Total
profits are derived by subtracting TC from TR. Initially TC being greater than
TR, the firm is incurring losses. Points ‘A’ and ‘B’ are the breakeven points as
here the firm has neither the profits nor the losses. Profit is maximum where the
gap between TR and TC is the highest and it is the equilibrium quantity.

Fig. 1.3 Maximum profit condition for a monopolist

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Monopoly

MARGINAL APPROACH NOTES

As per marginal approach there can be three cases of equilibrium that a monopolist
faces depending upon the relation between per unit revenue and per unit cost. The
two conditions that need to be satisfied to attain the equilibrium are as follows:
(1) MR = MC
(2) MC cuts MR from below or Slope of MR < Slope of MC at the point of
equilibrium
Equilibrium of a monopolist can be derived under two time periods:
• Short Run – It is a time period where there are certain costs that are fixed
in nature along with the variable costs and entry or exit of the firms is not
possible. Here a monopolist can have supernormal profits; normal profits
and can even incur losses.
• Long run – It is a time period where all costs become variable and entry or
exit of firms is also possible. Here a monopolist usually gets supernormal
profits.
Equilibrium in the Short Run
In the short run, a monopolist may earn supernormal or abnormal profit or
normal profit or even incur loss depending on the position of short run average
cost curve.
Case 1: Supernormal Profit
Figure 1.4 shows downward sloping Average revenue (AR) and Marginal revenue
(MR) curves. Short run average cost curve (SAC) and Short run marginal cost
curves (SMC) are also shown. Equilibrium is at point E where both the conditions
of MR = MC and MC cutting MR from below are being satisfied. Equilibrium
quantity is OQ* that monopolist would sell at a price of OP*. Total profits can
thus be calculated as follows:
TP = TR – TC
= (Price * Quantity) – (Average Cost * Quantity)
= (OP*) * (OQ*) – (BQ*) * (OQ*) = OP*CQ* – OABQ* = AP*CB =
Supernormal Profits Self-Instructional
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 Principles of Microeconomics II

NOTES

Fig. 1.4 Supernormal Profit

Hence, condition for supernormal profits is that Price or AR > SAC.

Case 2: Normal Profit
In Figure 1.5, equilibrium is at point E where both the conditions of MR = MC
and MC cutting MR from below are being satisfied. Equilibrium quantity is OQ*
that monopolist would sell at a price of OP*. See that in this case the SAC curve
is tangent to AR curve at point B implying that both AR and SAC are equal to
BQ* = OP*. Total profits can thus be calculated as follows:
TP = TR – TC
= (Price * Quantity) – (Average Cost * Quantity)
= (OP*) * (OQ*) – (BQ*) * (OQ*) = OP*BQ* – OP*BQ* = Zero =
Normal Profits

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Monopoly

NOTES

Fig. 1.5

Hence, condition for Normal profits is given as Price or AR = SAC.

Case 3: Loss

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Fig. 1.6 Material 11

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 Principles of Microeconomics II

NOTES In Figure 1.6, equilibrium is at point E where both the conditions of MR =

MC and MC cutting MR from below are being satisfied. Equilibrium quantity is
OQ* that monopolist would sell at a price of OP*. However, in this case the SAC
curve is positioned above the AR curve, thus implying that, SAC = CQ* which
is more than AR = BQ* or OP*. Total profits or losses can thus be calculated
as follows:
TP = TR – TC
= (Price * Quantity) – (Average Cost * Quantity)
= (OP*) * (OQ*) – (CQ*) * (OQ*) = OP*BQ* – OACQ* = – P*ACB =
Loss.
Hence, condition for loss is given as Price or AR < SAC
A monopolist can continue to operate despite having losses as there is a chance
of earning profits in the long run if the monopoly power is strong.
(2) Equilibrium in the Long Run
In the long run, a monopolist can bring changes in the level of output by changing
any and/or all factors of production as there are no fixed factors in the long run.
Here usually a monopolist earns supernormal profits because of the barrier to
entry of new firms. The equilibrium is attained where long run marginal cost
curve (LMC) is equal to marginal revenue (MR) and LMC cuts MR from below.
It is shown in Figure 1.7. Figure 1.7 shows downward sloping Average revenue
(AR) and Marginal revenue (MR) curves. Long run average cost curve (LAC)
and Long run marginal cost curves (LMC) are also shown. Equilibrium is at point
E where both the conditions of MR = LMC and LMC cutting MR from below
are being satisfied. Equilibrium quantity is OQ* that monopolist would sell at a
price of OP*. Total profits can thus be calculated as follows:
TP = TR – TC = (Price * Quantity) – (Average Cost * Quantity)
= (OP*) * (OQ*) – (BQ*) * (OQ*) = OP*CQ* – OABQ* = AP*CB =
Supernormal Profits

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Monopoly

NOTES

Fig. 1.7

1.4 ABSENCE OF SUPPLY CURVE IN MONOPOLY

In perfect competition the supply curve of a firm is the segment of marginal cost
curve above the minimum point of short run average variable cost curve. This
is because of the reason that the marginal revenue or the price curve is constant
(parallel to x axis) and hence it is only the marginal cost curve that is required
for determining the quantity that would be sold by a perfectly competitive firm
at a particular price. Thus, it shows that there is one to one relation between price
and quantity supplied in case of perfect competition as the firm is only the price
taker as the price is set by the industry. This is however not the case in monopoly.
A monopolist firm has no supply curve as there is no one to one relation between
price and quantity supplied due to the fact that here demand curve is not constant
but is downward sloping. So, the quantity supplied at different prices depend upon
the shape of the demand curve (elasticity) and marginal cost curve as equilibrium
is obtained by the intersection of marginal revenue and marginal cost curve. It
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NOTES can be shown by shifting the demand curves that two different quantities can be
supplied at the same price and the same quantity can be supplied at two different
prices depending upon the elasticity of the demand curve.
Case 1: Same quantity being supplied at two different prices – It
is shown in Figure 1.8. Here, initially demand curve is shown by AR and
corresponding marginal curve is MR. Equilibrium takes place at the intersection
of MC and MR, and it is obtained at point E where the monopolist is selling OQ*
units of commodity at a price of OP per unit. Now if the demand curve shifts to
AR1 with corresponding marginal revenue curve being MR1, the new equilibrium
is at the same point ‘E’ where monopolist is selling the same number of units that
is OQ* but at a reduced price of OP1 as the new demand curve is relatively more
elastic. Thus, it shows how change in the elasticity can force the monopolist to
sell the same quantity at different prices.

Fig. 1.8

Case 2: Two different quantities can be sold at same price – See Figure
Self-Instructional 1.9, where the initial demand curve is AR and corresponding marginal revenue
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Monopoly

curve is MR. Equilibrium is at a point where MR and MC intersect that is point E NOTES
showing that monopolist is selling OQ units of commodity at a price of OP* per
unit. Now if the demand curve shifts to AR1 with corresponding marginal revenue
curve being MR1, then equilibrium shifts to E1 where monopolist is selling a
higher quantity but at the same price of OP*. Thus, it shows how monopolist
cannot obtain any one to one relation between price and quantity supplied as here
the demand curve is downward sloping and its elasticity and shape of marginal
cost curve both have an impact on the equilibrium.

Fig. 1.9

Degree of Monopoly Power

Monopoly is a condition with only one seller having no close substitutes which
gives monopolist the freedom to set the price. However, such pure monopoly
rarely exists and what we have is the situation where several firms compete
with one another. In perfect competition, each firm earns only normal profits
in the long run because in the short run if there is any supernormal profit, new
firms enter the market till all the excess profit is wiped out and all firms set their
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NOTES equilibrium quantity at a point where marginal revenue is equal to marginal cost.
As in perfect competition the price is constant, it is equal to marginal revenue
and hence the equilibrium is:
Price = MR = MC
But in case of monopoly demand curve is downward sloping, therefore P
> MR and equilibrium condition being MR = MC, we get a difference between
price and MC as P > MC. This gap between price and MC shows the extent of
monopoly power that a firm possesses.
Abba Lerner, an economist, gave an index in 1934 to measure this
monopoly power and it is called Lerner’s Index of Monopoly Power.
L = (P–MC) / P = – 1/ Ed where 0 ≤ L < 1
The more is the elasticity of the demand curve the lesser is the monopoly
power and the lesser is the elasticity of the demand curve the more is the
monopoly power.
For perfect competition as P = MC; L = 0, there being no monopoly power.
The closer the value of L to 1, the higher is the monopoly power.

1.5 LEARNING OUTCOME

Monopoly is a market structure characterized by a single seller where the firm

itself is the industry. Monopolist firm thus faces a demand curve that is downward
sloping and equal to the market demand curve giving it the freedom to determine
its equilibrium. This however does not mean that the monopolist can charge
any price and sell any quantity that it desires. Out of the two variables (price
and quantity), it can set only one variable and the other is given by the market
depending upon the shape of the demand and cost curves. Equilibrium is where
the marginal revenue and marginal cost curves intersect. If a monopolist sells
an output less than this, then marginal revenue being greater than marginal cost
it loses profits and if it sets a quantity more than this, then MR being less than
MC, the monopolist incurs losses. Thus the equilibrium takes place where MR
Self-Instructional becomes equal to MC as this is the situation where profits are maximum. Unlike
16 Material perfect competition there is no supply curve of a monopolist firm, because there

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Monopoly

is no one to one relation between price and quantity supplied. A monopolist can NOTES
sell two different quantities at the same price or same quantity at two different
prices depending upon the elasticity of the demand curves.

1.6 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. In case of perfect competition there is no monopoly power.
2. Firms can easily enter in a monopoly market structure.
3. A monopoly firm always earns supernormal profits even in the short run.
4. A monopolist can determine the price at which it sells the commodity as
well as the number of units it wants to sell.
5. The objective of a monopolist is to maximize profits.
6. The higher is the elasticity of demand curve the more is the monopoly
power
7. There is no supply curve in case of monopoly
Ans. 1(T), 2(F), 3(F), 4(F), 5(T), 6(F), 7(T)
Exercise 2: Fill in the Blanks
1. Lerner’s Index is a tool to measure ……………….
2. In case of perfect competition, the gap between price and marginal cost is
……………….
3. A monopolist firm is the price ……………….
4. There is ………………. of supply curve in case of monopoly
Ans 1. Monopoly Power 2. Zero 3. Maker as well as taker 4. Absence
Exercise 3: Questions
1. Using shifting demand curves show that there is no supply curve in case
of monopoly.
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NOTES 3. How does a monopolist firm reach its equilibrium in the short run?
4. Explain the relation between Average revenue, Marginal revenue and
Elasticity of demand.
Mathematical Proof (Optional)
1. Relation between Total Revenue (TR), Average Revenue (AR) and
Marginal Revenue (MR) under Monopoly
Let demand function of a monopolist is given by
P = a – bQ .... (1)
Where P = Price, Q = Quantity, a = intercept and b = slope of the demand
curve.
Now Total Revenue (TR) = P*Q, substituting Equation (1) in TR, we get:
TR = (a – bQ) * Q = aQ – bQ2
AR = TR / Q = (aQ – bQ2)/Q = a – bQ = Price .... (2)
MR = ∂TR/∂Q = ∂ (aQ – bQ2)/ /∂Q = a – 2bQ .... (3)
Comparing AR and MR, i.e., equation (2) and (3) we get the following
results:
AR = a – bQ
MR = a – 2bQ
a. Intercept of both AR and MR is same = a, so both the curves start from
the same point on the Y axis.
b. Both have a negative sign in between showing that both the curves are
downward sloping.
c. Slope of AR is ‘b’ and MR is ‘2b’, so slope of MR is twice the slope
of AR.
2. Relation between AR, MR and Elasticity of Demand in case of a Monopoly
Total Revenue, TR = Price *Quantity = P*Q
Average Revenue, AR = TR/Q = P*Q)/Q = P
Marginal Revenue, MR = ΔTR/ΔQ = Δ (P*Q)/ΔQ = P (ΔQ/ ΔQ) +
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Monopoly

MR = P + Q (ΔP/ ΔQ) NOTES

Multiplying and dividing above by P we get following
MR = P + Q/P (ΔP/ ΔQ)*P .... (1)

Also, Ed = , (– ) 1/ Ed =
Substituting the value of Ed in Equation (1) we get
MR = P + P*[(– ) 1/ Ed], MR = P [1 – 1/ Ed ], MR = AR [1 – 1/ Ed ]
Above result shows relation between MR, AR and Elasticity of demand
in the below given results (Figure 1.1):
(a) If demand curve has unit elasticity i.e. Ed = 1, MR = 0
(b) If demand curve is relatively elastic i.e. Ed > 1, MR = Positive
(c) If demand curve is relatively inelastic i.e. Ed < 1, MR = Negative
3. Equilibrium Conditions
The objective of a monopolist is to earn profits and profits are maximized when
the following conditions are satisfied:
Total Profit (TP) = Total Revenue (TR) – Total Cost (TC)
To maximize profits the gap between total revenue and total cost should
be maximized, i.e., first differentiation is equated to zero
∂TP/ ∂Q = ∂TR/∂Q – ∂TC/∂Q = 0
= MR – MC = 0,
MR = MC .... 1st order condition
∂2TP/ ∂Q2 = ∂2TR/∂Q2 – ∂2TC/∂Q2 < 0
Slope of MR < Slope of MC .... 2nd order condition
4. Rule of Thumb Pricing for Monopoly Power
As shown above the equilibrium of a monopolist is at a point where marginal
revenue and marginal cost curves intersect but it is not always feasible for the
monopolist to trace the marginal revenue and marginal cost curves for all the
levels of output. Because of limited knowledge it is preferable to use a rule of
thumb for pricing as derived below. Self-Instructional
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NOTES MR = ∆TR/∆Q = ∆(P*Q)/ ∆Q. Using Product rule, we get:

MR = P + Q(∆P/∆Q). Multiplying and dividing the second part by P we get:
MR = P + (Q/P) (∆P/∆Q) * P .... (1)
Ed = (∆Q/∆P) * (P/Q) or 1/ Ed = (Q/P) (∆P/∆Q) substituting this in Equation
(1)
MR = P + (1/ Ed ) * P, MR = P (1 + 1/ Ed ) .... (2)
Equilibrium condition is that MR = MC, substituting this in Equation (2)
MC = P (1 + 1/ Ed ) or P = MC / (1 + 1/ Ed ) or (P – MC)/P = – 1/ Ed
This is the rule of thumb for pricing. From this we can also move to the
concept of Monopoly Power.

1.7 RECOMMENDED READINGS

• Mankiw, N. G. (2018). Principles of Microeconomics 8th ed.

• Bernheim, B., Whinston, M. (2009). Microeconomics. Tata McGraw-Hill.

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Some Applications of Monopoly

LESSON 2 NOTES

SOME APPLICATIONS OF MONOPOLY

Prof. J. Khuntia
Professor
School of Open Learning
University of Delhi

Structure
2.1 Learning Objectives
2.2 Introduction
2.3 Social Costs / Allocative Inefficiency of Monopoly
2.4 Comparison of Perfect Competition with Monopoly
2.5 Price Discrimination
2.6 Natural Monopoly
2.7 Antitrust Laws
2.8 Learning Outcome
2.9 Self Assessment Questions

2.1 LEARNING OBJECTIVES

• To understand the concept of integration of firms

• To differentiate between perfect competition and monopoly
• To analyse different types of price discrimination
• To explain the concept of deadweight loss

2.2 INTRODUCTION

A monopolist derives its monopoly power because of the barriers to entry

that prohibit new firms to enter the market. If the barriers are not there then
monopoly situation cannot exist for long. The barriers can be natural barriers
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NOTES (raw material availability), economic barriers (economies of scale, cost advantage
or technological superiority) or legal barriers (patents, copyrights, trademarks).
Depending upon the monopoly power that a firm possesses, monopolist can
even go for price discrimination where it charges different prices from different
consumers for the same product. A pure monopoly situation can reduce the
consumer surplus (benefit of the society) to a great extent and hence it is
usually undesirable unless it is controlled by the state for welfare of the society
at large or it is a natural monopoly (where it is more efficient to let it serve the
entire market rather than to have several firms). This lesson discusses about the
difference between perfect competition and monopoly, the costs that society has
to bear because of monopoly and various types of price discrimination that a
monopolist can exercise.

2.3 SOCIAL COSTS / ALLOCATIVE INEFFICIENCY

OF MONOPOLY

In case of perfect competition, a firm sells a product at a point where Price (P) is
equal to marginal cost (MC) and there being no cost to the society. A monopolist
however sells at a price that is greater than its marginal cost as shown in Figure 2.1.
Demand curve of a perfectly competitive industry is downward sloping and supply
curve obtained from summation of the marginal cost curves is upward sloping.
Equilibrium of the industry is where demand is equal to supply, it gives OQpc,
i.e., quantity at OPpc price. If it would have been a monopoly then equilibrium
would be at a point where marginal revenue and marginal cost are equal which
is given by point A in the Figure 2.1, monopolist is selling OQm quantity at a
price of OPm. It can be seen that a monopolist sells lesser quantity as compared
to perfect competition and that too at a higher price. This leads to the cost that
society has to bear and termed as allocative inefficiency of monopoly market.

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NOTES

Fig. 2.1

There are two costs that arise because of monopoly:

1. Dead Weight Loss
2. Rent Seeking
Dead Weight Loss: It is net loss to the society that includes both producers
and consumers. To understand the concept of dead weight loss we need to explain
consumer surplus and producer surplus and see how these changes because of
monopoly power.
Consumer Surplus – The difference between the price that consumer
is willing to pay and what he actually pays is known as consumer surplus.
Graphically it can be located as the difference between the demand curve and
the equilibrium price
Producer Surplus – The difference between the price that producer actually
gets and the price at which he is willing and able to sell is called producer surplus.
Graphically it can be located as the difference between the equilibrium price and
the marginal cost (supply) curve. Self-Instructional
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NOTES To see how there is a change in the consumer and producer surplus on
conversion of a perfectly competitive industry to monopoly assuming the same
demand and cost conditions we make use of Figure 2.2.
Table 2.1

Consumer Surplus Producer Surplus

Perfect Competition
A+B+C+D+E F+G+H
(Before)
Monopoly
A+B C+D+F+G
(After)
Change (After – Before) –C–D–E C+D–H

Net Change = – C – D – E + C + D – H = – H – E = Dead weight loss

Fig. 2.2

Initially we assume that there is a perfect competition in the market. Here

demand curve AR and supply curve are given by Mc, equilibrium is where
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Some Applications of Monopoly

is Qpc and price is Ppc. Here, the consumer surplus and producer surplus are NOTES
given in Table 2.1. Now if all the firms under perfectly competitive industry are
undertaken by a monopolist assuming that demand and cost conditions remain
same, the equilibrium is obtained by the intersection of MR and MC which
is at Em giving equilibrium quantity as Qm and price as Pm. It can be seen that
Monopolist is selling a lesser quantity and that too at a higher price. The new
consumer surplus and producer surplus are shown in the Table 2.1. To find out
whether consumers or producers are at loss or gain, we calculate the change in
consumer and producer surplus. It is seen that consumer surplus has reduced by
C + D + E, the reduction of C + D is because of a higher price that consumers
now have to pay while reduction in E is because of reduction in the quantity
as now few consumers have to do without the commodity. Producer surplus on
the other hand has increased by C + D but reduced by H. The increase of C +
D is because of higher price that producers get now; it is actually just a transfer
from consumers to producers (a zero sum game) and the loss in H is because of
reduction in quantity that producers sell now. To find out whether society as a
whole is at gain or loss, we add the change in consumer and producer surplus
and find out that society at large is at a loss of H+E, this being the dead weight
loss or cost to the society because of monopoly.

2.4 COMPARISON OF PERFECT COMPETITION

WITH MONOPOLY

The following points discuss the comparison of perfect competition with

monopoly.
1. Number of Sellers: Pure competition has many buyers and sellers whereas
there is just one seller in the monopoly.
2. Substitute Products: In Pure competition all firms sell identical
(homogeneous) products unlike monopoly where there are no close
substitutes available.

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NOTES 3. Entry and Exit of Firms: Pure competition provides free entry and exit to
the firms though it is possible only in the long run while monopoly prevents
entry of any new firm to the industry.
4. Profits in the Long run: In perfect competition firms earn normal profits
in the long run while monopolist usually has supernormal profits because
of barriers to entry and exit.
5. Demand curve of the firm: The firm in a perfect competition firm has no
control over the price as it is the industry which fixes the price, the demand
curve therefore is a straight line parallel to X axis at the price given by the
industry. But in the case of monopoly there is only one firm and there is
no difference between the firm and the industry and market demand curve
which is downward sloping is the demand curve of the firm itself.
6. Social cost: A perfectly competitive industry sets its equilibrium at a point
where demand and supply are equal; hence there is no cost to the society.
Monopolist sets a price according to MR = MC where P > MC which
brings cost to the society.
7. Price Discrimination: A perfectly competitive industry cannot discriminate
on the basis of price whereas a monopolist can follow price discrimination.
8. Supply curve of the firm: A perfectly competitive firm has one to one
relation between price and quantity supplied which is shown by the supply
curve which is the segment of marginal cost over and above the minimum
point of short run average variable cost curve. However, there is no supply
curve in case of monopoly as same quantity can be sold at two different
prices or two different quantities can be sold at the same price depending
upon the shape of demand curve and marginal cost curve.
9. Price and output comparison: Perfectly competitive firm sells a larger
output and that too at a lesser price as compared to a monopolist that sells
less and at a higher price as shown in Figure 2.3.

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NOTES

Fig. 2.3

2.5 PRICE DISCRIMINATION

Price discrimination refers to charging different price from different consumers

for the same product. This is done by the monopolist to capture the consumer
surplus that is there with the consumers as shown in Figure 2.4.

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NOTES

Fig. 2.4

A single price monopolist would maximize its profits by setting the

equilibrium where MR=MC such that it sells OQm quantity at a price of OPm.
Here the consumer surplus is APmB. Now if the monopolist wants to earn even
higher profits then it can go for price discrimination such that it can charge
different prices from different consumers like it can charge higher price P1 from
consumers who are willing to pay more and charge lower price P2 and P3 from
the consumers who cannot afford Pm. This way the monopolist can earn even
higher profits.
Pigou has described three degrees of price discrimination on the basis of
how much consumer surplus the monopolist can take away from the consumers.
1. First Degree Price Discrimination
2. Second Degree Price Discrimination
3. Third Degree Price Discrimination

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First Degree Price Discrimination: There are two types of first-degree NOTES
price discrimination:
Case 1: The monopolist charges each consumer the maximum price that
he is willing to give – known as the reservation price thereby taking away all
the consumer surplus of the consumers. The demand curve here itself becomes
the marginal revenue curve. Impact of first-degree price discrimination is shown
in Figure 2.5.

Fig. 2.5

A single price monopolist charges OPm and sells OQm units of the commodity
by equating marginal revenue with the marginal cost. The consumer surplus here
is shown by the area APmB. Now if the monopolist goes for price discrimination,
then he would charge the maximum price that a consumer is willing to give
which is shown by the demand curve. Thus, here MR curve becomes irrelevant
as demand curve itself is the MR curve for the discriminating monopolist. The
consumer surplus is reduced to zero as whatever price the consumer is willing

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NOTES to give is charged by the monopolist. This is the highest form of discrimination
as nothing is left for the consumers as surplus. To see how the monopolist
is benefited by the price discrimination, we calculate incremental (variable)
profits before and after the discrimination. Variable profits are calculated as the
difference between Marginal revenue and marginal cost as it is the incremental
profit and not the total profits.
Incremental profit before price discrimination is shown by the area of
triangle ACEm.
Incremental profit after price discrimination is shown by the area of triangle
ACEpd.
Thus, increase in the incremental profit = ACEpd – ACEm = Area of triangle
AEmEpd. It is shown by the shaded area in the Figure 2.5.
However, there is a limitation of perfect first-degree price discrimination,
i.e., it is very difficult if not impossible to find out the reservation price for each
and every consumer. This type of price discrimination is thus not found in real
life, what we have is imperfect first-degree price discrimination.
Case 2: In case 1 as discussed above, the monopolist charges different price
from each consumer depending on how much he is willing to pay. There is an
alternative method as well. The monopolist can also charge a few different prices
based on the reservation prices of different groups of consumers. So here, there
are certain ranges for different consumers which a monopolist can still identify.
For example, a doctor can charge different fees depending upon the locality he
is operating in. It is being explained in Figure 2.6.

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NOTES

Fig. 2.6

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

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NOTES pricing is also an example of second-degree price discrimination where prices

are different for different blocks (Figure 2.7).
With a single price to be followed a monopolist would set its output at OQm
at a price of OPm. However, with price discrimination on the basis of quantity
being purchased by the consumers there are three sets of prices that is P1, Pm and
P2 for Q1, Qm and Q2 quantities respectively. Here cost curves are not U shaped
but downward sloping as it is the case of a natural monopoly. Thus, the last block
is at a point where demand is equal to average cost and not where demand is
equal to marginal cost as at the latter point firm would be incurring losses. Here
also consumers are left with consumer surplus and all of it is not taken away by
the monopolist as the price that the consumers have to pay is less than what they
are willing to pay which is shown by the demand curve.

Fig. 2.7

Third Degree Price Discrimination: A discrimination that charges

different prices from different subgroups of the market for the same product with
different elasticities thereby charging a higher price in the subgroup that has lower
elasticity and charging lower price in the subgroup that has higher elasticity. It
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is the most common type of price discrimination. For the firm to successfully NOTES
follow third degree price discrimination, following conditions should be satisfied:
1. Firm is a monopolist.
2. The whole market is divided into sub-markets/subgroups. Let us assume
that there are two sub-markets/sub-groups.
3. Price elasticity of demand is different in the different sub-markets.
4. Sub-markets should be kept separate, i.e., it should not be possible for
the consumers to shift themselves from one submarket to the other.
5. It should not be possible to transfer goods from one sub-market to
the other otherwise arbitrage opportunities would eliminate the price
differential thereby making price discrimination infeasible.
Third degree price discrimination is explained with the help of Figure 2.8
wherein the total market of the monopolist is divided into two sub-markets. In
sub-market 1 as shown in Panel 1 of the figure 2.8, AR1 is the demand curve
which is inelastic and hence it is steeper showing that this sub-market is not that
responsive towards prices. MR1 is the corresponding marginal revenue curve. In
sub-market 2 as shown in Panel 2 of the same figure, AR2 is the demand curve that
has greater price elasticity and is therefore flatter showing higher responsiveness
of the group towards price changes. MR2 is the corresponding marginal revenue
curve. The demand curves for the total market of the monopolist are derived by
adding up the demand curves of these two sub-markets. Panel 3 of the figure
shows the total AR and MR curves as AR1+2 and MR1+2 respectively where AR1+2
= AR1 + AR2 and MR1+2 = MR1 +MR2.

Determining Equilibrium Condition

The conditions for equilibrium are given below:

1. MR1+2 = MR1 = MR2 = MC and
2. MC cuts MR1+2 from below
Total Profits (Π) of the monopolist =

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NOTES Total Revenue from first sub-market + Total Revenue from second sub-
market – Total cost
Π = TR1 + TR2 – TC
As per the marginal conditions stated above, first determine the equilibrium
point at E0 where MR1+2 = MC as shown in Panel 3 of the figure 2.8. The rate of
total quantity to be produced by the monopolist is given as Q0 which corresponds
to point E0. The price for this rate of output should have been P0 as per standard
practice of price setting by a monopolist which is done on the AR1+2 curve.
However, under price discrimination, the monopolist does not charge P0 price nor
does it sell Q0 quantity. Instead the monopolist divides the total market quantity
in two sub-markets by following the condition MR1+2 = MR1 = MR2 = MC.
Diagrammatically, this is done by drawing a horizontal line through the point
E0 such that the said line cuts MR1 at point E1 in sub-market 1 and MR2 at point
E2 in sub-market 2. Accordingly, in sub-market 1, rate of quantity corresponding
to equilibrium point E1 will be Q1 and price on its inelastic AR1 curve will be set
at P1. Similarly, in sub-market 2, rate of quantity corresponding to equilibrium
point E2 will be Q2 and price on its relatively elastic AR2 curve will be set at P2.
See that Q0 = Q1 + Q2. It can also be verified that P1 and P2 are not equal; rather
P1 > P2 showing that a relatively elastic demand curve commands a lower price
as compared to relatively inelastic one. So, for the same good the monopolist is
charging two different prices in two different sub-markets which conforms to
price discrimination which is mainly made possible due to different elasticities
of demand in these two sub-markets.

Determining Relative Prices

In Lesson 1, we proved a relation between Average Revenue (AR), Marginal

Revenue (MR) and Elasticity of demand as:
MR = P (1 + 1/ Ed)
Using above equation for the two subgroups with different marginal
revenue curves and different elasticities, we get:
MR1 = P1 (1 + 1/ Ed1) ………………………………. (1)
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In the equilibrium MR1 = MR2, thus equating equations (1) and (2) we get: NOTES
MR1 = MR2
P1 (1 + 1/ Ed1) = P2 (1 + 1/ Ed2 )
P1/ P2 = (1 + 1/ Ed2)/ (1 + 1/ Ed1) ………………………. (3)
From Equation (3) there can be two cases:
(a) If Ed1 = Ed2, then P1 = P2
(b) Ed1 │ < │Ed2│, P1 > P2

Fig. 2.8

2.6 NATURAL MONOPOLY

Natural Monopoly occurs in case of Public utilities like Electricity, water supply,
telephone services, etc., where initial cost of the Plant remains higher but after
that cost starts falling and output increases. That’s why under Natural Monopoly
Average Cost and Marginal Cost Curves are downward sloping and MC is always
lower (below) Average Cost. When there are no regulations imposed on Natural
Monopoly then they will Produce Qm quantity and sell at Pm price. But if Natural
Monopoly is regulated then the firm’s Price go down to the competitive market
level Pc and quantity increases by Qc. At the Price of Pc firm would not cover
average cost and firm will shut down or go out from business. So, the ideal option
is to set the price Pn where AC, and AR intersect each other. Here firms are not Self-Instructional
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NOTES getting anormal monopoly profit but will produce large quantity of output Qn
and without driving the firm out of business.

Fig. 2.9

2.7 ANTITRUST LAWS

Antitrust laws reduce market power and promote competition in market as we

know that monopoly power creates social cost due to inefficient allocation of
resources. Antitrust laws vary from nation to nation. But the action of these
laws is generally to promote competitiveness in the business world and restrict
Monopoly Power and to give (provide) protection to the consumers. Antitrust
laws prohibit those actions which create monopoly or restrict competition.
Sherman Act, passed in 1890, prohibits contracts, combinations, or
conspiracies in restraint of trade.
The Clayton Act (1914) prohibits mergers and acquisitions which create
monopoly power.
The antitrust laws also limit possible anticompetitive behaviour of the firm.
Federal Trade commission Act (1914, amended in 1938, 1973, 1995)
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puts restrictions on unfair trade practices, and anti-competitive practices such NOTES
as fraudulent advertising and labelling, agreements with retailers to exclude
competing brands, and so on. Because these prohibitions are interpreted and
enforced in administrative proceedings before the FTC, the act provides broad
powers that reach further than those of other antitrust laws.

2.8 LEARNING OUTCOME

Monopoly is a market structure characterized by a single seller possessing

monopoly power that it can exploit to take away the surplus from the consumers.
Since the producer is gaining at the cost of consumers, there is a social cost which
is known as Deadweight loss of monopoly power due to which total surplus in
the market is not maximized as compared to the same under perfect competition.
The practice of capturing consumer surplus is studied under price
discrimination that includes first degree price discrimination which is not that
common as it involves knowledge of reservation price of the customers that is
not easy to know. It is the worst form of discrimination as it takes away the entire
surplus from the consumers. Then there is second degree price discrimination
which is suitable in case of natural monopoly where different prices are
charged for different blocks of commodities. There is also third-degree price
discrimination which is the most common form of discrimination that divides
the whole market into subgroups with different elasticities such that each group
is homogeneous amongst itself.
Since, monopoly is not desirable for the society, the government has created
Anti-trust laws to regulate such a market so that consumers can get the product
at competitive price.
Natural monopoly is a market where size of the plant is bigger than size
of the market. Here, the average cost is so high that regulating such a monopoly
will create loss and drive it away from the market. Public utility services such
as electricity generation and supply, etc., come under this category. Hence, such
enterprises are normally owned by government.
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NOTES
2.9 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. In monopoly there is no dead weight loss.
2. Second degree price discrimination is applicable in case of Natural
monopoly.
3. There is no loss to the producer surplus in conversion of perfect competition
to monopoly.
4. Perfect First degree price discrimination is the most common form of
discrimination by the monopolist.
5. In third degree price discrimination elasticity of two sub markets should
be different.
6. Peak load pricing and inter temporal pricing are one and the same thing.
Ans. 1(F), 2(T), 3(F), 4(F), 5(T), 6(F)
Exercise 2: Fill in the Blanks
1. Perfect first degree price discrimination uses ...……….. to differentiate
between different types of consumers.
2. The net loss to the society because of monopoly is called ...………..
3. A simple monopoly charges ...……….. price for its product from all
consumers.
4. Producer surplus is the difference between equilibrium price and ...………..
Ans 1. Reservation Price 2. Deadweight loss 3. Same 4. Marginal cost curve
Exercise 3: Questions
1. Explain the differences between perfect competition and monopoly.
2. Explain third degree price discrimination. When is it successful?
3. What is the cost that society has to bear because of monopoly?
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Monopolistic Competition

LESSON 3 NOTES

MONOPOLISTIC COMPETITION
Prof. J. Khuntia
Professor
School of Open Learning
University of Delhi

Structure
3.1 Introduction
3.2 Learning Objectives
3.3 Features of Monopolistic Competition
3.4 Average and Marginal Revenue Curves under Monopolistic Competition
3.5 Equilibrium of A Firm Under Monopolistic Competition
3.6 Excess Capacity under Monopolistic Competition
3.7 Perfect vs Monopolistic Competition: A Comparison
3.8 Learning Outcomes
3.9 Recommended Readings

3.1 INTRODUCTION

Perfect competition and monopoly are far removed from the real world market
situations. These two extremes are only theoretical constructs made to simplify
analysis. Competition and monopoly are matters of degree rather than of
monopoly and competition in different degrees. Price taking (i.e., complete
absence of individual influence on the market price) and full freedom of entry and
exit of capital from the industry are the two basic features of perfect competition.
The conditions necessary to ensure the above-mentioned features have already
been explained in sufficient detail. Whenever, one or more of the conditions
necessary for perfect competition are violated, competition becomes imperfect.
For example, the number of buyers and sellers may not be very large and as
a result an individual buyer or seller may be able to exercise some “influence
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NOTES purchases. Number of producers may be small due to a variety of reasons such
as economies of scale, initial cost disadvantage, difficulties in mobilizing the
required quantum of capital, and so on. Secondly, the products of different sellers
may not be identical in the eyes of the buyers (i.e., there may be real or imaginary
differences between the products of different producer). Thirdly, buyers may not
have perfect knowledge about the price offers of different producers. Or they
may be aware of the price offers of different sellers but because of transport costs
involved due to the locations of different sellers or simply because of inertia or
irrational preferences), they may be reluctant to shift their purchases from one
seller to another. Finally, quite apart from inertia ignorance, customers have a
number of good reasons for preferring one seller to another. Different customers
are affected differently by factors such as the guarantee of quality provided by a
well-known name or brand, difference in facilities provided by different sellers’
quickness of service, good manners of salesmen, length of credit, attention paid
to individual wants, advertisement, etc. Thus, there can be several reasons for
imperfection of competition.

3.2 LEARNING OBJECTIVES

• To explain the features of monopolistic competition

• To differentiate between perfect competition, monopoly and monopolistic
competition
• To explain the slope of AR and MR curves under monopolistic competition
• To understand the existence of normal profit in the long run under
monopolistic competition
• To find out the inefficiency of monopolistic market
• To measure excess capacity of firm under monopolistic competition

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NOTES
3.3 FEATURES OF MONOPOLISTIC COMPETITION

Let us discuss the features of monopolistic competition.

1. There are large number of buyers and sellers in the market.
2. Product Differentiation and Close Substitutes: Unlike perfect competition,
the firms under monopolistic competition sell differentiated products
which are close substitutes of each other. Close substitute products are
those products whose uses, production technology and respective prices
are almost similar. However, these products can be different in terms of
presentation, style, packaging, colour and branding, etc. For example, take
the product toothpaste. There are several varieties of toothpastes available
in the market whose use is same. The prices and production technologies
are also not very different. However, two different toothpastes differ in
terms of style, taste, colour and branding.
3. Selling Cost: Firms under monopolistic competition incur selling cost
besides production cost in the form of advertising, dealership or for
adoption of other marketing strategies. The aim is to create an edge over
other firms in the market with respect to profit making, having larger market
share, etc.
Both product differentiation and selling cost give a particular firm some
degree of monopoly power in the market to compete with other firms,
hence the name monopolistic competition.
4. There is free entry and exit from the market.
5. Price and Non-price competition: Firms under monopolistic competition
are seen to be indulging in both Price and Non-price competition. Price
competition takes the form of price cutting or offering discounts while
non-price competition can take the form of attracting customers by offering
gifts, buy one get one offers, giving more of free quantity, etc.
6. There is lack of perfect knowledge about cost of product, demand and
other market conditions.
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NOTES 7. There is absence of perfect mobility of factors in the market due to lack
of perfect knowledge.

3.4 AVERAGE AND MARGINAL REVENUE CURVES

UNDER MONOPOLISTIC COMPETITION

The essential feature of imperfect competition is that an individual producer

exercises some control over the market price of his product but this control is
not as much as under monopoly. In other words, the elasticity of demand for the
product of an individual producer at any price is higher compared to the elasticity
of market demand. The entry and exit of firms into and out of the industry is
assumed to be free under imperfect competition, but because of various reasons
explained earlier the number of firms cannot be large enough to eliminate
completely an individual firm’s control over price. Thus, as under monopoly,
under imperfect competition also the AR curve of firm will be downward sloping
and the MR curve will lie below it. However, compared to a monopolist’s AR and
MR curves, the AR and MR curves of a firm under imperfect competition will
slope downwards less steeply for the simple reason that by lowering its price the
firm can always attract some customers from its rivals, whereas, by definition, a
monopolist has no rival sellers at all. Freedom of entry and exit of firms under
imperfect competition implies that in the long run price of the product will equal
average cost and the firms in the industry will earn only normal profits, i.e., normal
earnings of management already included in average (total) cost as an element
of fixed costs. The AR and MR curves of a firm under imperfect competition
are shown in Figure 3.1.
In the Figure 3.1, the AR curve shows the different quantities that can be
sold in the market at different prices. The MR curve on the other hand shows
the additional revenue that the firm gets by selling an additional unit of the
commodity. Due to product differentiation and close substitute products, the
AR and MR curves are price elastic or flatter under monopolistic competition
as against the inelastic demands seen under monopoly (Figure 3.1).

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NOTES

Fig. 3.1

In-Text Questions
Choose the right answer.
A. Demand curves under monopolistic competition are Elastic/Inelastic.
B. Monopolistic competition is identified with close substitutes / no
substitutes.

3.5 EQUILIBRIUM OF A FIRM UNDER

MONOPOLISTIC COMPETITION

Monopoly and perfect competition are two extreme market forms. As pointed out
earlier, pure monopoly and perfect competition do not represent the real world
market situations. Real world market situations are characterized by a blend
of monopoly and competition in different degrees. Like monopoly, imperfect
competition also is typically characterized by a downward sloping AR curve.
The corresponding MR curve lies below the AR curve.
We have the same set of cost curves whatever the market situation.

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NOTES Short Run Equilibrium

Given the cost and revenue curves, equilibrium requires the satisfaction of the
same condition, that is:
(1) MC = MR
(2) MO > MR beyond the point of their equality
Figures 3.2 and 3.3 below depict two possible short-run equilibrium
positions of a firm under imperfect competition.

          Fig. 3.2 Fig. 3.3

In the Figures 3.2 and 3.3, the intersection of MC and MR curves

determines the firm’s equilibrium at point R. Figure 3.2 depicts an equilibrium
position in which the firm is earning abnormal profits equal to the area of the
rectangle PEBC because price OP = (QC) is higher than average cost (=QB).
Figure 3.3, on the other hand depict an equilibrium position in which the firm
is incurring losses equal to the area of the rectangle PEBC because price OP
(=QC) falls short of the average cost (= QB) by BC. BC represents the loss per
unit. Price being greater than the average variable cost provides justification for
continuing production in this case. Equilibrium with abnormal profits or losses
are possible in short-run situations.
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Long Run Equilibrium NOTES

Unlike monopoly freedom of entry and exit of firms from the industry is the
distinguishing feature of imperfect competition. Therefore, equilibrium positions
with abnormal profits or losses are sustainable only in the short run but not in
the long run. If the firms in the industry are earning abnormal profits and if this
situation is expected to persist in the long run, this will attract new firms into
the industry. As more firms enter the industry, the given market demand for the
product will be shared by a larger number of firms so that each will have a smaller
share of the market demand. As a result, at any given price an individual firm will
be able to sell less than before. In other words, as a result of the influx of new
firms into the industry, each firm’s AR curve (i.e., the demand curve) will shift
leftward. This process will continue so long as there are any abnormal profits to
be earned in the industry. Ultimately the firm’s AR curve becomes tangential to
the U-shaped average cost curve at some point on its falling portion. When AR
curve becomes tangential to the average cost curve, price equals cost and thus,
abnormal profits are completely wiped out. Figure 3.4 shows how, because of
the influx of new firms into the industry firm’s AR curve is pushed leftward and
ultimately becomes tangential to the average cost curve.
Figure 3.2 depicts a possible short run equilibrium position in which the
firm is earning abnormal profits equal to the area of the rectangle PECB. Because
of the influx of new firms into the industry, the firm’s AR curve is pushed leftward
and ultimately (as shown in Figure 3.4) becomes tangential to the average cost
curve at B. At B price average cost and the firm earns only normal profits. When
firms in the industry earn only normal profits, there is no incentive left for new
firms to enter into the industry.

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NOTES

Fig. 3.4

On the other hand, if firms in the industry are incurring losses, and when
this situation is expected to persist in the long run, firms start leaving the industry
for better prospects elsewhere. With the exit of some of the firms from the
industry, the given market demand for the product comes to be shared by fewer
firms and their AR curves shift rightward. The process of the exit of firms from
the industry and the resulting rightward shift of the AR and MR curves continues
till the AR curves ultimately becomes tangential to the U-shaped average cost
curves on their falling portions. When AR curve becomes tangential to the average
cost curve and a firm earns only normal profits, it is said to be in its long run
equilibrium. When all firms in the industry earn only normal profits, there is no
incentive for firms to leave the industry and the number of firms neither tends
to increase nor tends to decrease. When this situation takes place, the industry
is said to be in its long run equilibrium.

3.6 EXCESS CAPACITY UNDER MONOPOLISTIC

COMPETITION

We saw that the firms under both perfect as well as imperfect competitions
earn normal profits in the long run by selling at a price equal to the long run
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competition equals minimum of LAC where output is larger, the price under NOTES
imperfect competition is determined at a point where LAC is still falling. This
means that the LAC is not minimized under imperfect competition at equilibrium.
Minimization of LAC is called productive efficiency. So, by not minimizing
LAC and producing on the falling portion of LAC the imperfectly competitive
firm produces less than competitive output by not utilizing its plant capacity.
So imperfectly competitive firm is productive inefficient while competitive firm
is productive efficient. This is also referred to as excess capacity of imperfect
competition which is measured as the difference between output produced at the
minimum point of LAC, i.e., competitive output and the output produced at some
point on the falling portion of LAC even though it corresponds to equilibrium
between MR and MC under imperfect competition.
Figure 3.5 shows the situation of excess capacity.
In the Figure 3.5, the long run average cost curve is shown as LAC. A
firm under imperfect competition produces at point A on LAC where LAC is
still falling and tangent to its demand curve ARM. The output of imperfectly
competitive firm is Q1. On the other hand, a competitive firm produces Q at the
0
minimum of LAC curve. The range AB on LAC curve showing the difference
in output as Q –Q is the measure of excess capacity.
0 1

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NOTES
3.7 PERFECT VS MONOPOLISTIC COMPETITION:
A COMPARISON

A horizontal AR/MR curve of an individual firm may be said to be the hallmark

of perfect competition. On the other hand, a downward sloping AR curve of an
individual firm characterizes all other market forms. The MR curve corresponding
to a downward sloping AR curve is also downward sloping and lies below the
former throughout. The differences in the equilibrium quantities (prices, output,
MC/price relationship, etc.) under perfect competition and under other market
forms arise because of the differences in the shapes of the AR and MR curves.
The differences are given briefly below:
(1) Equality of MC and MR determines the equilibrium of a firm under all
market conditions. However, under perfect competition, by definition, AR always
equals MR. By implications, therefore, MC = MR = AR (price) in equilibrium.
Thus, under perfect competition, price equals MC. On the other hand, under
imperfect competition, MR being always less than AR (price), price is necessarily
higher than MC as well as MR.
(2) Under perfect competition, a single price prevails in the market and
all firms equate their MCs with the market price. By implication, the MCs of
all firms in the industry are equal. Equality of MCs ensures efficiency in the
industry. However, under imperfect competition there is no single price ruling
in the market and the AR and MR curves of different firms differ in their shapes
and locations. Therefore, MCs of different firms are normally different. This is
said to be an indicator of inefficient use of resources.
(3) Under perfect competition as well as under imperfect competition,
long-run equilibrium of a firm requires (i) MC = MR and (ii) AC = AR. However,
under perfect competition, by virtue of the identity between AR and MR, in long
run equilibrium MC = MR (= AR) and AC = AR (=MR) necessarily implies that
MC = MR = AR = AC. Thus, in long run equilibrium under perfect competition
price (AR) equals MC as well as AC. MC equals AC only at the lowest point
of the AC curve, therefore, under perfect competition in long-run equilibrium
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price of a commodity equals its minimum average cost. (You may recall under NOTES
perfect competition in long run equilibrium the horizontal AR/MR curve becomes
tangential to the U-shaped AC curve necessarily at its lowest point).
Even though under imperfect competition (as under perfect competition)
long-run equilibrium requires MC = MR and AC = AR. By virtue of the MR
curve always lying below the AR curve, MC will necessarily be less than AC.
MC is less than AC when the latter is falling. This implies that under imperfect
competition long-run equilibrium will take place on the falling portion of the
AC curve, in other words, in long run equilibrium under imperfect competition
price will necessarily be higher than the minimum average cost.
(4) As explained above, under perfect competition long-run equilibrium
takes place necessarily at the lowest point on the AC curve whereas under
imperfect competition it takes place to the left of the lowest point on the AC
curves. From this, it follows that level of output under perfect competition will
be optimum while under imperfect competition it will be less than optimum. In
other words, under imperfect competition productive capacity is underutilized.

3.8 LEARNING OUTCOMES

In this lesson you have learned the following:

1. Monopolistic competition is a market structure wherein large number of
firms sell differentiated products which are close substitutes.
2. Due to above point, AR and MR curves are elastic or flatter in shape.
3. Firms incur selling cost in the form of advertising etc.
4. In the short run firms under monopolistic competition may earn normal or
abnormal profits, even loss. But in the long run there is normal profit.
5. There is existence of excess capacity under monopolistic competition as
firms operate on the falling portion of long run cost curve and do not utilize
full capacity as seen under perfect competition.

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NOTES Terminal Questions

1. What are the features of monopolistic competition? How are they different
from perfect competition?
2. Explain determination of short run and long run equilibrium of firm under
monopolistic competition.
3. Write a short note on excess capacity under monopolistic competition.

3.9 RECOMMENDED READINGS

• Mankiw, N. G. (2018). Principles of Microeconomics 8th ed.

• Bernheim, B., Whinston, M. (2009). Microeconomics. Tata McGraw-Hill.

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Oligopoly

LESSON 4 NOTES

OLIGOPOLY
Prof. J. Khuntia
Professor
School of Open Learning
University of Delhi

Structure
4.1 Learning Objectives
4.2 Introduction
4.3 Features of Oligopoly
4.4 Behaviour of Oligopoly Firms
4.5 Equilibrium in Oligopoly
4.6 Models of Non-Collusive Oligopoly
4.7 Summary
4.8 Self Assessment Questions
4.9 Recommended Readings

4.1 LEARNING OBJECTIVES

• To understand the concept of oligopoly

• To differentiate between different types of oligopoly
• To determine the nature of demand curve in case of oligopoly
• To comprehend various models of non-collusive and collusive oligopoly

4.2 INTRODUCTION

Monopoly and perfect competition are those types of market structures which
are at the two ends of a market continuum and do not really exist except in case
of monopolies that are owned and regulated by the state. The types of markets
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NOTES or oligopoly. While in monopolistic competition there are many firms selling
products that are differentiated but are close substitutes of each other and there
is no barrier to entry or exit, but in case of oligopoly there are few large firms
that sell products which can be homogeneous or differentiated and there are
strong barriers to entry and exit. Both monopolistic and oligopoly firms have
monopoly power that enables them to be the price makers unlike the firms in
perfect competition that are just the price takers. This lesson would talk about
oligopoly and its different types that are actually seen in the market along with
deriving equilibrium in case of collusive as well as non-collusive oligopolies.

4.3 FEATURES OF OLIGOPOLY

Oligopoly has been derived from Oligo + Polein, Oligo meaning few and polein
means to sell. Oligopoly can thus be defined as: “A market structure characterized
by few large sellers selling homogeneous or differentiated products, having strong
barriers to entry and exit and firms recognize their mutual interdependence.”
When oligopolist firms are selling homogeneous products, it is called pure
oligopoly and if they are selling differentiated products then it is called impure
oligopoly. In case there are just two sellers in the oligopolist market structure
then it is a special case called Duopoly.

Characteristics of Oligopoly

1. Few Large Sellers: Oligopoly consists of just few sellers that control the
whole market and hence the market share of each seller is quite large.
2. Homogeneous or Differentiated Products: Oligopoly can be pure
oligopoly where the sellers are selling homogeneous products like in the
case of LPG cylinders or it can be impure oligopoly where sellers are selling
differentiated products like in case of automobile industry. An important
point to note here is that differentiation can be real (where the composition
of the products is actually different) or perceived (where there is no actual
difference between the products, but consumers perceive it to be different
because of aggressive advertisement, etc.)
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3. Strong Barriers to Entry and Exit: New firms are not prohibited from NOTES
entering the market though there are strong barriers that hinder their entry,
it can be because of the cost advantage of the existing firms, economies
of scale that existing firms enjoy or huge capital requirements or any such
reason.
4. Interdependence: This is one of the most significant and distinguishing
features of oligopoly firms, that arises because of the fact that there are few
firms and share of each firm is quite significant, thus if any firm changes
its strategy with respect to price, promotion or any such variable it is
bound to impact the other firms and they would retaliate. Therefore, each
firm before bringing a change in any of its variables should consider the
possible reaction of the rival firms.
5. Advertisement: It is one of the instruments that the oligopoly firms
frequently use and it is one of the most powerful weapons that they can
use against the rivals. Instead of changing the prices often, firms go for
this as prices are usually rigid because of the fear that price changes can
lead to a price war.

4.4 BEHAVIOUR OF OLIGOPOLY FIRMS

There are instances of both co-operation and competition among firms under
oligopoly. They are explained below. There could be distinctive behavioural
pattern in the long run as well.

Co-operation: Types of co-operative behaviour

In order to avoid uncertainty arising out of interdependence and to avoid price

war and cutthroat competition, firms under oligopoly often enter into some
agreement about determining uniform price and output. The agreement can be
of the following two types.
Explicit Collusion: It is a situation when firms under oligopoly do formal
(explicit) agreement to determine uniform price and output and maximize their
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NOTES joint profit. Such agreements at international level is called Cartel, many such
agreements have taken place in the past. The best example of a cartel in the past
is that of OPEC - Oil Producing and Exporting Countries. Saudi Arabia and other
countries after 1973 formed a cartel. An individual firm always has incentive to
cheat. Possibility of cheating is larger if the number of firms is large. Cheating
by a small firm has negligible effect on the market price.
Tacit Co-operation: When firms co-operate without any explicit agreement
is called tacit co-operation. For example, if firm A produces one-half of monopoly
output hoping that firm B will do the same and firm B does so then they achieve
the co-operative equilibrium without any formal agreement.

Competition: Types of competitive behaviour

In the absence of formal or informal agreements about co-operation, firms under

oligopoly compete with each other. Competitive behaviour under oligopoly can
be of following types:
• Competition for market share: Firms under oligopoly always compete
with each other for market share. They use various forms of non-price
competition such as advertising, quality products, etc., to increase their
market share. For example in Delhi major mobile service providers like
Airtel, Vodafone and Reliance Jio compete for increasing their mobile
connections.
• Covert Cheating: In oligopoly, because of huge market share, firms sell
their products through contract. Large scale production and distribution is
done through contracts. When firms provide secret discounts and rebates
to their buyers to increase sales is called covert cheating.
• Very long-run competition: Under oligopoly, firms often change the
characteristics of their products. They keep innovating to improve the
quality of their products and try to capture majority of market share. It
can be possible only when a firm decides to compete for a long period.
Firms sometimes cut their prices in the short-run to capture market share,
it helps them to enjoy exclusive market power and profit in the long-run.

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Long-Run Behaviour: the Importance of Entry Barriers NOTES

In the long run, when oligopolistic firms earn abnormal profits by increasing
their prices over and above total average cost, new firms are attracted to this
industry. In such a situation, entry barriers become important for the existing
firms to sustain the abnormal profits. In the absence of natural oligopolists do
create barriers to restrict the new firms.
Some of the firm-created barriers are as follows:
(a) Brand Proliferation – It is a situation when the existing firms under
oligopoly produce multiple products with differentiated features
and capture major share in the market due to their brand image. For
example in the automobile industry all existing branded companies
produce various models of cars with different features. It becomes
difficult for a new firm to compete with the existing multi product
branded firms. New firms entering the market with single product can
fetch very share in the market. Through advertisement and innovative
marketing strategies consumers are made so brand savvy that they
do not want to buy non-branded (local) products. Branded products
are considered superior than the non-branded products.
(b) Set-up Costs – Oligopolistic firms can restrict entry of new firms
by imposing high fixed cost. This becomes possible in an industry
where sales are promoted by huge advertisement. Oligopolistic firms
spend a huge amount on advertisement to shift the demand in their
favour. New firms can not afford to spend such a huge amount in the
beginning with a little share in the market. Chances of loss always
keep the new firms away in such a situation.
(c) Predatory Pricing – It is a situation when the existing firms in
oligopolistic market cut their prices below costs when they expect
that new firms will enter the market. A new firm will not enter the
market if it expects losses after entry. New firms are often discouraged
by the existing firms through predatory pricing. This strategy may
be costly since the existing firms need to cut the price below the
average variable cost in the short run but it creates profit as well as
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NOTES
4.5 EQUILIBRIUM IN OLIGOPOLY

Equilibrium is a position of rest where there is no tendency to change on the part of

the firms. The price and quantity are determined in such a manner that the profits
are maximized, and it is set where the marginal revenue and marginal cost curves
intersect. However, in case of oligopoly the situation is not that easy because of
the fact that there is no one to one relation between price and quantity demanded
as when a firm changes its price because of the characteristic of interdependence,
the rival firms are bound to react but how they would react remains uncertain
and therefore how much would be the impact of their decision on the quantity
demanded of the firm that changed its price also remains uncertain. Thus, the
demand curve of an oligopolist firm is indeterminate which makes the equilibrium
determination a tedious task. To solve this problem various economists have given
models based on different set of assumptions that determine the equilibrium of
an oligopolist firm. It can be broadly divided into:
1. Non-Collusive Oligopoly
(a) Cournot Nash Equilibrium Model
(b) Stackelberg Model
(c) Sweezy’s Kinked Demand Curve Model
2. Collusive Oligopoly
(a) Cartels
(b) Price Leadership Models
First let us talk about the non-collusive oligopoly models.

4.6 MODELS OF NON-COLLUSIVE OLIGOPOLY

Cournot Model

The model was given by Augustin Cournot in 1838 based on only two firms that
were selling homogeneous products (spring water). It is based on the following
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1. It is a duopoly model, i.e., there are only two firms. NOTES

2. Firms do not recognize their interdependence or rivalry and act
independently.
3. The marginal cost of production of both the firms is zero, that is MC = 0.
4. Straight Linear demand curves.
5. Objective of the firms is profit maximization.
6. Both the firms decide simultaneously how much to produce.
7. Each firm treats the output level of its competitor as fixed when deciding
how much to produce. – Most important assumption of Cournot model
Based on these assumptions we can find out how both the firms decide
about their equilibrium. This model makes use of the reaction curves to find out
the simultaneous equilibrium of the firms under duopoly. In Figure 4.1, D is the
market demand curve that the two firms are facing and its corresponding marginal
revenue curve is MR. MC is the marginal cost that is a horizontal straight line
parallel to x axis showing that MC is constant. Now to find out the reaction
schedule of the two firms, we assume that Firm 2 is not producing anything, so
the entire market demand is the demand that firm 1 is facing. Firm 1 can produce
and sell 200 units, that is where market demand curve and supply curve given by
MC intersect each other but this would not be the profit maximizing output as
profits would be maximum when MR = MC which occurs if the firm is producing
and selling 100 units. Similarly, if we assume that firm 2 is producing and selling
100 units then the demand curve of the firm 1 becomes D1 as maximum market
demand that it can cater now is 100 units the remaining 100 is already taken by
firm 2. The corresponding marginal revenue curve is MR1 and profit maximizing
output is 50 units. If Firm 2 is producing and selling 150 units then firm can
sell maximum of 50 units (200– 150) and so its demand curve now is D2 with
corresponding marginal revenue curve being MR2. Profit maximizing output is
25 units where MR2 intersects MC. Thus, the above situation can be plotted in
the form of a graph and reaction schedule as shown in Figure 4.1and Table 4.1,
respectively.

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NOTES

Fig. 4.1

Table 4.1 Reaction Schedule of Firm 1

Assumed Output of Firm 2 Profit Maximizing Output of Firm 1

0 100
100 50
150 25
200 0

Similarly, we can have the reaction schedule for Firm 2 and when the
reaction schedules are plotted on a graph, we will get the reaction curves. The
point of intersection of the two reaction curves is the Cournot Equilibrium
determining the output of the two firms as is shown in Figure 4.2.

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NOTES

Fig. 4.2

Limitations of the Cournot Model:

1. The basic and most important assumption that both the firms of the
model set their output independently is quite unrealistic.
2. The firms compete only on the basis of quantity as they keep the
variable price outside the competition but how long this can continue
is questionable.
3. The length of the adjustment process that is how much time the firms
would take to reach the final equilibrium has not been discussed
anywhere in the model.

STACKELBERG MODEL – FIRST MOVER ADVANTAGE

Cournot model assumed that both the firms set their output simultaneously
however Stackelberg model assumes that the firms do not take their decision

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NOTES simultaneously. There are two firms in this model where one sets its output first
and then the second firm enters. This model is based on the following assumptions:
1. Duopoly model– Two firms A and B
2. Straight linear demand curves
3. There is zero marginal cost for both the firms.
4. One firm is the leader that sets its output first and the second is the follower
who is behaving as per Cournot assumption (assumes that the leader
would keep its output constant). A firm can act as the leader because of its
knowledge, experience or sophistication.
5. There is no collusion between the firms, both the firms act independently.
6. Both the firms are selling homogeneous products.
The model is thus an attempt to find answer to two questions:
1. Is it advantageous to enter the market first?
2. How much output would each firm produce?
Cournot vs Stackelberg: A question now arises is that out of the two
models both of which belong to non-collusive oligopoly, which one is more
suitable. The answer depends on whether the industry comprises of the firms
that are similar, of equal size and none having a leadership position, Cournot
model is more suitable, whereas in an industry where one firm has a sophisticated
(leadership) position over the others, Stackelberg model should be preferred.
SWEEZY’S KINKED DEMAND MODEL
Paul Sweezy gave the kinked demand curve model in 1939 based on
the great Depression of US that showed that the prices in an oligopoly market
structure are sticky (rigid), firms here recognize their interdependence but act
without collusion. The model lays more emphasis on explaining the stickiness of
prices rather than to determine the equilibrium price and quantity. Sweezy showed
that during depression if any firm increased its price, no other firm would follow
and hence the reduction in the quantity of the firm that raised the price would
be huge as majority of the customers would shift to the competitors whereas if
firm reduced its price, all the other firms would follow and hence change in the
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quantity would be little. This is the reason behind the kinked demand curve as NOTES
it consists of two segments – one that is relatively elastic (with price increase)
and the other relatively inelastic (with price decrease). The kink is at the existing
price and that is where the prices remain stuck. This can be explained using the
Figure 4.3.

Fig. 4.3

Figure 4.3 shows that demand curve consists of two segments – one that
is relatively elastic which is above the equilibrium price of OP* showing that if
the firm increases its price above OP* then none of the other firms would follow
it and hence only its quantity would reduce. It is represented by segment ‘DA’
of the demand curve. However, the other segment is ‘AD1’ which is relatively
inelastic showing that if firm reduces its price all other firms would follow and
hence the change in its quantity would be little. Thus, combining both the demand
curves we get a kinked demand curve DAD1 where kink is at the prevailing price.
The corresponding marginal revenue curve (MR) is actually a combination of
three segments:
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NOTES 1. DB, which is the marginal revenue corresponding to DA segment of

the demand curve.
2. CMR, which is the marginal revenue corresponding to AD1 segment
of the demand curve.
3. The gap between the two segments of the marginal revenue curves is
joined by drawing a vertical straight line that is BC and it is below the
kink. It is because of this vertical stretch of the marginal revenue curve
that the prices are rigid, as even if the marginal costs shift up or down
but is within this stretch, the equilibrium does not change making the
prices sticky.
The profit maximizing output is obtained by equating the marginal revenue
with marginal cost (MR = MC), equilibrium is at point ‘e’ where the price is OP*
and quantity is OQ*. If marginal cost increases to MC2 then also the equilibrium
price and the quantity are same. If marginal cost reduces to MC1 then also there
is no change in equilibrium price and quantity. This shows that why prices are
sticky in an oligopoly market structure.

Limitations of the model

1. The model is applicable in the times of depression and does not talk about
the boom period.
2. The model said that kink is at the prevailing price but how that prevailing
price is obtained is not clear.
3. Economist Stigler found the model to be empirically unfit to be tested.
4. The model talks about movement of marginal cost within the vertical
stretch, it does not talk about what would be the change in the equilibrium
if marginal cost moves beyond the vertical segment.

4.7 SUMMARY

Oligopoly is a market structure with the presence of few sellers and each seller
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having a large market share. The most distinguishing feature of oligopoly is the
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recognition of mutual interdependence. Firms know that their actions would not NOTES
go unnoticed by the competitors and hence the counter strategy that the rivals
take have to be considered before bringing any changes in the existing variables.
The demand curve of an oligopolist is indeterminate because of the inability
to predict the rival’s behaviour and its impact on the firm itself. Economists
however have given various models which are based on certain assumptions
about the rival’s reaction. All these models can be broadly divided into collusive
and non-collusive. This lesson has talked about the non-collusive model in
which firms recognize their interdependence but do not collude. There are three
models under this category namely, Cournot Duopoly model, Stackelberg first
mover advantage model and Paul Sweezy’s Kinked demand curve model. All
these models talk about how firms reach their equilibrium position after taking
into consideration the rival’s action. Cournot suggested that in case there are two
firms selling identical products with zero cost of production, both firms would
simultaneously decide to produce an output that would be ultimately equal.
Stackelberg however showed that the first mover to the market is benefited as it
is able to sell an output that is double as compared to the follower. Paul Sweezy
did not only talk about the equilibrium determination but also showed that during
the times of recession, firms usually keep their prices fixed and compete on the
basis of non-price variables as frequent price changes may lead to price war
which is not beneficial for the market as a whole.

4.8 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. Cournot model makes use of the reaction curves to obtain its equilibrium.
2. The demand curve of an oligopolist firm is downward sloping.
3. Sweezy model is applicable during Depression as well as Boom periods.
4. Stackelberg shows that the first mover has an advantage over the followers
in terms of higher output and profits.
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NOTES Exercise 2: Fill in the Blanks

1. Sweezy model assumes that the shape of the demand curve is ……………….
2. Cournot assumes the marginal cost of the firms to be ……………….
3. The demand curve of a firm in oligopoly is ………………..
4. Oligopoly that sells perfectly homogeneous products is known as
………………. oligopoly.
Ans. 1. Kinked 2. Zero 3. Indeterminate 4. Pure
Exercise 3: Questions
1. Explain the difference between monopoly and Oligopoly.
2. If P = 20 – Q where Q = total output Q1 + Q2 and marginal cost is zero.
Calculate Cournot equilibrium and compare it with the Stackelberg model.
3. Explain what is meant by Oligopoly and how it is different from other
market structures.
4. What is the shape of the demand curve in case of Oligopoly?
5. What is the difference between Cournot and Stackelberg model?
6. Why are prices sticky in an Oligopoly?

4.9 RECOMMENDED READINGS

• Mankiw, N. G. (2018). Principles of Microeconomics 8th ed.

• Bernheim, B., Whinstton, M. (2009). Microeconomics. Tata McGraw-Hill.

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Collusive Oligopoly

LESSON 5 NOTES

COLLUSIVE OLIGOPOLY
Reena Bajaj
Guest Faculty
University of Delhi

Structure
5.1 Objective
5.2 Introduction
5.3 Models of Collusive Oligopoly
5.4 Prisoner’s Dilemma
5.5 Self Assessment Questions
5.6 Game Theory: Example
5.7 Ligopoly and the Functioning of The Economy
5.8 Contestable Markets and Potential Entry
5.9 Learning Outcome
5.10 Terminal Questions

5.1 OBJECTIVE

• To differentiate between different types of Collusions possible in case of

Oligopoly
• To understand various models of Collusive Oligopoly
• To comprehend Sales Revenue Maximization model of Baumol

5.2 INTRODUCTION

Oligopoly, a market structure having few sellers with each having a large market
share, provides the firm with the power to set their prices depending upon the
monopoly power that each firm enjoys. Here the firms have the option to compete
with one another as they recognize that they are mutually interdependent, or Self-Instructional
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NOTES they can collude and enjoy monopoly benefits. The former known as non-
collusive oligopoly models have been discussed in the previous lesson and this
lesson would talk about the models of collusive oligopoly. This collusion can be
explicit or implicit. Explicit collusion is where firms have proper written, formal
agreement amongst themselves to collude, though these types of collusions are
usually not permitted by the countries. Implicit collusion on the other hand is
said to be where there is no written formal agreement between the firms but they
implicitly collude and work in tandem to avoid the costs of competition and reap
the benefits of monopoly.

5.3 MODELS OF COLLUSIVE OLIGOPOLY

Collusive Oligopoly can be divided into two parts:

1. Implicit collusion
(a) Price Leadership by a Dominant Firm
2. Explicit Collusion – Here we have the following models:
(a) Cartels : OPEC and CIPEC
(b) Centralized Cartel
Implicit Collusion – Price Leadership Model
A form of collusion where the firms try to avoid the uncertainty related to the
rival’s action is Price Leadership model where one firm sets the price and others
follow it not because it is obligatory but because it is implicit, as otherwise it
would create unnecessary competition and reduce the combined profits. There
can be various types of price leadership, the most common are as follows:
1. Price Leadership by a Low cost firm – Here the firm that has the least
cost act as a leader and the other firms follow the price changes.
2. Barometric Price Leadership – A firm, that is considered to be the
barometer of the economy as it can gauge the economic environment
in a better way as compared to other firms because of its learning or
experience, is considered a price leader which is then followed by the
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3. Price Leadership by a Dominant Firm – A firm having the dominant NOTES

(largest) market share acts as the price leader and other small (fringe)
firms accept the price that it sets. A dominant firm is the one that has
the largest market share in terms of total sales. Here, the dominant firm
sets the price according to its profit maximizing criteria but after taking
into consideration the supply response of the fringe firms at different
prices. Thus, dominant firm is the price maker and the other smaller
firms are just the price takers.
Explicit collusion
From Implicit collusion, now we move to the Explicit collusion and the most
common one is Cartels. Cartels would be studied under three heads as given
below:
1. OPEC – Organization of Petroleum Exporting Countries. It was formed
in 1960 and presently has 14 countries that are part of this cartel.
2. CIPEC – Intergovernmental Council of Countries Exporters of Copper.
It was formed in 1967 and presently has 8 members.
3. Centralized Cartel – When all the firms in an oligopoly join the explicit
cartel, it is known as centralized cartel.

OPEC: Organization of Petroleum Exporting Countries

OPEC is a cartel of oil and captures majority of the oil reserves of the world. It is
an explicit cartel where there is a written formal agreement between the countries
to abide by the price set and other regulations. It is an example of a cartel that
has been successful in raising the prices for the firms than what would have been
there if there was pure competition. It can be explained using Figure 5.1:

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NOTES

Fig. 5.1

DD1 is the market demand curve of oil which is relatively inelastic as there
is no substitute of oil; Snon– opec is the supply curve of all those countries (firms)
combined together that have not joined the cartel and hence are competing with
each other and the cartel. It is also relatively inelastic as the supply of oil is also
limited as it being a natural resource. It is obtained by the summation of the
marginal cost of these firms and can be seen that the cost of non-OPEC firms is
quite high. Now the first step is to locate the demand curve of the OPEC which
is obtained by setting different prices and finding out how much of the market
demand would be left for the OPEC after the rest has been supplied by the non-
OPEC firms combined together. If OPEC sets the price as P1 which is obtained
from the intersection of market demand curve and supply curve of the non-OPEC
then the whole market demand can be satisfied by them and hence nothing
would be left for the OPEC to supply. Thus here the demand from the OPEC is
zero. If however it sets the price at P2 which is so low that the non-OPEC firms
would not supply anything then the whole market demand is to be fulfilled by
the OPEC. It is shown by point A on the market demand curve. Thus the demand
curve of the OPEC is kinked ‘P1AD1’ and the corresponding marginal revenue
curve is MRopec., marginal cost curve is MCopec. The equilibrium price that would
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condition for OPEC that is the price maker. Thus the equilibrium price is OP* NOTES
at which the OPEC sells OQopec units and all the competitive firms combined
sells OQnon– opec such that
OQopec + OQnon– opec = OQtotal and
OQopec > OQnon– opec
To see whether OPEC has been successful or not we compare the price
difference between what OPEC has set and what would have been there if there
was no cartelization and all firms would have competed freely. In the latter case,
price would have been where demand curve of OPEC and MCopec intersect. Thus,
the difference is huge as shown by the difference between P* and Ppc which
shows significant monopoly power that OPEC enjoys.

Long Run Effect of OPEC Action

(i) OPEC action of restricting its output caused increase in supply of oil by
non-OPEC countries because of increase in price. This caused shift in
supply curve of these countries to the right. The share of OPEC declined.
By 1985, it reduced to 30 percent. The price fell and in order to maintain
the price OPEC had to further reduce its output.
(ii) Secondly, the long run demand curve becomes more elastic as compared
to the short-run demand curve in above diagram. This is because people
have to spend their money more on insulation of oil heated buildings,
economical diesel engines, etc. In the very long run more money was
diverted for research to develop more petroleum efficient and alternative
technologies such as solar technology, etc. All these resulted in fall of
OPEC exports. Production limitations continued to maintain the price at
high level.
(iii) Because of heavy reduction in output to maintain price, OPEC started
experiencing fall in income. Disturbed by this development, members
started violating their quotas and had to meet frequently to settle things.
Ultimately OPEC had to eliminate quotas by 1985. The price fluctuated
before settling down in the 1990s.
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NOTES OPEC experience tells that:

(i) It is highly profitable for competitive firms to form a cartel and behave
like monopoly in the short run by restricting output given inelastic
demand curve.
(ii) In the long-run however, it becomes increasingly difficult to retain
the monopoly power and the firms have to choose between short run
and long run profits.
(iii) Also, in the long run it is not possible to continue output restrictions
due to loss in revenues and threat of breaking down of cartel.

CIPEC: Intergovernmental Council of Countries Exporters of Copper

CIPEC is a cartel of copper and captures only 30% of the copper producing
countries of the world. It is also an explicit cartel like OPEC where there is a
written formal agreement between the countries to abide by the price set and
other regulations. As against OPEC, it is an example of a cartel that has been
unsuccessful in raising the prices of copper in the international market. It can
be explained using Figure 5.2.

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Collusive Oligopoly

DD1 is the market demand curve of copper which is relatively elastic NOTES
because of the fact that there are substitutes of copper like aluminium, etc. Supply
curve of the non-CIPEC countries (firms) is Scipec that is also relatively elastic
because of the fact that supply of copper can be easily obtained from scrap, etc.
Demand curve and marginal revenue curve of the CIPEC is obtained in the same
manner as done for OPEC taking into consideration the non-collusive countries.
The equilibrium price is set by CIPEC which is obtained from equating marginal
revenue and marginal cost of the CIPEC. It is point E where price is set at OP*
and quantity sold by CIPEC is OQcipec and by non-CIPEC is OQnon– cipec. Here it
can be noted that the quantity sold by non-CIPEC is more than that of CIPEC as
CIPEC is a minority cartel where only 8 countries have joined the cooperation.
The monopoly power here is also very less as there is very small difference
between the price that would have prevailed in case of pure competition shown
by Ppc and cartel price OP*.
So, we can conclude by saying that though OPEC has been successful
in raising the prices of oil in the international market but CIPEC has been
unsuccessful at doing so. It can be because of the following reasons:
1. OPEC is a big cartel that consists of majority of countries that produce
oil whereas CIPEC is a minority cartel where only few firms have joined
the cartel.
2. OPEC is a cartel of oil whose demand and supply both are relatively
inelastic providing it a better scope for exploiting its monopoly power
whereas CIPEC is a cartel of copper whose demand and supply both
are relatively elastic thus providing lesser monopoly power.
3. The difference between the cost of the cartel firms and the competitive
firms (those which have not joined the cartel) is quite large as OPEC
firms produce at a much lesser cost whereas in CIPEC this difference
is not quite significant.
These reasons have led to the success of OPEC and the failure of CIPEC
and from this we can summarize a few conditions that are required for successful
functioning of a cartel:

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NOTES 1. The demand for the commodity for which cartel has been made should
be relatively inelastic.
2. The firms that join cartel should be able to control majority of the
world’s supply.

Centralized Cartel

This is an extreme form of cartel and rarely visible in real life as it assumes that
all the firms join the cooperation and none of the firms is outside the cartel. This
cartel thus acts as a monopoly where there is a centralized body that sets the price
and quantity that is equal to the monopoly and then allocates the total output and
total profits amongst different cartel members. If we assume that there are four
firms in the market, and all have same costs of production then the output and
price determination can be shown using Figure 5.3.
Dmarket is the total demand curve of the market and MR is the corresponding
marginal revenue curve. MCtotal is the summation of the marginal cost curves of
the four firms combined together. Equilibrium is obtained by the intersection of
marginal revenue and marginal cost curves and it is at point E where the price
is OP* and the quantity is OQt. The centralized authority would distribute the
output equally between the four firms such that each firm sells OQt/4 output at
a price of OP* per unit.
Above three cases of cartel showed that it is very difficult if not impossible
for a cartel to be successful as there is incentive for a firm to cheat on the cartel
and earn even higher profits than what it could have earned by being a member
of the cartel. This has been explained by a model of Game Theory known as
Prisoner’s Dilemma.

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NOTES

Fig. 5.3

5.4 PRISONER’S DILEMMA

Prisoner’s Dilemma is a model that explains how oligopolist firms could act
to their mutual disadvantage. The prisoner’s dilemma is a paradox in decision
analysis in which two individuals acting in their own best interest pursue a course
of action that does not result in the ideal outcome. It shows why firms cheat and
get a worse result than what would have been if they would have cooperated. It
is based on the concept of Game Theory, a mathematical technique that helps
in understanding the nature of interdependence among rival firms that are faced
with uncertainty in their pricing and output decision. A game is described by
its payoffs, strategies, number of players and information available. Prisoner’s
Dilemma can be explained with the help of following case:
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NOTES There are two friends A and B, who are suspects in a crime and are being
interrogated in separate rooms such that they cannot communicate with each
other. The two strategies available with them (to confess the crime or to not
confess) with their respective payoffs are given in the matrix below:
B
Confess Do not Confess
Confess B = 10 years B = 20 years
A = 10 years A = 2 years
A

Do not Confess B = 2 years B = 4 years

A = 20 years A = 4 years

Thus the matrix above reveals why A and B both have an incentive to cheat
(confess) while it would have been best for both of them to have cooperated
by not confessing. If both A and B confessed then both would get 10 years
imprisonment. The best however would have been where both do not confess
and get away with 4 years of imprisonment. If however one of them confesses
while the other does not confess then the one who confesses gets away with a
lesser imprisonment of just 2 years. Thus both think that it is best for them to
confess thinking that the other would not confess and both get away with 10 years
of imprisonment. This shows how prisoners thinking for their individual best
bring an outcome that is worse for them as well as for the group. The same can
be applied to the oligopoly where firms try to maximize their individual gains
by cheating on the other and hence get away with the profits that are worse for
the group as a whole. The above matrix can be modified to show the situation
for oligopoly as well if we assume that there are just two firms C and D with
the strategies available to them being that of to cheat or not to cheat on the price
being decided collectively.
D
Cheat Do not Cheat
Cheat D = Low Profits D = Very Low Profits
C = Low Profits C = Very High Profits
C

Do not Cheat D = Very High Profits D = High Profits

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Collusive Oligopoly

The matrix above revealed that if two firms C and D colluded, they could NOTES
have fixed up monopoly price and earned monopoly profits or high profits. If
however a firm tries to cheat on the cartel by charging a lower price assuming
that the other firm would not cheat and keep the price high as set by the collusion
then the firm which cheats or lowers the price earns very high profits and the
firm that does not cheat earns very low profits. This makes both the firms to
cheat on the cartel and both the firms reduce the price and hence they end up
earning low profits.
The prisoner’s dilemma shows that oligopolists always follow a strategy
that leads to competition amongst firms and leads to lower profit. But if the
game is repeated again and again the outcome can change as firms may learn
from their past outcome.

5.5 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. Prisoner’s dilemma is a model based on Game Theory of mathematics.
2. Both OPEC and CIPEC are examples of implicit cartels.
Ans. 1(T), 2(F)
Exercise 2: Fill in the Blanks
1. Prisoner’s dilemma shows why firms ……………. when it is beneficial
for them to ……………. .
2. OPEC is a cartel of…………….
3. For a cartel to be successful the demand of the product should not be
perfectly …………….
Ans 1. Cheat, Cooperate 2. Oil 3. Elastic.

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NOTES Exercise 3: Questions

1. Why OPEC has been successful in raising the prices while CIPEC has
been unsuccessful?
2. How Prisoner’s Dilemma can be applied to Oligopoly to show the non-
cooperative behaviour of the rival firms?

5.6 GAME THEORY: EXAMPLE

Co-operative behaviour in oligopoly is a situation when firms jointly decide

the prices and output and maximizes their joint profit. This situation is called
collusion, in this situation it becomes profitable for one firm if it defects and
cuts the prices and rises output, as long as other do not do so. Non-cooperative
behaviour is a situation when they do not co-operate and decide their prices and
output separately and compete with each other. When firms in oligopoly do not
co-operate, it is called non-cooperative equilibrium or Nash equilibrium (Named
after US mathematician John Nash).
In oligopoly the basic dilemma the firms face is whether to co-operate or to
compete. If they co-operate, profit will be maximum and if they do not, profit for
all will decrease. Now we will see the behaviour of an oligopolistc firm through
an example of game theory. Game theory is the study of decision making in
situations where strategic interaction (moves and countermoves) between rival
firms occurs. We will assume a case of only two firms in the market, called
Duopoly. The case is as follow:
Table 5.1 The Oligopolist’s dilemma: to co-operate or to compete

Firm B’s Output

One-half Monopoly output Two-third Monopoly output
One-half Monopoly 20 20 15 22
output
Firm B’s Output 22 15 17 17
Two-third
Monopoly output
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The Table 5.1 above explains the dilemma faced by oligopolists of whether NOTES
to co-operate or to compete. It is called Payoff Matrix for a two firm duopoly
game. The right-side figures on each cell shows the profits of firm A and left side
figures on each cell show the profits of firm B (in Rs. Crores). It can be explained
that if the two firms co-operate and produce one half of market share each, they
will earn Rs. 20 crores of profit. In case of co-operation they can maximize their
profits. If firm A defects and produces two thirds of output and firm B produces
half of monopoly output, then firm A will earn Rs. 22 crores and firm B Rs. 15
crores. Similarly, if firm B defects and produces two-third and firm A produces
one-half then firm B will earn Rs. 22 crores and firm A will earn only Rs. 15
crores. If both decide to compete and produce two-third of monopoly output each
then profits for both will fall to Rs. 17 crores. This type of game, where they
reach a non-cooperative solution when they could co-operate, is called Prisoner’s
Dilemma. Prisoner’s Dilemma is shown in Table 5.2.
Table 5.2 The Prisoner’s Dilemma

Mr. Ram
Confess Not confess
Mr. Shyam Confess 6 6 0 9
Not confess 9 0 1 1

Two prisoners Mr. Ram and Mr. Shyam are arrested for committing a crime
and interrogated separately. They are told the following:
(a) If both are claimed to be innocent, they will get a light sentence that
is 1 year in jail.
(b) If one confesses and the other does not, then who confesses will be
released free and the other will be punished for 9 year in jail, and
(c) If both confess, then both of them will get a-punishment of 6 years
in jail.
The payoff matrix presented in Table 5.2 shows the dilemma of the
prisoners about whether to confess or not to confess. If none of them confesses
then both will get 1 year of jail, but if Ram confesses and Shyam does not then
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NOTES Ram will be left free and Shyam will get 9 year of imprisonment and the vice-
versa. And if both of them confess then both will get 6 years of imprisonment.
Not confessing is the best solution in this game (Pareto efficient solution) but
this leaves one always in uncertainty. This solution is not a stable solution as one
gets an imprisonment of 9 years if he/she does not confess and the other does.
Therefore, confession dominates in the mind of both the prisoners. If both of
them confess then they end up with 6 years jail each. This kind of equilibrium
is called Nash equilibrium. From both the figures above it is clear that if they
co-operate, they will earn the maximum profit than if they compete.

5.7 OLIGOPOLY AND THE FUNCTIONING OF THE

ECONOMY

Oligopoly is an important market feature in modem economies. Oligopoly

has played an important role in modern economic growth. It is an emerging
phenomenon in the developing economies in recent time. Many industries are
operating through oligopoly market structure. The existence of economies of
scale and economies of scope make impossible for perfect competition and
monopolistic competition to survive. Too many firms cannot exist in such a
situation. In the long run, oligopoly can be evaluated through the following
three questions:
1. The market mechanism under oligopoly
Under perfect competition, prices are determined by the forces of demand and
supply whereas prices are administered by the firms under oligopoly. Despite
this difference, Lipsey observes that, the market system reallocates resources in
response to change in demand and costs roughly by the same way under oligopoly
as under perfect competition.
2. Profits under oligopoly
Oligopolists either co-operate or compete in the market. They can maximize
their joint output and profit through co-operation, but one can always increase
its individual profit by defecting. High profit in the long run can always attract
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the new firms, unless natural and/ or firm-created barriers exist to restrict entry NOTES
of new firms in the market.
3. Very long-run competition
To survive in the long run, oligopolists keep on innovating to upgrade the quality
of product and minimize their cost of production. Each firm spends significant
amount on Research and Development to produce better quality at minimum
costs. Differentiated products with different character are available in oligopoly
market. Consumers get more choice in the market. Consumers get quality
products at competitive rates. Oligopoly market structure is more conducive to
economic growth in the long-run.

5.8 CONTESTABLE MARKETS AND POTENTIAL

ENTRY

The theory of contestable markets explains that in the long-run, abnormal profits
earned by oligopolists can be eliminated without actual entry. Potential entry can
also affect the market as much as an actual entry does. It is possible only when
the following two conditions are fulfilled
1. Entry must be easy to accomplish: There should not exist any barriers
to entry, either natural or firm-created.
2. The existing firms must consider potential entry while making price
and output decisions: The existing firms must react when new firms try
to enter into the market. They must cut their prices and sacrifice profits
(short run) to restrict the new entrants.
Contestable markets always expect potential entry because of huge profits
earned by the existing firms in the market. But entry to such markets is too
costly. Fixed costs are very high. To develop, design, and sell a new product in
such a market involve huge sunk cost. Sunk costs are those costs which cannot
be recovered if a firm leaves the market soon. Firms which produce multiple
and differentiated products can easily distribute these costs among those many
products. For new firms, producing huge number of differentiated products is
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NOTES not easy. Therefore, these costs are very high for a firm which produces single
product in the market.
If a new firm can enter and leave the market without any sunk costs of
entry, such markets are called perfectly contestable markets. A market can be
perfectly contestable, even if, firms have to pay some costs of entry if these
costs are recovered when firms leave the market. If the sunk costs are lower, the
market will be more contestable and vice-versa.
Sunk costs of entry constitute entry barriers. Higher the sunk costs, larger
will be profits earn by the existing firms. If the firms operate in the market
without, large sunk costs of entry, then they will not earn large profits. As part
of strategy, existing firms keep their prices as low as that can only cover the total
costs. If they charge high prices and earn abnormal profits then the new firms will
enter and may capture the profits and leave until it is vanished. Contestability
forces the existing firms to keep the prices low. Potential entry works as good as
actual entry in a contestable market to limit the profits of existing firms.

5.9 LEARNING OUTCOME

Oligopoly, a market structure that is most common in the real world consists of
two different categories – collusive and non-collusive. This lesson talked about
collusive oligopoly where collusion can be explicit and there is a proper written
formal agreement between the firms to decide the price and output that each
firm would produce and sell. Its most common form is Cartel, but this type of
collusion is usually not allowed by the countries’ legislation as it can lead to the
creation of monopoly that can exploit the consumers. Two most famous cartels
are OPEC – cartel of oil producing countries and CIPEC – a cartel of copper
producing countries. While OPEC has been successful in raising the prices by
cartelization, CIPEC is an unsuccessful cartel because of the reason that demand,
and supply of oil is relatively inelastic whereas that of copper is elastic. The
lesson also discussed about Implicit form of collusion that is price leadership
by a dominant firm where there is no agreement between the firms to collude

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but still firms follow the price set by a leader firm as that avoids the uncertainty NOTES
and reduces the chances of a price war. However, in spite of the benefits of
cartelization, firms still cheat as that brings them more profits and it has been
highlighted by Prisoner’s Dilemma which shows that why firms in an oligopoly
cheat while they would have been better off if they would have colluded.
Game theory is applied to explain co-operative and non-cooperative
behaviour of oligopolistic firms.

5.10 TERMINAL QUESTIONS

1. Explain the features of oligopoly.

2. Explain the various co-operative and competitive behaviour of oligopolistic
firms.

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UNIT II: CONSUMER AND PRODUCER
THEORY

LESSON 6 CONSUMER AND PRODUCER THEORY

IN ACTION
LESSON 7 MARKET FAILURE
Consumer and Producer Theory in Action

LESSON 6 NOTES

CONSUMER AND PRODUCER THEORY

IN ACTION
Devender
Assistant Professor
School of Open Learning
University of Delhi

Structure
6.1 Learning Objectives
6.2 Cost Changes
6.3 Comparative Statics
6.4 Changes in Input Prices
6.5 Changes in Technology
6.6 Effects of Taxation on Competitive Industry
6.7 Learning Outcome
6.8 Terminal Questions

6.1 LEARNING OBJECTIVES

• To explain the changes in supply and technology in a competitive industry

• To use the theory of competitive market behaviour to understand some
important real world problems
• To explain how the economy responds in the short run as well as in the
long run to the shifts in supply
• To analyse the effects of taxation on competitive industry
This lesson is divided into following parts:
Part I: Changes in supply in a competitive industry
Part 2: Changes in technology in a competitive industry
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NOTES Part I: Changes in supply in a competitive industry

The main aim of this part is to use the theory of competitive market
behaviour to understand some important real world problems. In particular, we
shall see how the economy responds in the short ran as well as in the long ran
to shifts in supply that are brought about by changes in the cost structure of an
industry.

6.2 COST CHANGES

Costs for an industry can change for a variety of reasons.

1. A common reason for a change in costs for an industry is a change in the
price of some input used by the industry. We can think of several recent
examples: Wheat prices in India have gone up sharply since 2006. This
has increased the costs for several industries. For instance, restaurants
and hotels, manufactures of bread and biscuits, etc., have seen their costs
escalate in recent times as a result of the increase in wheat price. Another
example is provided by the sharp increase in crude oil prices in the last
few years. This has lead to an increase in costs for the petroleum products
industry and consequently for the transportation industry. Another example
that has been discussed a lot in the newspapers recently is the effect of a
sharp hike in cement prices witnessed in India since 2006 on the costs for
firms engaged in construction and infrastructure creation.
2. Technological changes might also lead to changes in costs. For example,
technological advances over the last few decades have drastically
reduced the costs of several industries. Computers and mobile phones
are some of the examples that immediately come to mind if one wants to
see evidence of a dramatic reduction in costs over a very short span of
time due to technological advancement. However, there are times when
use of a different technology in order to reduce environmental damage
might actually lead to an increase in costs. This might explain why some
advanced industrial countries are so vehemently opposed to pollution
control measures advocated by environmentalists.
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3. Another common reason for a change in costs is a change in taxes paid by NOTES
the firms in the industry. In India, every year industry watchers eagerly wait
for the budget speech of the Finance Minister in the Lok Sabha to analyze
the impact of changes in excise and customs duties on a wide variety of
industries like iron and steel, cement, cars, petroleum products, etc.
4. Acts of nature might also be an important source of costs changes for some
industries. Winter fog in Delhi, for instance, increases the costs for aviation
industry because it leads to delays in landing and take-off of aircrafts and
sometimes might even result in cancellation of flights. Massive rains that
lead to widespread flooding in Mumbai a few years ago resulted in an
increase in the costs for the insurance industry. On the other hand, adequate
rain in the months of July and August in states like Punjab and Haryana
might lower the costs of paddy production for farmers since they might
not be required to use diesel-run pump sets for irrigation.

6.3 COMPARATIVE STATICS

In this lesson, we use the comparative static technique. We start with a market
that is in long run equilibrium. We then introduce a cost change that leads the
market to a new equilibrium (i.e., a new state of rest or no change for the system
when all the adjustments to cost changes have taken place). We compare these
two equilibrium states to study the impact of cost changes. Comparative statics
is to be contrasted with static analysis that looks at equilibrium in a market that
does not receive any external shocks or disturbances (i.e., a change in a variable
fixed from outside). Both these methods are to be contrasted with dynamic
analysis that looks at the path of evolution of the state of a system when it is not
in equilibrium.

Long run response might be very different from what happens in the
short run

We shall first see how the economy adjusts to changes in costs in the short run.
In the long run, however, the response of a competitive industry can be very
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NOTES different. We will analyse the long run response next. A large part of the difference
in our analysis and conclusions between the short run and long run effects is
explained by free entry and exit of firms in a competitive industry in the long
run in response to abnormally high or low profits.
Freedom of entry and exit of firms is one of the most important characteristics
of competitive markets. Most of the efficiency results of competition stem from
this. Freedom of entry and exit of firms lies at the heart of adjustment process
in a competitive market and we try to illustrate it in a wide variety of situations.
At times our conclusions are quite different from the answers of those who have
not received a formal training in economics. A little investment of time and
energy on your part will, we hope, change the way you think about major issues
of public concern.

6.4 CHANGES IN INPUT PRICES

To begin with, we illustrate the general impact of a change in input prices on a

competitive industry by considering a specific example. We consider the impact
of a reduction in the price of wheat flour on the bread industry. Suppose each
loaf of bread requires a constant amount of wheat flour, say 200 gm per loaf of
bread. If the price of wheat flour declines, say by 5 Rs. per kg, the marginal and
the average cost curves of a typical bread factory decline by the same vertical
amount (by one Rupee for all levels of bread output).
This is shown in Figure 6.1. Notice that there is a parallel vertical shift in
the average and marginal cost curves in Panel B and the extent of vertical shift
is the same. Assume all firms in the industry have the same cost curves. The
industry supply curve is obtained by horizontally adding up each firm’s MC
curve that lies above the AVC.
We start from a position of long run equilibrium. In Panel A of Figure 6.1,
initial industry equilibrium is at E0 where the industry demand curve D and initial
industry supply curve S0 intersect. The initial market price is P0 and the quantity
demanded and supplied in the industry is Q0.
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NOTES

Fig. 6.1

The corresponding initial equilibrium for a typical firm in the industry is

at e0 in Panel B of Figure 6.1, where price = MC = AC. Each firm supplies q0, a
quantity at which AC is minimized and every firm makes zero economic profit
(that is, it earns normal profits) and hence there is no incentive for an existing
firm to exit or for a new firm to enter the industry. Given our assumption about
fixed input use per unit of output, a reduction in price of wheat flour leads to
a downward parallel shift of one Rupee in MC and AC curves from MC0 and
STAC0 to MC1 and STAG1 respectively. In general, shifts in AC and MC are
not parallel. As a matter of fact, while a cost reduction will always lead to a
downward shift in AC curve, though not necessarily a parallel one, the MC
might not shift down at all. This might happen, for instance, if only fixed costs
decline and variable costs remain the same.

Short run impact of a decline in input prices

Since each firm’s MC has shifted down, the industry supply curve also shifts
down to S1, market price falls to P1 and industry output rises to Q1 in Panel A
of Figure 6.1. Notice that the fall in market price is less than the one Rupee
fall in costs given by P0P2, the vertical distance between S0 and S1 in Panel A
of Figure 6.1.
In Panel B we see that when the market price is P1 and the costs for each
firm have declined (by more than the decline in market price). Each firm in
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NOTES the industry increases its optimal quantity supplied to q1 a level higher than the
efficient one at which AC is minimum. Moreover, each firm in the industry makes
supernormal profits in the short run since price is greater than AC. The area of
the shaded rectangle in Panel B of Figure 6.1 gives the magnitude of this profit.

Long run impact of a decline in input prices

In the long run, however, in a competitive industry these positive economic

profits will attract new firms into the industry. As the number of firms in the
industry rises, the short run industry supply curve shifts to the right, the market
price falls and the industry output rises. This process continues till the short run
industry supply curve has shifted to S2 and the market price falls to P3, equal to
the new minimum AC. The industry output rises to Q2.
Fall in market price from P1 to P2 implies that each firm in the industry is
now producing output q0, the efficient level of output at which AC is minimum.
Notice that q0 is less than q1, the output produced by an existing firm in the
industry in the short run after a cost decline. The entry of new firms pushes down
the market price and hence leads to disappearance of supernormal profits earned
by the existing firms.

Long run Supply Curve of the Industry

An alternative way of analysing the long run impact is to look at how the long run
industry supply curve shifts. With free entry and exit of firms and with identical
cost curves for all the firms, the long run industry supply curve is a horizontal
straight line whose vertical intercept is equal to the lowest AC for a typical firm.
This is shown in Panel A of Figure 6.2 The long am industry supply curve shifts
from S to S*. The market price drops from P to P*, the full extent of drop in
costs, and industry output rises from Q to Q*.
In Panel B Figure 6.2, we see that each firm continues to produce output q,
the efficient output level, when market price and costs decline. Moreover, each
firm continues to make zero economic profits in the long run.

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NOTES

Fig. 6.2

In the long run, under perfect competition, the price declines by the full
extent of the decline in the lowest AC. The output is higher and the price is lower.
The firms are still making zero economic profits. All the benefits of lower input
prices are passed on to consumers.

Questions for Review

1. We discussed above the case of a reduction in input prices. Discuss the

opposite case of an increase in input prices. Carefully describe the short
run and long run impact on the industry as well as on a typical firm in the
industry.
2. We discussed a special case of cost change above where both MC and AC
curves shifted down by the same vertical distance. We remarked that this
need not always happen. Discuss the short run and long run impact of a
decline in fixed costs on the industry as well as on a typical firm in the
industry.
(Hint: The MC curve for a firm will not shift at all.)
(a) What happens to price and quantity in the short run?
(b) What happens to profits of the firms in the industry in the short run?
(c) Are there any incentives for entry of new firms in the industry?
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NOTES Part 2: Changes in technology in a competitive industry

In this part we try to learn how a change in the technology for the production
of a good affects its market. Preferences and technology are the basic building
blocks from which demand-and supply curves are derived. In economics we
normally take technology and preferences as exogenous (that is, we regard them as
given from outside). Changes in technology, however, have important economic
implications. In this lesson we will study the impact of exogenous changes in
technology within the framework of competitive markets.

6.5 CHANGES IN TECHNOLOGY

We shall first see how the economy responds in the short run as well as in the
long run to shifts in supply that are brought about by technological changes in
an industry.
We noted in the previous lesson that technological changes are frequently
major sources of changes in costs in the real world. In this lesson, we will analyse
the short run and long-term impact of two kinds of technological changes.
1. A once-for-all-change in technology
2. A continuous process of technological change

A once-for-all-change in technology

Assume that the industry starts from a situation where there has been no change
in technology for a long time and all firms have the same cost curves. Further,
suppose that the industry is initially in a state of long run equilibrium.
This is shown in Figure 6.3. We start from a position of long run equilibrium.
In Panel A of Figure 6.3, initial industry equilibrium is at E0 where the industry
demand curve D and initial industry supply curve S0 intersect. The initial market
price is P0 and the quantity demanded and supplied in the industry is Q0.

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NOTES

Fig. 6.3

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NOTES The initial equilibrium for a typical firm in the industry is at e0 in Panel B
Figure 6.3, where price = MC = ATC. Each firm supplies q0, a quantity at which
ATC is minimized and every firm makes zero economic profit (i.e., it earns normal
profits) and hence there is no incentive for an existing firm to exit or for a new
firm to enter the industry. Notice that P is greater than AVC, hence the firm is
making positive operating profits (the difference between total revenue and total
variable costs) that just cover its fixed costs.
Now suppose that a single advance in the industry’s production technology
takes place that lowers the costs of production for newly built plants. We assume
that existing plants can not take advantage of this technological advance since
the new technology has to be embedded in new plant and equipment. In the short
run there will be no change in the industry since it takes time to build new plant
and equipment.
In the medium run, since new technology lowers the average total cost
curve to ATC1 and the original price P0 was equal to the average total cost for
the existing plants; new plants are profitable and will be built soon. With this
capacity expansion, the industry’ supply curve shifts to the right to S1, market
price falls to P1 and industry output rises to Q1 in Panel A of Figure 6.3. Notice
that capacity expansion and fall in market price continues till price has fallen to
the lowest AC for the new plants and further entry is not profitable,
At price P1, the new plants are operating at the most efficient scale where
they are producing an output at which AC is minimized. Firms with new plants
are making zero economic profits since their operating costs just cover their fixed
costs. This is shown in Panel C of Figure 6.3.
Firms with old plants, however, will not be covering their total costs. If the
costs for the new plants are sufficiently lower than that of the old plants, the new
market price PI will be lower than minimum AVC of old plants. Old plants will
be shut down immediately and all surviving firms will use the new technology.
A more interesting case, however, is where the new market price P1 is
higher than minimum AVC of old plants. This is shown in Panel B of Figure
6.3. At price P1 firms with old plant produce output q2, a level of output at which
price = MC and since price is less than ATC, each firm with an old plant makes
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a loss given by the area of rectangle P1CDE. It is, however, optimal to produce NOTES
output q2 since price is higher than AVC and the firm is making an operating
profit given by the area of the rectangle ABC P1. Had the firm shut down its loss
would have been higher. Its revenue would have been zero, it would still have
to incur the fixed cost of production (given by the area of the rectangle ABDE)
and losses would have been greater since the firm would not have been able to
use its operating profits to at least partially offset its fixed costs.
Old plants will continue to coexist with new ones and firms with old plants
will be making losses. A non-economist might think that operating loss-making
old plants is inefficient and it would be advantageous to discard them. He could
not be more wrong! As long as old plants recover their variable costs, it is optimal
to operate them. Fixed costs are sunk; they can not be avoided by shutting down
old plants. One of the first lessons in economics is to ignore sunk costs. Let us
try to understand this by looking at an example from everyday life. If you go to a
restaurant and happen to order a lousy meal, don’t force it down your throat just
because the price you paid is very high. You have to pay the price whether you
finish the meal or not. It is a sunk cost. The decision whether to eat all of what
you ordered or to leave it in the plate depends not on the size of the bill (you have
to pay that in either case), but on whether not eating (or eating something else
or somewhere else and paying something additional for it) makes you happier
than eating what is in front of you. Let bygones be bygones.
With the passage of time, however, old plants will wear out. They will
now be replaced by plants using new technology. At the time of replacement,
the cost of plant is not sunk. Profit maximizing firms will choose plants with
lower costs. Plants with old (higher cost) technology will gradually disappear.
In the long run a new equilibrium will be attained in which all plants use the
new technology. As shown in Panel A of Figure 6.3 output will be Q1, higher
than output Q0 in the original equilibrium. Price will be P1 lower than P0 in the
original equilibrium. The new plants will be operating at an efficient scale and
will be just covering their costs.
All the benefits of lower costs due to technological advancement will be
passed on to the consumers in the long run.
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NOTES Ongoing technological change

We can generalize the analysis of the previous section to consider the outcome in
a competitive industry where there is a continuous technological change. Plants
built today have lower costs than plants that were built in the past. However,
costs are expected to be even lower for plants that might be built at a future date.
It is clear from the analysis of previous section that ongoing technological
progress will lead to a continuous process of entry of newer lower cost firms. The
market price will continually decline. However, older plants will not necessarily
be shut down as soon as plants with better and lower cost technology make an
appearance. Owners of old plants will continue to operate them as long as they
cover their variable costs.
This situation is described in Figure 6.4. The Plant shown in Panel A of
Figure 6.4 is the oldest plant that is on the margin of shutdown. It is making
a loss since market price is lower than its average total cost. The plant is just
covering its AVC and is indifferent between shutting down and continuing to
produce output q1. If the price drops any further, the plant will be shut down.

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NOTES

Fig. 6.4

The plant shown in Panel B is using an intermediate technology. It is also

making a loss, but it is covering at least some part of its fixed costs (shown by
the shaded area) in addition to covering all its variable costs by producing its
optimal level of output q2.
The plant shown in Panel C is the one that uses the newest technology and
has the lowest costs. It not only covers its fixed costs (notice that price is higher
than its AVC), but it also makes a profit (price is higher than its ATC) for the time
being by producing its profit maximizing output, q3. Since the potential entrant
firms know that technological progress is continuous, they will enter the industry
only if they make positive profits at the lime of entry that will compensate them
for the losses they expect to make in the future when newer firms with lower
cost technology will enter the industry and push down the price.
The point made above about the link between modernization and economic
efficiency needs to be emphasized. Older plants have higher costs and firms using
them might be making losses. At the same time there are firms in the industry that
operate newer plants and have lower costs. These firms are making profits. Is this
compelling evidence of economic inefficiency on the part of firms using the old
plants? Is it true that firms using older loss-making plants should discard them
immediately and modernize their plant and equipment? Is doing so profitable
for these firms? Is it welfare enhancing for the society? It should be clear from
our analysis above that the answer to all these questions is not necessarily in the
affirmative. It is efficient to use older loss making plants as long as they cover
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NOTES their variable costs. They produce goods that are valued more by the consumers
than the resources currently used up by operating the old plants (their variable
costs). It is in the interest of the firms with old plants and also in the social interest
to continue to use these old plants as long as the variable costs are covered.
Another point to be noted is that market price paid by consumers is
determined not by the average costs of the old inefficient plants, but by the costs
of the firms with the newest and the most efficient plants. Entry of firms with the
most efficient technology into the industry will continue and supply will keep on
increasing till the price has dropped to a level where latest entrants can barely
cover the opportunity cost of their capital over the expected lifetime of their
plants. It implies that new entrants today must earn positive economic profits
for some time to offset the losses that they expect to earn later when firms with
even more efficient technology enter the industry and push down the market
prices to a level lower than the ATC of these current entrants. The full benefit
of new technology is passed on to the consumers as soon as it begins to be used
by the new entrants even though a vast majority of firms in the industry might
still be using old technology. The price paid by the consumers depends only on
the costs of the most efficient firms. As Paul Samuelson once said, it is the tail
that wags the dog in economics. Owners of older firms have to sell their goods
at the same lower price that is charged by the new firms. Their operating-profits
keep on declining as entry of lower cost firms keeps on driving down the market
price. These firms will ultimately quit the industry when they can not even cover
their variable costs.
This brings us to the final point that we want to make in this lesson. The
concept of economic obsolescence is different from that of physical wear and tear.
We emphasized above that old machinery should not necessarily he discarded
just because firms using it have higher costs and might even be making losses
since market price depends on the costs of the most efficient firms. Just as one
should not be overenthusiastic about discarding old machinery, one should not
continue to use an old machine because it is still functional. When the price
drops below average variable costs the machine is economically obsolete even
though it may not be physically worn out. Old capital equipment is obsolete and

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should not be operated if by using it the firm can not even cover the variable NOTES
costs. This might happen well before the equipment is physically worn out. The
concept of economic efficiency should be understood both by those who have
a fetish for new technology and want to discard old equipment as soon as they
see something more modern and also by those who would never discard old
equipment, as long as it works.

Questions for Review

1. In what sense are the benefits of technological progress passed on to the

consumer in a competitive industry? Would your answer change if entry
to the industry were restricted?
2. How would your answer to the first question be modified, if the new
technology is patented and only one firm can use it?
3. In reality, firms have to spend money on research and development to
generate technological progress. Use your answer to questions 1 and 2 to
present an economic case for patents.

6.6 EFFECTS OF TAXATION ON COMPETITIVE

INDUSTRY

There are various kinds of taxes that the government imposes which ultimately
affect the costs of firms and industry. We will consider three different types of
taxes-per-unit tax, lumpsum tax and profit tax.
(1) Per-unit tax: It is a tax that is levied on each unit produced by the firm. In
a way it can be said to be another cost to the firm. As a result of per unit
tax (say sales tax) the marginal cost of the firm shifts up by the amount of
the tax. At the industry level the supply curve shifts up by the amount of
the tax. Accordingly, the effects of a per-unit tax on output of a competitive
industry can be listed as follows:
(i) In the short run the price of the output will rise but by less than the
amount of the tax. So, the tax burden will be shared by consumers and
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NOTES producers. The consumers pay higher price than before and producers
do not cover their average total costs.
(ii) In the long run, some firms who do not cover their costs may leave
the Industry. The industry will contract (fall in size) and losses will
disappear. If the cost curves of existing firms remain unaffected due
to contraction of the industry then price will rise by full amount of
the tax. In such a case the burden of the tax will be totally on the
consumers. This also implies that government intervention in the
competitive industry may affect its size, volume of sales and price in
the short run but it cannot influence its long-run profitability effects
of per-unit tax as shown in Figure 6.5.

    Fig. 6.5                  Fig. 6.6

Figure 6.5 shows the effect of per-unit tax on price and quantity by
shifting the supply curve upwards. The original equilibrium point is E0
with price P0 and quantity Q0. A per-unit tax supply shifts from S0 to S, so
that new equilibrium is now at point E1. Tax equals S0S1 or E1T or P1P2.
Price increases to P1 since increase in price is P0P1 which in less than the
tax E1T, the tax burden is shared by consumers and producers in the short
run. After tax quantity has also fallen to Q0.
In Figure 6.6, the effect of per-unit tax is shown by shifting the demand
curve down by the amount of tax. It shows that after tax producer gets
price P2 after tax which is less than the market price P1.
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(2) Lump-sum tax: Lump sum tax is a kind of fixed cost of the firm. It NOTES
increases the total cost of the firm and industry. The marginal costs and
marginal revenues remain unaffected. The average cost curve shifts up due
to tax at the existing level of output. Lumpsum tax reduces the revenue.
As long as the firm is able to recover its variable costs, it will remain in
business otherwise it will shut down in the short run. Lump sum tax does
not affect price and output in the short run. However, in the long run some
firms, who do not cover their increasing costs leave the industry and the
size of the industry will fall. Price will rise and output will fall until the
whole of tax burden is passed on to the consumers.
(3) Tax on profits: From the economists’ point of view the firm in perfect
competition earns normal profit or zero economic profit in the long run.
So, on this basis a tax on profits will neither affect price nor output of a
competitive industry in equilibrium. So, it will also not affect allocation
of resources.
However, in reality profits are defined in tax laws according to accountants,
usage which includes returns to capital, reward for risk-taking and could be taxed.

6.7 LEARNING OUTCOME

In this lesson you have learnt the following:

1. The cost of competitive firm and industry changes due to change in input
price, change in technology and imposition of taxes.
2. Change in input price (rise/fall) causes change in supply (fall/rise) and
change in MC (rise/fall).
3. Improvement in technology causes increase in supply and fall in average
cost of competitive industry and firm and vice versa.
4. Imposition of per unit tax causes decrease in supply (upward shift) and
decrease in demand (downward shift).

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6.8 TERMINAL QUESTIONS

1. Explain effect of per-unit tax on price and quantity from the demand side
of the market.
2. Explain effect of per-unit tax on price and quantity from the supply side
of the market.

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Market Failure

LESSON 7 NOTES

MARKET FAILURE
Devender
Assistant Professor
School of Open Learning
University of Delhi

Structure
7.1 Learning Objective
7.2 Introduction
7.3 Allocative Efficiency under Perfect Competition
7.4 Market Failure
7.5 Externalities
7.6 Public Goods
7.7 Self Assessment Questions
7.8 Functions of Government
7.9 Public Policy Towards Monopoly and Competition
7.10 Learning Outcome
7.11 Terminal Questions

7.1 LEARNING OBJECTIVE

• To identify the situations that lead to market failure

• To understand the concept of Public Goods
• To compute the impact of Externalities
• To identify the situations that lead to Moral Hazard and how it can be
reduced

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7.2 INTRODUCTION

The aim and objectives of market should be as follows:

1. There should be efficient production of goods by making use of the available
resources. It being assumed that there are only two factors of production,
i.e., labour and capital and their quantity is fixed, both have to be optimally
utilized to produce two commodities. Here, the efficient production would
be only if it is not possible to increase the production of either one or both
the commodities without reducing the production of the other.
2. The goods being produced should be efficiently distributed amongst the
consumers in the economy. This happens only when the distribution
amongst the consumers is such that it is not possible to increase the
satisfaction of one consumer without decreasing the satisfaction of the
other. This happens when the indifference curves of the two consumers
are tangent to each other, the marginal rate of substitution being same for
both the consumers.
3. The output mix should be efficient such that the output is distributed
amongst the consumers in such a manner that the marginal rate of
substitution and marginal rate of transformation are equal.
In an economy that has perfect competition, all the above conditions are
automatically fulfilled. However, such an economy rarely exists and it gives rise
to imperfections in the economy and non-optimal allocations which would be
discussed in the current lesson. Let us understand and explain the efficiency of
perfect competition.

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NOTES
7.3 ALLOCATIVE EFFICIENCY UNDER PERFECT
COMPETITION

Allocation efficiency refers to the situation where allocation of resources leads to

maximum gain to the society reflected in maximization of the sum of consumers
and producers surplus.
Consumer surplus is the difference between the total value which the
consumers are willing to place on all the units consumed of the product and the
actual payment that they make on its purchase.
Producers surplus is the difference between the value the producers receive
by selling the product at its equilibrium price at which demand and supply of
the product are equal and the value of the product at its minimum supply price
which is its transfer earning.
Sum of consumers and producers surplus is maximized when price equals
marginal cost of the product which actually occurs under perfect competition. We
know that price reflects the value that household place on a good and marginal
cost reflects the opportunity cost of the resources needed to produce the good.
This implies that as long as price exceeds marginal cost then society gains by
producing more of the good and when price falls below marginal cost society
gains by producing less. Hence maximum gain takes place when price equals
marginal cost which is referred to as allocative efficiency.
The left-hand panel of Figure 7.1 gives equilibrium of competitive firm
showing price P0 = MC at point e. The price P0 is market clearing price at which
market demand AD equals supply BS at point E as shown on right hand panel
of the diagram. For equilibrium quantity Q0, the maximum price consumers are
willing to pay is at point A so that consumers surplus is the area P0AE. Similarly,
minimum supply price being at point B the producer surplus is the area BP0E.
The total surplus is the area BAE which is maximum possible for quantity Q0
because the total surplus is reduced if quantity is either below or above Q0.

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Fig. 7.1

7.4 MARKET FAILURE

Market failure refers to failure of market mechanism to achieve efficient allocation

of resources in the economy allowing a smooth circular flow of income. There
are several factors responsible for market failure. They are as follows:
(i) Lack of competition among firms and presence of market power in the
form of oligopoly or monopoly which is also called imperfect competition.
There is presence of excess capacity in these markets and price exceeds
marginal cost causing allocative inefficiency by reducing consumers and
producers combined surplus.
(ii) Provision of public goods whose consumption cannot be only restricted
to those who can pay for them and common property resources whose
owners are none but users are everybody.
(iii) Problems of externalities in both consumption and production wherein
action of one agent affects another in the society.
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(iv) Asymmetric information which creates a situation where one party to NOTES
a market transaction has more knowledge of its consequences than the
knowledge available to the other party. For example in the market for
second-hand cars, only the seller knows the actual condition of the car
and buyer has no information about the quality of the product.
(v) If there are missing markets, i.e., needed markets do not exist at all.
Market failure does not mean that nothing good is happening in the market
but it means that the best possible outcome has not been attained. It arises in
the following cases:
1. Asymmetric Information
2. Insurance Market
3. Market Signalling
4. Moral Hazard Problem
5. Principal Agent Problem
1. Asymmetric information: Asymmetric information means that the
buyers and sellers do not possess the same set of information, one
having a better or more set of information as compared to the other
and hence is better off. The problem is also known as Lemons Problem
given by Ackerlof. A ‘lemon’ is a derogatory term for a poor quality
second-hand car. However, the lemon’s problem has many wider
implications in terms of understanding information failure in general.
It can be explained with the help of an example as given below:
Example 1 – Let us assume that there is a car dealer who deals in
second-hand cars and is aware about the conditions of the car and does
not pass on the entire information to the buyers. Here the car dealer
is thus having better and more information and takes the advantage
of the information by selling the cars at a higher price then what they
are worth off. The buyers would purchase it once but after becoming
aware of the situation of the second-hand cars, they would not go for it
the second time at the same price as they are suspicious of the seller’s
intention and hence the market and the demand for second-hand cars
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NOTES reduce because of asymmetric information as all the good quality cars
are driven out of the market because of the lesser price being paid for
it and only low quality cars would be left in the market. After a short
period, it can be predicted that all cars sold in the second-hand car
market will be lemons. When applying this concept to other markets
it can be suggested that, whenever there is information failure, there
is the possibility that markets will become lemons markets. If so, the
supply of good quality products will fall and the supply of poor quality
products will rise.
This problem of asymmetric information can be reduced by getting more
information, like in the above case the buyers can get the second-hand
cars evaluated by an independent car evaluator to find the correct status
and price of the used cars.
2. Insurance market: Here also the problem is because of asymmetric
information but unlike the used cars, here it is buyer of the insurance
policy that is in possession of better and more information. It also leads
to adverse selection as can be explained using the following example:
Example 2 – Let us assume the case of a medical insurance where the
buyer of the policy has more information about his health. The premium
set by the insurance company is according to the average individual
that includes both the healthy and unhealthy individuals, but it is the
unhealthy ones that are more likely to go for insurance and it increases
the losses of the insurance company because of which the premiums
increase and it further rations out the healthy individuals out of the
insurance market as they are not willing to buy the insurance at such
high premiums. Thus the market now has only unhealthy individuals
which further increases the losses and hence forces the insurance
companies to go out of the market. This is also because of asymmetric
information.
3. Market signalling: The problem of adverse selection can be reduced or
even eliminated by market signalling wherein the producer gives signals
about better quality of its products to the buyers thereby preventing
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problem. Thus the buyers are able to differentiate between high quality NOTES
and low quality products and it gives the sellers an advantage as they
are able to sell high quality products at a higher price. This can be done
by branding the product or providing guarantees and warranties that
assure the buyer about the quality of the product and helps in reducing
the suspicion that buyers have about seller’s description of the product
or service.
4. Moral Hazard problem: This problem generally arises in case of
insurance where if an individual is insured then there are greater chances
of him being negligent about the subject matter of the insurance. Moral
hazard refers to a situation where you do not behave in a manner that
you are expected to in case there has been no one else to share the loss.
For example if an individual gets his building insured for fire then if
he does not take proper care to ensure that there is no fire then it is a
case of moral hazard. Similarly, if an individual after taking medical
insurance does not take preventive measures for his health, it also
leads to issue of moral hazard. Such situations lead to market failure,
because if the moral hazard is not reduced or eliminated then it leads
to increased premiums of insurance thereby defeating the very purpose
of insurance. The issue of moral hazard can be tackled by going for
Coinsurance wherein the insurance company bears a part of the loss
and the rest is borne by the beneficiary himself. For example in case
of an insurance by an individual wherein the insurance company
would bear 70% of the losses subject to a maximum limit in case of
a mishap and the remaining 30% of the total loss would be borne by
the insurance policy holder. Thus, in this case as the entire loss is not
covered up by the insurance company, the beneficiary is bound to take
care which he would have otherwise not assumed. Another way is to
ensure that enough precautions have been taken to avoid the loss, for
example in case of fire insurance even after taking the insurance it has
to be made sure that enough safety provisions were made and loss is
unavoidable. However, if the insurance company finds out that enough
safety provisions were not there then no compensation of loss is made
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NOTES 5. Principal agent problem: In a modern world there is separation of

ownership and management where the principal or the owners are the
shareholders whereas the organization is managed by the agents or the
managers. Because of this separation of ownership from management
arises the principal– agent problem. The problem arises because of
the distinction in the requirements and interests of the principal and
agent whereas owners want maximum profits or total present value of
the firm, the managers are usually interested in their self interests that
is increased salaries, reputation, etc. For example, the shareholders of
firms, the principals, usually delegate responsibility for day–to–day
decision making to appointed managers, the agents. This creates a
situation of asymmetric knowledge, with managers knowing much
more than the shareholders, and raises the possibility of inefficiencies,
especially when shareholders and managers have different objectives.
To avoid the conflict and ensure that the organization is working for the
best interest of the owners extra cost is incurred in terms of monitoring
costs that reduces the efficiency which would have been there without
these extra cost burden. The problem can be reduced to a certain extent
by providing incentives to the managers to work in the best interest of
the owners by providing them with Golden Parachutes or linking their
incentives with the fulfilment of owners requirements.

7.5 EXTERNALITIES

Till now all the lessons and the discussions are concentrated on the buyer and
the seller, there is however a third party also that is affected by the production
and/or consumption of the goods or services though not being directly a part of
the production or exchange process. The impact on such third party is known
as externality as it is external to the parties that are directly involved in the
generation process. Such effects can be positive or negative that is beneficial
or harmful, the former being external benefit and the latter being external cost.

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A simple example of external benefit can be getting oneself immunized for a NOTES
communicable disease; it is called external benefit as it will reduce the spread
of the disease to others who have not got themselves immunized. External cost
can be the effects of pollution that is being felt by the parties that reside near the
factories in spite of not being a part of the generation process. While individuals
who benefit from positive externalities without paying are considered to be free-
riders, it may be in the interests of society to encourage free-riders to consume
goods which generate substantial external benefits.
Positive Externality in Production: A farmer grows apple trees. An external
benefit is that he provides nectar for a nearby bee keeper who gains increased
honey as a result of the farmer’s orchard.
Negative Externality in Production: Making furniture by cutting down
rainforests in the Amazon leads to negative externalities to other people. Firstly,
it harms the indigenous people of the Amazon rainforest. It also leads to higher
global warming as there are fewer trees to absorb carbon dioxide.
Positive Externality in Consumption: If you take a three-year training
course in IT. You gain skills but also other people in the economy can benefit
from your knowledge.
Negative Externality in Consumption: If you smoke in a crowded room,
other people have to breathe in your smoke. This is unpleasant for them and can
leave them exposed to health problems associated with smoking.
Now government should try to encourage positive externalities and
discourage negative externalities which can be done by providing subsidies or
imposition of taxes as shown below:

Taxes and its Impact on External Costs

Taxes on negative externalities are intended to make consumers/producers pay

the full social cost of the good. This reduces consumption and creates a more
socially efficient outcome. Without a tax, there will be over consumption because
people ignore the external costs. It has been shown below using Figure 7.2.

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Fig. 7.2

In the above Figure 7.2, D is the demand curve of a commodity which

is downward sloping. S is the supply curve of the firm which is assumed to
be constant and therefore is horizontal straight line parallel to X axis, it is the
marginal private cost of production of the firms and does not include the external
costs. MEC is the marginal external cost curve which is upward sloping as with an
increase in output the external cost also increases, for example if we assume that
the external cost is the pollution that firm makes when it carries out production
then it will increase as the production increases. The total cost of production is
obtained by summation of private cost and external cost which gives Ss supply
curve that is parallel to MEC. The equilibrium that firm derives is where demand
and supply curve given by private cost intersects that is at point E’, where the firm
produces OQ level of output. However, the firm’s equilibrium should be at point
E where demand and total cost that includes both private and external costs are
equal. The firm should reduce its output to OQ’. This can be done if government
imposes tax on the firm which increases the private cost of production to S’ and
reduces the output to the desired level and with the tax revenue government can
carry out the task of pollution control thereby reducing the impact of externality.

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Subsidies and its Impact on External Benefits: NOTES

Fig. 7.3

In Figure 7.3, D is the demand curve that the firms take into consideration
for determining their equilibrium level of output; it includes only the marginal
private benefit. MEB is the marginal external benefit and S is the supply curve
of the firm derived from the marginal cost. The equilibrium is where demand
and supply curves intersect that is at point E where the firm is producing OQ
level of output. But this is not what the firm should be actually producing as it is
not taking into account the external benefit. Ds is the demand curve after adding
the marginal private benefit and marginal external benefit and the actual output
that should be produced should be where Ds and S intersect, it is at point E’ and
firm should be producing OQ’. To increase the output, government can provide
subsidy that reduces the cost of production and supply curve shifts downwards
to S’ and output increases to OQ’. Thus, increase in the output brings an increase
in the total external benefit.

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NOTES
7.6 PUBLIC GOODS

Generally, a commodity that is supplied by the government is known as public

good but in economics the term is somewhat different as for a good to be called
public good it should fulfill the following two characteristics:
1. Non-Rival – Consumption by one consumer does not restrict consumption
by other consumers – in other words the marginal cost of supplying a
public good to an extra person is zero. If it is supplied to one person, it is
available to all.
2. Non-Excludable – The benefits derived from public goods cannot be
confined solely to those who have paid for it. Non-payers who have not
paid anything for the production of the commodity too can enjoy the
benefits of consumption at no financial cost and economists call this the
‘free-rider’ problem. This leads to market failure as once the commodity
is produced it can be enjoyed by all and therefore there is problem in the
initiation that is who will pay for it.
The derivation of equilibrium in case of a public good is different from
that of the market demand curve as here the market demand is not obtained by
the horizontal summation of the individual demand curves but by the vertical
summation of the individual benefits derived by the persons enjoying the benefits
of the public good this is because of the fact that once one unit of public good is
produced it can be enjoyed by all. It has been shown in Figure 7.4.

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Here, let us assume that there are two consumers A and B and their demand NOTES
curves that show marginal private benefit, DA and DB, respectively. To get the
market demand curve or the total demand curve we need to add the two individual
demand curves vertically that gives DS as the demand curve. The equilibrium
is where DS intersects MC and it provides that OQ units of output would be
produced in the economy that would give the benefit of OA’ to consumer A
and OB’ to consumer B. Public goods are not normally provided by the private
sector because they would be unable to supply them for a profit. It is up to the
government to decide what output of public goods is appropriate for society. To
do this, it must estimate the social benefits from making public goods available.
Because public goods are non-excludable, it is difficult to charge people for
benefiting from a good or service once it is provided. The free-rider problem
leads to under-provision of a good and thus causes market failure.

7.7 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. Moral Hazard is a problem that usually arises in case of insurance.
2. Public goods are the goods being produced by the government.
3. Free-rider problem arises because of usage of a commodity by the non-
payers.
4. External costs can be reduced by granting of subsidy.
5. Externalities are not taken into account by the producer while determining
the equilibrium.
Ans. 1(T), 2(F), 3(T), 4(F), 5(T)
Exercise 2: Fill in the Blanks
1. The combined demand curve in case of public good is obtained
by………….. summation of the individual demand curves.

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NOTES 2. Free Riders is the problem associated with………….. .

3. A public good is one that has two important characteristics …………..
and ………….. .
4. Problem of moral hazard to a certain extent can be reduced by going for
………….. .
Ans. 1. Vertical 2. Public Goods 3. Non rival and non excludable 4.
Reinsurance.

Exercise 3: Questions

1. How is equilibrium obtained in case of Public goods?

2. What is market failure and under what conditions is there a situation of
market failure?
3. How is equilibrium obtained in case of Externalities?
4. Explain the concept of Lemons problem.
5. Explain why the combined demand curve of public goods is vertical
summation of the individual demand curves.

7.8 FUNCTIONS OF GOVERNMENT

Basic functions of government: According to Classical economist Adam Smith

government must-perform two basic duties:
(a) Government must protect the society from the violence and invasion of
other independent societies.
(b) Government must protect, as far as possible, every member of the society
from injustice or oppression of every other member of it. In the sphere of
economy this implies that government must provide security of property
and define and enforce property rights that give people a secure claim to
the fruits of their own labour and allow markets to function efficiently.

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These property rights include effective legislation on consumption and NOTES

production rights, working of institution such as insurance companies,
banking, stock exchanges and joint stock companies, etc. Accordingly, it
is the responsibility of the government to regulate and control monopoly
tendencies and ensure allocative and productive efficiency the way they
exist under a perfectly competitive market.

7.9 PUBLIC POLICY TOWARDS MONOPOLY AND

COMPETITION

We have already seen that monopoly is allocatively inefficient because of lower

output and price being higher than marginal cost which causes dead weight loss
to the society. This calls for government intervention. Government intervention
can take several forms as given below:
(i) Government may ask monopoly firm to produce at a price equal to marginal
cost. This is not a problem if the monopolist continues to earn profit at
marginal cost pricing. But in case of natural monopoly marginal cost pricing
will create losses to the firm. (See Figure 7.5)
In panel-1 of Figure 7.5 if government controls the price at p0 which is
equal to marginal cost at point-E there is still profits for the monopolist
since at this price average cost is C which is less. So, profit is P C , per
1 0 1
unit of output. Here the government successfully controls the monopolist
who also survives in the market by getting some profit.
But in case of a natural monopoly (panel-2 of Figure 7.5) marginal cost
pricing leads to loss because at price P = MC, average cost C is more
0 1
so that loss is C P per unit of output. Natural monopolies emerge in the
1 0
provision of public utilities where a single firm can supply the market
output.

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NOTES

Fig. 7.5

(ii) Even controlling price at average cost level may be inefficient again for
natural monopoly. As in panel-2 of Figure 7.5 P1 is average cost price
which is higher and the corresponding output, is below competitive level
of Q0.
(iii) Since both marginal cost and average cost pricing do not yield desired
result for natural monopolies, they are directly taken over by government
itself in many countries.
(iv) Technological changes have made many natural monopolies behave
like competitive industry. So, government policies must adjust itself to
continuous technological change.
(v) Due to failure of government as business organization there have been a
wave of privatization recently in many countries including India. Many
nationalized industries have been privatized in the UK. Disinvestment of
public sector units in India is another example. While allowing privatization
to be implemented rapidly governments are also creating public regulatory
authorities to look into the functioning of these natural monopolies. In
the UK, example of such bodies are OFTEL (Telephones), OFGAS (gas),
etc. Security Exchange Board of India SEBI is a regulatory body in India.
Privatization reduces governments’ role in business and allows innovations
to take place faster. It is expected that government’s intervention as
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NOTES
7.10 LEARNING OUTCOME

Economics generally revolves around demand and supply of a commodity that

is used to determine the equilibrium price and quantity but while doing so they
do not take into consideration the external costs and benefits that the third party
incurs because of the production and/or consumption process. These are known
as externalities and if it is external costs then government should try to reduce
the usage by imposition of tax and in case of external benefit the usage should be
increased by granting subsidies as that is the true equilibrium. Another important
concept that was discussed in the lesson was that of the public goods which is
not same as the goods produced by government but are the commodities that
are non-rival and non-excludable. Public goods also lead to market failure as it
brings the problem of free riders where in once a commodity is being produced
one cannot stop the non-payers from taking its benefit. Various other causes that
lead to market failure are moral hazard, principal agent issue, Lemons problem
and so on and the solution is reinsurance, golden parachutes, etc.
Government intervenes to regulate monopolies and other imperfect markets
to ensure allocative and productive efficiencies the way they exist under perfect
competition.

7.11 TERMINAL QUESTIONS

1. Give the meaning of market failure. What are the causes of market failure?
Explain.
2. Differentiate between positive and negative externalities with the help of
examples. How can they be dealt with to ensure better market outcomes?
3. What are the features of public goods? How are the public goods responsible
for market failure? Determine the efficient amount of public good that
should be produced?

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UNIT III: INCOME DISTRIBUTION AND
FACTOR PRICING

LESSON 8 MARKET FOR FACTOR INPUTS

DEMAND AND SUPPLY OF FACTORS
LESSON 9 FACTOR PRICING
Market for Factor Inputs Demand and Supply of Factors

LESSON 8 NOTES

MARKET FOR FACTOR INPUTS DEMAND

AND SUPPLY OF FACTORS
Devender
Assistant Professor
School of Open Learning
University of Delhi

Structure
8.1 Learning Objectives
8.2 Introduction
8.3 The Demand for Factors
8.4 Supply of Factors
8.5 Learning Outcome
8.6 Terminal Questions

8.1 LEARNING OBJECTIVES

• To explain demand for factors

• To understand relation between MRP and VMP
• To explain supply of factors

8.2 INTRODUCTION

The total output of an economy is the result of the joint productive efforts of
the various factors of production; land, labour, capital and enterprise. This
total output ultimately gets distributed among the factors that contributed to its
production in the form of wages, rent, interest and profit. The purpose of the
theory of distribution is to explain the principles that govern this distribution.
The distribution of total product depends on how the various factors are priced
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NOTES in the market. Thus, pricing of the various factors of production is the subject
matter of the theory of distribution.
There are two aspects of the factorial distribution of national income; (i)
determination of the per unit prices of the different factors and (ii) the division
of the national income as between the different factors, i.e., absolute and relative
shares of different factors in national income. The first question is essentially
a micro-economic problem concerning the determination of equilibrium at the
level of an individual firm or an industry. The second question concerns the
factorial distribution of income at the level of the economy and, therefore, forms
part of macro analysis. Thus, we have micro and macro theories of distribution.
In the present set of lessons we are concerned only with the micro theories of
distribution, i.e., the question of factor-price determination.
Just as the price of any commodity is determined by the interaction of the
forces of supply and demand, similarly the price of a factor is determined by the
interaction of the forces of supply and demand for it. The theory of distribution is,
thus, a special case of the theory of price determination discussed in the earlier set of
lessons. However, the supply and demand for factors exhibit some peculiarities which
have to be taken into account while considering the pricing of particular factors.
Herein lies the justification for a separate theory of factor price determination. Let
us first examine the demand for and supply of factors in some detail.

8.3 THE DEMAND FOR FACTORS

1. The Nature of the Demand for a Factor

Why does a producer demand a factor? The demand for a factor is derived (or
indirect) and not direct demand. The demand for a commodity is direct in the
sense that it directly satisfies some human want. The demand for a factor, on
the other hand, is not direct in this sense. A factor is demanded not for its own
sake, but simply because it can contribute to the production of some commodity
demanded by the consumers. For example, a farmer pays rent for the use of
land simply because it helps to produce, let us say, wheat which is demanded
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by the consumers. Similarly, he pays for seeds and fertilizers because they help
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Market for Factor Inputs Demand and Supply of Factors

When a producer employs an additional unit of a factor it yields him some NOTES
extra output. While demanding a factor, the producer is not so much interested
in the extra output that it yields him as in the amount of the extra revenue he
will get from the sale of that output. In other words, he demands a factor simply
because it ultimately contributes to his revenue. Hence the price a producer
will be willing to pay for a factor unit will depend upon the addition to his total
revenue which results from the employment of an additional unit of that factor.
The additional revenue yielded due to the employment of an additional unit of a
factor is called the marginal revenue product (MRP). For example, suppose that
by employing 10 labourers on a given plot of land a farmer gets 100 quintals of
wheat which sell for Rs. 20,000 in the market and by employing 11 labourers
instead of 10 he is able to raise 110 quintals of wheat which sell for Rs. 22,000.
It is evident that due to the employment of an additional labourer total revenue
of the producer rises from Rs. 20,000 to Rs. 22,000. Rs. 2000 is, thus, the MRP
of the 11th unit of labour. While demanding a factor the producer has his eyes
set on this quantity. It is in this sense that the demand for factors is derived out
of the demand for the commodities that they help to produce.

2. Different Concepts of Marginal Product

There are three different senses in which the concept of marginal product (MP)
is used. Firstly, it may be used to express the addition made to the total physical
product of a producer due to the employment of an additional unit of a factor, the
amounts of all other factors remaining constant We call this additional physical
product as the marginal physical product (MPP). For example, if by employing 11
labourers on a given piece of land instead of 10, the total wheat output of a farmer
increases from 200 quintals of rice to 220 quintals, then the MPP of the 11th unit
of labour will be said to be 20 quintals. Thus, the MPP of a factor is the addition
made to the total physical output of a producer due to the employment of an
additional unit of a factor while keeping the amounts of all other factors constant.
Secondly, the concept of MP may be used in value productivity sense.
The addition to the total revenue of a producer made by the employment of an
additional unit of a factor, with amounts of all other factors remaining constant,
is called the marginal revenue product (MRP) of the variable factor in question.
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According to this above example, the total physical product of the producer Material 125

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NOTES increases from 200 quintals to 220 quintals when he employs 11 labourers
instead of 10 on the same plot of land. Now if the total revenue of the producer
increases from Rs. 40,000 to Rs. 42,000 when he sells 220 quintals instead of
200, the MRP of the 11th labourer will be said to be Rs. 2,000.
It is evident that the MRP of a factor depends upon two things: (a) the
additional units of output produced and (b) the contribution of each unit of
output to the total revenue of the producer. The additional output produced
by the employment of an additional unit of a factor is called the MPP and the
contribution of an additional unit of output to the total revenue of a producer is
called the marginal revenue (MR). Thus:
MRP = MPP × MR
Thirdly, the concept of marginal product may also be used to denote the
market value of the MPP of a factor. For instance, the MPP of the 11th labourer
according to the above example is 20 quintals of wheat. Now if the ruling market
price of wheat, when the larger output is sold (220 quintals instead of 200 quintals)
is Rs. 200 per quintal, the market value of the additional output will equal Rs.
4,000, Rs. 4000 then will be said to be the value of marginal product (VMP) of
the 11th labourer. VMP is simply the MPP multiplied by the market price of the
commodity. As already explained in the context of the theory of firm, market
price and average revenue (AR) are one and the same thing. Thus:
VMP = MPP × AR

3. Relation between MRP and VMP

MRP equals MPP × MR while VMP equals MPP × AR MPP is common to both
concepts. MPP depends solely on the technical conditions of production while
MR and AR depend upon the structure of commodity market where the firm
sells its output. If the firm sells its output on a perfectly competitive commodity
market, it will be faced with a perfectly elastic demand curve and its AR and MR
will then be identical. Thus, in the event of perfect competition in the commodity
market the MRP (=MPP × MR) and VMP (=MPP × AR) of a factor to a firm will
be the same because AR and MR are identical. But if the firm is faced with an
imperfectly competitive commodity market, then MRP and VMP will not be the
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already studied, MR will necessarily be less than AR. From this, it follows that NOTES
in the event of imperfect competition in the commodity market, MRP (which
equals MPP × MR) will necessarily be less than VMP (which equals MPP ×
AR) because MR is less than AR. Thus, in conclusion we note that in case of
perfect competition in the commodity market MRP equals VMP and in case of
imperfect competition MRP will necessarily be less than VMP. Thus:
MRP (=MPP × MR) VMP (=MPP × AR) in case of perfect competition
in commodity market.
MRP (=MPP × MR) < VMP (=MPP × AR) in case of imperfect competition
in the commodity market.
We clarify the point further with a simple example. Suppose the total
physical product of a farmer per year increases from 200 quintals to 220
quintals of rice when he employs 21 labourers instead of 20, on a given piece
of land. The MPP of the 21st labourer, according to this example, would be
20 quintals. Further, suppose that the farmer sells his output on a perfectly
competitive commodity market so that the price of rice remains constant at Rs.
100 per quintal even when he sells the larger output. MRP of the 21st labourer
in this case would equal the change in the total revenue of the producer due to
the sale of the larger output, i.e., 220 × 100-200 × 100 = 22000–20000 = Rs.
2000. VMP (MPP × AR) in this case would also equal Rs. 2000 (=20 × 100 =
2000). Now suppose the farmer is faced with an imperfect commodity market
so that he is able to sell the larger output at Rs. 98 per quintal and not at Rs. 100
per quintal. In this case MRP of the 21st labourer would equal 220 × 98 – 200
× 100 = 21560 – 20000 = Rs. 1560. And VMP would equal MPP (=20) × AR
(=Rs. 98) = Rs. 1960. Why is MRP in this case smaller than VMP? The reason
is very simple. When the price falls from Rs. 100 to Rs. 98, this reduction in
price applies not only to the extra output but also to the earlier output (i.e., 200
quintals) which was earlier sold at Rs. 100 instead of Rs. 98. Thus, while the
producer gets additional revenue from the sale of the extra output (=20 quintals)
at the current market price equal to Rs. 1960, at the same time he suffers a loss
in his earlier total revenue equal to the fall in price (i.e., Rs. 2) multiplied by the
earlier total output (i.e., 200 quintals) i.e., output but also to the earlier output
(i.e., 200 quintals) i.e., Rs. 400. The MRP (or the net addition to the earlier Self-Instructional
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NOTES Thus as a general rule we note that in the event of imperfect competition in the
commodity market MRP will be less than VMP by the amount of loss of revenue
suffered by the producer on his earlier output due to the fall in price. In the
present case when, in order to sell the larger output (220 quintals instead of 200.
quintals), price falls from Rs. 100 to Rs. 98, he is compelled to sell the earlier
output (200 quintals) also at Rs. 98 per quintal and thus suffers a loss of revenue
of Rs. 400/-. Therefore, MRP of 21st unit will be less than its VMP by Rs. 400.

4. The Shape of the MRP Curve

The demand for a factor is derived from its MRP. MRP, as we have seen above
depends upon MPP and MR. The behaviour of MRP will thus depend upon the
behaviours of its components with changes in the quantity of the variable factor
employed. Under a given set of conditions, the behaviour of MPP is determined
by the operation of the law of diminishing returns (or the law of variable
proportions). The law states that as more units of a variable factor are used
with a given amount of other factors, after a point its MPP starts diminishing,
provided there is no change in the state of technology. We can explain this law
with a simple numerical example. Imagine a farmer employing more and more
labourers on a given plot of land. The Table 8.1 below records total, average and
marginal products as the farmer employs more and more labourers on the given
plot of land and other equipment, etc.
Table 8.1

No. of workers Total Product Average Product Marginal Product

(In physical units)
1 15 15 15
2 36 18 21
3 60 20 24
4 92 23 32
5 120 24 28
6 144 24 24
7 161 23 17
8 176 22 15
9 189 21 13
10 189 19 0
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Market for Factor Inputs Demand and Supply of Factors

The figures in the above Table 8.1 show that both the average and marginal NOTES
products increase at first and then decline. The marginal product falls faster than
the average. The important point to note is that with the employment of the fifth
unit the marginal product starts diminishing. The same phenomenon is depicted
in Figures 8.1 and 8.2.
In the Figure 8.1 below the MPP curve rises till the employment of OA
units of labour and thereafter it falls continuously. The APP curve rises till the
employment of OB units and thereafter starts declining. The relationship between
APP and MPP is the same as that between AC and MC explained in the earlier
set of lessons.

Fig. 8.1 Fig. 8.2

In order to convert the MPP curve into the MRP curve we need to know
the contribution to revenue made by the MPP at each level of employment of
the factor. It bears repetition to point out at this stage that while MPP depends
entirely on the technical conditions of production, its value productivity depends
upon the commodity market where the firm sells its output. If the firm sells its
output on a perfectly competitive market, its MR will equal its AR and thus the
MRP curve can be derived from the MPP curve simply by multiplying the MPP
corresponding to each level of employment of the factor by the given market
price of the product (AR). Figure 8.2 depicts the MRP curve corresponding to
the MPP curve of the Figure 8.1.
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NOTES Carefully note the fact that just like the MPP curve the MRP curve is also
downward sloping. The reason for this is the diminishing marginal productivity
of the factor. Also note the fact that in this particular case MRP curve is also the
VMP curve.
However, as already explained, if the firm is confronted with an imperfectly
competitive commodity market, it will be able to sell larger outputs only by
reducing the market price so that MR will be less than AR. As a result two things
happen. Firstly, as the firm is able to sell its extra output at a lower price, the VMP
curve (which is derived from the technically given MPP curve by multiplying
MPP corresponding to each level of employment of the factor by the market price
of the product) will fall more sharply than the MPP curve. Secondly, since MR
will be less than AR, the MRP curve will lie below the VMP curve and slope
more sharply than the latter. Figure 8.3 depicts the VMP and MRP curves of a
firm selling its product in an imperfectly competitive commodity market.

Fig. 8.3

The difference between MRP and VMP is further explained with

hypothetical figures given in Table 8.2 below.

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Table 8.2 Difference between MRP and VMP under Perfect NOTES
and Imperfect Competition in the Commodity Market

Units of Total MPP. Perfect Competition in the Imperfect Competition in the

the Factor Product Commodity Market Commodity Market
Pirce T.R. M.R.P. V.M.P. Pirce T.R. M.R.P. V.M.P.
1 15 15 100 1500 1500 1500 100 1500 1500 1500
2 36 21 100 3600 2100 2100 99 3564 2064 2079
3 60 24 100 6000 2400 2400 98 5880 2316 2352
4 92 32 100 9200 3200 3200 97 8924 3044 3104
5 120 28 100 12000 2800 2800 96 11520 2596 2688
6 144 24 100 14400 2400 2400 95 13680 2160 2280
7 161 17 100 16100 1700 1700 94 15134 1454 1598
8 176 15 100 17600 1500 1500 93 16368 1234 1395
9 189 13 100 18900 1300 1300 92 17388 1020 1196
10 197 8 100 19700 800 800 91 17927 539 728

Explanatory Notes:
1. MPP = Difference between two successive total products.
2. T.R, = Total revenue = Total product × price at which it is sold:
3. MRP = Marginal revenue product = Difference between two successive
total revenues.
4. VMP = Value of MPP = MPP × the price at which total product sells.
Carefully note the following:
1. Total product and MPP figures are the same because they are determined
purely by technical factors.
2. In case of perfect competition in the commodity market, MRP and VMP
figures are identical.
3. In case of imperfect competition in the commodity market MRP is
always less than VMP.

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NOTES 5. Firm’s Demand Curve for a Factor

Just as it is true that a profit maximizing firm, whether it is selling its product
under conditions of perfect competition, imperfect competition or monopoly,
will produce to the point at which its MC equals its MR, so it is true that a profit-
maximizing firm will purchase units of a variable factor up to the point at which
the addition to its total cost resulting from the employment of an additional unit
(i.e., marginal factor cost, MFC) equals the MRP of the factor in question. Thus,
in the purchase of a single variable factor a firm will be in equilibrium when
MFC equals MRP of the factor.
Thus, in equilibrium:
MFC = MRP (1)
The above condition is a perfect general equilibrium condition applicable
to all market situations. If we further assume that the firm is able to purchase
any amount of the factor without influencing market price (i.e, purchases in a
competitive factor market), the MFC of the factor to the firm is simply the market
price (AFC). Therefore, for firms that purchase their factor supplies in a perfectly
competitive market the above equilibrium condition (1) can be alternatively
stated as follows:
AFC = MRP (2)
This condition allows us to derive a firm’s demand curve for a factor from
the MRP curve. The factor’s MRP curve shows different MRPs corresponding
to the different amounts of the factor employed with given amounts of all other
factors, Firm’s demand curve for a factor would show the different amounts of
the factor that the firm would be willing to purchase at different prices of the
factor. Therefore, when a firm purchases its factor supplies in a competitive factor
market (so that MFC = AFC) the MRP curve of the factor becomes the firm’s
demand curve for the factor as shown in the Figure 8.4.
In the Figure 8.4, amount OA of the factor equates its MRP at point ‘a’
with the price OW. Therefore, at OW price the firm would be willing to purchase
OA amount of the factor. Amount OB of the factor equates its MRP at point ‘b’
with price OWS. Therefore, with OW, as the price the firm would be willing
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Market for Factor Inputs Demand and Supply of Factors

to purchase OB amount of the factor. Similarly, at OW2 price the firm would NOTES
be willing to purchase OC amount of the factor. However, at this stage let us
carefully note that the MRP curve is the firm’s demand curve for the variable
factor in question on the assumption that the price of the product and the price
of the factor are both given for the firm.

Fig. 8.4

6. Market Demand Curve for a Factor

In the preceding Figure 8.4, the MRP curve is the firm’s demand curve for the
factor in question on the assumption that changes in the price of the factor do
not, directly or indirectly, affect the price of the commodity produced and hence
the given MRP curve. This assumption would be valid only if all other firms in
the industry keep their outputs fixed. However, this is not a realistic assumption.
In the event of a fall in the price of a variable factor we would expect all firms
in the industry to employ more of this relatively cheaper factor. This would
increase the total output of the industry and cause the price of the commodity
to fall. A fall in the price of the commodity would cause the MRP curves of all
the firms (based on the higher price of the commodity) to shift leftward. Firms
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NOTES (corresponding to the lower commodity price). Thus, each fall in the price of a
variable factor (via its effects on the factor’s total employment, total output and
hence the price of the commodity produced) will give rise to a new lower MRP
curve with one equilibrium point corresponding to the new factor price. The line
joining such equilibrium points on the different MRP curves will be the firm’s
demand curve for the variable factor in question when the reactions of other
firms in the industry to changes in the price of the factor are allowed for. This
is shown in the Figure 8.5.

Fig. 8.5

In Figure 8.5 let us start from an equilibrium position such as point a on

the curve MRP, with OW as the factor price and OA as the amount demanded
of it by the firm. Now suppose the price of the variable factor falls from OW to
OW1. All firms in the industry employ more of this factor, as a result total output
of the commodity increases and consequently price of the commodity falls. Fall
in the price of the commodity (say, from Rs. 100/- to Rs. 98/-) causes the MRP
curves of all firms to shift leftward. Suppose as a result of these indirect effects
the MRP in the Figure 8.5 above shifts position MRP2 with MRP2 and OW1
as the factor price equilibrium is established at point b with OB as the amount
demanded of the factor 0. Similarly, when the price of the factor rails further to
OW2, MRP2 shifts leftward to the position of MRP3 on which equilibrium with
the lower factor price (OW2) is established at point ‘c’; with OC as the amount
demanded of the factor. The line DD joining equilibrium points such as a, b, c,
etc., is the firm’s demand curve for the factor when reactions of other firms in
the industry to variations in the price of the factor are allowed for.
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The lateral summation of the demand curves of all firms for a factor, as NOTES
derived above, gives us the market demand curve for the factor in question. Just
like the firm’s demand curve, the market demand curve for a factor will also be
downward sloping.

7. Firm’s Demand Curve for a Factor when factor Market Imperfect

As explained earlier, equality of MRP with MFC of a variable factor determines

a firm’s equilibrium in the purchase of a single variable factor under all market
situations. However, a firm’s demand curve for a factor, defined as indicating the
different amounts of the factor demanded by the firm at different prices of the
factor, is based on the assumption that MFC of the factor to the firm equals its price
(AFC) so that equality of MFC with MRP also means the equality of price of the
factor (AFC) with MRP. This implies that the firm purchases its factor supplies in
a perfectly competitive factor market so that it is able to purchase any amount of
the factor without influencing the given market price and as a result MFC of the
factor equals its AFC. We derived the individual and the market demand curves
in the preceding sub-section on the basis of this assumption. However, if a firm
does not purchase its factor supplies in a perfectly competitive factor market, it
will be able to purchase larger amounts of the factor only at higher prices. When
a firm purchases larger amounts of a factor at higher prices, MFC of the factor
will necessarily be higher than its AFC. For example, if in order to purchase 51
instead of 50 units of a factor a firm has to raise the factor price from Rs. 100
to Rs. 102, the MFC of the additional unit to the firm will equal Rs. 202 (102 ×
51- 100 × 50 = 202) which is greater than AFC.
When the MFC of a factor to a firm is greater than its AFC, it cannot afford
to equate MRP with the AFC because in doing so it will incur a net loss equal
to the excess of MFC over AFC and thus reduce its profits. In such a case the
MRP curve cannot be described as the firm’s demand curve for the factor in the
sense of indicating the different amounts of the factor demanded by the firm at
different prices of the factor. Even in such cases MRP curve will be described
as the firm’s demand curve for a factor but in a different sense which we will
explain in a latter section.

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NOTES
8.4 SUPPLY OF FACTORS

I. Supply of Factors to the Whole Economy

At first glance it may appear that quantities of most factors are fixed in an
economy. For example, there is an upper limit to the number of workers.
Similarly, there are upper limits to quantities of coal, oil, copper, iron ore, etc.,
available in the economy. However, in practice we are never near these limits.
Often a large undiscovered or unexploited quantity exists, and a shortage of the
resource that raises its price encourages exploration and the development of
previously unprofitable sources. Thus, the supply of a resource to the economy
usually varies considerably with changes in the price of the resource. With this
brief introduction we now come to a discussion of the characteristic features of
the supplies of individual factors.

2. Supply of Land

Land in economics includes all natural resources provided free by nature. The
quantity of a particular natural resource existing in the world is, of course,
limited. But we are never near these upper limits. Generally large undiscovered
(or unexploited) sources exist and a shortage that raises their prices encourages
exploration, research and development of previously unprofitable sources.
Therefore, the supply of any natural resource usually varies considerably with
changes in its price. A high return to land provides incentives for the development
of its productive powers through irrigation, drainage, fertilization, etc., which
greatly increase the supply of arable land. On the other hand, if the return to
land is low, its fertility may be allowed to be exhausted within a short period
of time. Traditionally, however, the supply of land (which includes all natural
resources besides mere space) to the whole economy has been assumed to be
absolutely inelastic.

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3. Supply of Labour NOTES

By the supply of labour (or the supply of effort) we mean the total number of
hours of work that the population is willing to supply. The supply of effort depends
upon the following factors:
(i) The size of the population: The size of the population sets the upper
limit to the total of labour. While there is some evidence that the birth
and immigration rates are higher in good times than in bad times, it is
doubtful especially in advanced economies, whether economic factors are
of paramount importance in determining the growth of population. It is
difficult to establish any definite relationship between the reward of labour
and growth of population. The reasons for which population varies are at
the moment largely unexplained. Therefore, for our purpose we may take
the size of population as fixed.
(ii) The proportion of the population willing to work: The proportion of
the population entering the labour market varies considerably in response
to variations in the wage rate. Generally, a rise in the wage rate results in
an increase in the proportion of the population willing to work. Women,
old people and even young boys are induced to join the labour force when
the wage rate is high. For example, the proportion of married women and
old persons in the labour force increased dramatically during the Second
World War. In addition to the rate, the proportion of the population entering
the labour market also depends on the age composition of population,
social institutions, customs and distribution of wealth in the economy. For
example, the extent to which women, especially married women, enter
the labour market partly depends on customs and opportunity. Customs
and opportunity can vary from one time to another and from one place to
another even within the same country. Greater equality in the distribution
of property in a society, by reducing the number of those who live on
unearned incomes and consequently do not need to work, will increase
the supply of labour in an economy.

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NOTES (iii) The number of hours of work offered by each individual worker: By
hiring out his services a labourer gets some money as his wage. With this
money he purchases goods and services for his consumption. Thus, the
labourer trades his leisure for goods, by giving up leisure (i.e., by working)
he gets money, and hence, goods. A rise in the wage rate means that there
is a change in the relative price of goods and leisure. Leisure becomes
dearer- relative-to goods (since each hour of leisure consumed now is at
the cost of more goods forgone), or alternatively, goods become cheaper
relative to leisure since each hour worked (i.e., leisure traded for goods)
now results in more goods than before. In the context of the theory of
consumer’s demand we noted that a consumer tends to substitute a cheaper
good at the cost of a dearer good when their relative prices change. The
same logic applies to change in the wage rate also. Due to rise in the wage
rate, goods become cheaper relatively to leisure and as a result a labourer
tends to substitute goods at the cost of his leisure; he tends to have more
goods by reducing his leisure. This is known as the, ‘substitution effect’
of wage increase.
The substitution effect of a wage increase will tend to expand the supply
of effort in two ways. Firstly, some of those who were not willing to work at
the lower wage rate would now like to work because leisure has now become
costlier in terms of goods forgone. Secondly, for the same reason those who
were already working would now like to put in more hours of work per day or
per week by reducing their leisure. Thus, the total supply of effort will tend to
expand due to these two factors.
Quite apart from the substitution effect discussed above, a wage increase
also generates an income effect. With an increase in the wage rate a labourer
grows richer than before even if he continues to work the same number of hours
per day or per week as he did when the wage rate was lower. Being richer the
worker would demand more of all normal goods including leisure. He will spend
a part of the increase in his real income in the purchase of leisure. He can do so
by reducing the number of hours worked. So, the income effect of a higher wage
rate induces the worker to reduce the number of hours worked per day or per,
week. Thus, the substitution and income effects of a wage increase tend to pull in
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worked while the income effect tending to reduce the number of hours worked. NOTES
The net effect of a wage increase on the supply of effort will, therefore, depend
on the relative strengths of the two opposing tendencies. If the substitution effect
is stronger than the income effect, labourers will put in longer hours of work in
response to a rise in the wage rate. But if at any stage income effect becomes
stronger than the substitution effect, labourers will put in shorter hours of work
consequent upon arise in the wage rate. The supply curve of effort in this case
will be backward rising as the one shown in Figure 8.6 below.
In figure 8.6 (A), as the wage rate rises from W1 to W2 and then to W3.
The supply of effort expands from OA to OC and then to OD. In other words,
upto the wage level W3 substitution effect is stronger than the income effect
and as a consequence supply of effort expands in response to increases in the
wage rate. But when the wage rate rises beyond W3 the income effect becomes
stronger than the substitution effect and consequently the supply curve of labour
starts sloping backwards to the left. In the Figure 8.6 (B) when the wage rate
increases from W3 to W4 instead of expanding, the supply of effort actually
contracts from OD to OB.

Fig. 8.6

Concluding our discussion of the supply of effort we can say that the
backward rising supply of effort curve presents a strong possibility but cannot
be taken as the typical case. There is no conclusive evidence available in support
of a backward labour supply curve. Therefore, we assume that normally labour
supply curve will be upward rising bending.
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NOTES 4. Supply of Capital

Capital is a man-made factor of production and interest is its cost. The supply
of capital in a country consists or the existing machines plants, equipment,
buildings, etc., and is called the Capital Stock. In the course of production during
the year a part of the existing capital stock is used up and to that extent the supply
diminishes. On the other hand, new machines, buildings, plant and equipment are
produced every year which go partly to replace the worn-out part of the capital
stock and partly to add to the stock. Ignoring cyclical fluctuations, the supply of
capital has been increasing over time in all modern economies.

5. Supply of factors to particular uses

Different factors of production can normally be put to alternative uses. Only

few resources may be specific to a particular use and that too only in the short
run. A given piece of land can be used to grow a variety of crops. Similarly, a
labourer can be employed either to weave cloth in a factory or to build a road or
to dig a canal or to grow various crops on a farm. Therefore, factors have to be
allocated among various competing industries and among different firms in the
same industry in a rational manner.
Factor owners choose the use for their resources in which they earn the
most. They, of course, take many other things into account besides monetary
benefits. Factors move among different uses until there is no net advantage in
further movement. A change in the relative price paid to a factor in two uses leads
factor owners to increase the quantity supplied to the use in which the relative
price has increased and to decrease the quantity supplied to the use where it has
decreased. This means that higher the (relative) price offered to a factor in a
particular use, the larger will be the amount of the factor supplied to it. This gives
rise to an upward rising supply curve to an industry as shown in the Figure 8.7.
SS curve in the Figure 8.7 is the supply curve of a factor to an industry.
It is upward rising indicating that higher the price offered to the factor, larger is
the quantity supplied to the industry in question. For example, when the price
offered is OW1 only OA amount of the factor is supplied.

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NOTES

Fig. 8.7

But when the price offered rises to OW2, amount supplied increases to OB.
And when the price offered rises to OW3 amount supplied increases further to OC.
As explained previously, the supply curve of any factor to the economy
as a whole will be normally more than perfectly inelastic. However, even in a
case where the supply curve of a factor to the economy as a whole is perfectly
inelastic (as for example, classical economists assumed the supply of land to
be), its supply to a particular industry will not be perfectly inelastic, it will be
more classic because the industry will always be able to attract more units of the
factor from other industries by offering a slightly higher price. Therefore, the
supply curve of a factor to an industry will normally be more elastic compared
to its elasticity of supply for the whole economy.

6. Supply of a factor to an individual firm

In a factor market a firm may be either one of a large number of purchasers or one
of the few purchasers of a particular factor. If the firm is one of a large number
of purchasers of the same factor, its purchases will constitute a negligibly small
fraction of the total market supply of the Factor. As a result, the firm would be
able to purchase any amount of the factor at the going market price. In other
words, the supply of the factor to such a firm will be perfectly elastic at the
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NOTES already explained, when the supply of a factor is perfectly elastic, price (AFC)
and marginal factor cost (MFC) to the firm are identical. On the other hand, if
the firm in question is one of the few big purchasers of a factor, its purchases
will constitute a sizeable fraction of the market supply of the factor and as a
result when the firm buys a large amount of the factor, its price is raised. Thus,
in such a case the firm is able to buy more units of the factor only at higher and
higher prices. The supply curve of the factor to the firm in such a case will rise
upward. When the supply curve is upward rising, as already explained, MFC is
higher than AFC and therefore, the MFC curve lies above AFC curve.
We may conclude our discussion by observing that normally the supply
of all factors to an economy is responsive to factor prices in the long run. In the
short run the same factor can have supply curves ranging from the vertical (i.e.,
perfectly inelastic supply curve) to the horizontal, depending on which demand
curve is coupled with supply-the demand curve of a small firm, of an industry
(or a big firm) of a group of industries (i.e., the whole economy). This is shown
in the Figure 8.8.
It is thus evident that even when the supply of a factor to the economy as
a whole is rigidly fixed (as in Figure 8.8 (A) below), it will be more elastic to a
particular use (as shown in Figure 8.8 (B) below), and will be perfectly elastic
to a small user of the factor (as shown in Figure 8.8 (C) below).

Fig. 8.8

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NOTES
8.5 LEARNING OUTCOME

In this lesson you have learnt the following:

1. In the economic sense factor supplies for the economy as a whole are never
perfectly inelastic except, possibly, in the very short run.
2. Supply of a factor to an industry is generally more elastic than its supply
to the whole economy.
3. Supply of a factor to a small user of the factor can be assumed to be perfectly
elastic.

8.6 TERMINAL QUESTIONS

1. What are the determinants of demand for factor? Derive individual and
market demand curve of factor.
2. What are the determinants of supply of factors in the economy and for
firms? Discuss.

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LESSON 9 NOTES

FACTOR PRICING
Tanu Singh
Assistant Professor
Delhi College of Arts & Commerce
University of Delhi

Structure
9.1 Learning Objectives
9.2 Introduction
9.3 Marginal Productivity Theory
9.4 Self Assessment Questions
9.5 Economic Rent
9.6 Self Assessment Questions
9.7 Learning Outcome
9.8 Terminal Questions

9.1 LEARNING OBJECTIVES

• To understand the concept of Factor Pricing

• To differentiate between pricing of commodity and factors of production
• To establish the equilibrium in pricing of factors
• To comprehend the Marginal Productivity Theory

9.2 INTRODUCTION

Till now all the lessons have discussed about output market, that is, how
equilibrium price of a commodity is determined by the analysis of its demand
and supply. This lesson concentrates on the input market, that is, how pricing of
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NOTES the factors of production that are used to produce the commodity is determined.
It is not only dependent on the demand and supply of the factor itself but also
on the productivity of the factor. There is however few differences between the
pricing of a commodity and a factor of production like:
1. Demand for a factor of production is not direct but indirect demand as
it is dependent on the demand for the commodity for which it is used. If
there is no demand for that commodity then the factor too would not be
demanded. For example if a particular type of labour is used in manufacture
of tyres and if demand for tyres increases then the demand for the labour
too would increase and vice versa.
2. Demand for a factor of production is a joint demand as no commodity can
be produced by using just one type of factor of production. A particular
combination of different factors of production is needed to produce a
commodity. Though the factors of production can be substituted for each
other but this substitution is not infinite.
As done in the commodities market that there can be various types of market
structures starting from perfect competition on one extreme and monopoly on
the other extreme, similarly in the factor market too price determination is done
under the following conditions:
1. Perfect competition in both the product (commodity) market and factor
market.
2. Imperfect Competition in product market and perfect competition in
factor market.
3. Perfect Competition in product market and imperfect competition in
the factor market.
4. Imperfect competition in both product and factor market.
Pricing of a factor of production say land, labour, raw material or other
inputs is explained by Marginal Productivity theory as given below.

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NOTES
9.3 MARGINAL PRODUCTIVITY THEORY

Marginal Productivity Theory, a significant work that explains how factors of

production are priced was given at the end of 19th century and its main contributor
was John Bates Clark who proposed that a business firm would be willing to pay
a productive agent only what he adds to the firm’s well-being or utility. In other
words every input will be paid the value of its marginal product.
According to J.B. Clark, “Under static conditions, every factor including
entrepreneur would get a remuneration equal to its marginal product.”
Productivity can be measured in three ways:
1. Marginal Physical Product (MPP) – It refers to addition to total
production by addition of one variable factor of production, other things
remaining constant.
For example: One unit of variable factor of production produces 10
units of output and two units of variable factor produces 22 units of
output, the MPPl would be = 22 – 10 = 12 units
MPPn = TPPn – TPPn– 1
Where TPPn = Total Physical Product or total output using ‘n’ units of
variable factor of production.
TPPn– 1 = Total Physical Product or total output using ‘n–1’ units of
variable factor of production.
2. Marginal Revenue Product (MRP) – It refers to addition to total
revenue by employing one additional variable factor of production,
other things remaining constant.
For example: In case of Perfect competition in the product market if
one unit of variable factor of production produces 10 units of output
which can be sold at the rate of Rs 20 per unit and two units of variable

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NOTES factor produces 22 units of output, then MRPl = 12 units * Rs 20 = Rs

240
MRPl = MPPl * MRx
where, MPPl = Marginal Physical Product of ‘l’ units of factor of
production
MRx = Marginal Revenue of the commodity (product)
Note: In case of Imperfect competition in the product market, marginal
revenue would be different from the price of the commodity. This has
been taken in Lesson 6.
3. Value of Marginal Product (VMP) – It refers to the Marginal Physical
Product multiplied by the price of the commodity.
VMPl = MPPl * Px
where, MPPl = Marginal Physical Product of ‘l’ units of factor of
production
Px = Price of the commodity (product)
Marginal Productivity Theory is based on the following assumptions:
1. Perfect Competition in Product Market - Product market has perfect
competition implying that the price of the commodity is determined
by the industry and all the firms take that price as given, also the price
remains same and firms can produce and sell any quantity at the same
price. In case of perfect competition in the product market, marginal
revenue product and value of marginal product are same as price and
marginal revenue of the commodity are equal.
2. Perfect Competition in Factor Market - Factor market also faces
perfect competition that is at the prevailing factor price, any units of
factor of production can be employed.
3. Factors of Production are Homogeneous - All units of the factors
of production are homogeneous that is all are equally efficient and no
unit of factor of production is more or less productive than the other.

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4. Substitution of Factors of Production is Possible - Different factors NOTES

of production can be substituted for each other, that is, labour can be
substituted for capital and vice versa.
5. Factors of Production are divisible - Factors of production can be
used in any divisible parts.
6. Goal of the Firm is Profit Maximization - Objective of the firm
carrying on the production of a commodity by employing factors of
production is to maximize profits.
7. There is Full Employment in the Economy - Economy is utilizing
all the factors of production that are available such that there is neither
underemployment nor overemployment.
8. Technology is Constant - There is no change in the technology because
if technology improves then production too can increase with the same
units of factors of production, but this is assumed to be constant.

Explanation of the Marginal Productivity Theory

The theory explains the demand for factors of production based on the belief that
a profit maximizing firm would employ a factor of production after analyzing
its marginal productivity (benefit to the firm) and its cost to the firm. The theory
is based on the Law of diminishing marginal returns which states that as more
and more variable factors of production are employed along with a fixed factor
of production, the output first increases at increasing rate then at diminishing
rate and ultimately the marginal product of the variable factor declines.

Step 1: Demand for Factor of Production by a Single Firm

Case 1: When there is only one variable factor of production.

Law of variable proportion suggested that as firm increases the variable
factor with fixed quantity of other factors then total output first increases at
increasing rate then at diminishing rate and ultimately falls. It also suggested
that a profit maximizing producer would operate in the second stage where total
physical product (total output) is increasing at diminishing rate and marginal
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NOTES physical product is falling. Thus, the shape of marginal physical product (MPP)
is downward sloping as shown below in Figure 9.1:

Fig. 9.1

Figure 9.1 reveals what happens in the factor market. Now moving to the
product market, here also the firm is operating under perfect competition, thus its
demand curve is a straight line parallel to X axis and price is equal to marginal
revenue as it is fixed by the industry. It is shown in Figure 9.2. It is because of
this that marginal revenue product and value of marginal product coincide as
shown in Figure 9.1.

Fig. 9.2

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Now to get the demand curve of labour (it being the only variable factor), NOTES
we assume that wage rate is w1, at this rate the firm demands OL1 units of labour
where the cost of employing labour is equal to its benefit to the firm which is
measured by its productivity (given by VMPl). If wage rate changes to w2 or w3,
the demand of the variable factor (in this case labour) changes to OL2 and OL3
respectively. Thus, the VMPl curve is the demand curve of labour (variable factor)
for the firm in case of perfect competition in the product and factor market and
when labour is the only variable factor as shown in Figure 9.3.

Fig. 9.3

According to Gould and Lazear, “Thus the individual demand curve for a
single variable productive service is given by the value of the marginal product
curve of the productive service in question.”
Case 2: When there are several variable factors of production.
In case of firms carrying on production with various factors such that
more than one factor is variable, then the VMP or MRP is not the demand curve
as now there are multiple variable factors and they are interdependent. This is
because a change in the price of any one factor brings relative changes in price
that brings adjustment in all the variable factors of production. There are three
effects that work behind this adjustment: Income effect, Substitution effect and
profit maximizing effect. This is being explained with Figure 9.4.
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NOTES

Fig. 9.4

Initially if the wage rate is w1 the iso cost line is AB’ and producer is at e1
equilibrium using OL1 units of labour. If we assume that there are only two factors
of production that are variable namely labour and capital then with reduction in
the wage rate of labour to w2, the iso cost line pivots to AB’ and producer moves
to higher isoquant using OL2 units of labour. The increase in labour from OL1
to OL2 in fact consists of two effects namely substitution and output effect. To
divide the total effect into these two effects we draw an iso cost line parallel to
AB’ and tangent to old isoquant. The movement from e1 to e3 on the same isoquant
shows the substitution effect as labour that has become relatively cheaper is being
substituted for capital to produce the same level of output. The remaining that
is OL3 to OL2 is the output effect showing how higher output can be produced
because of cheaper labour that gives the firm higher purchasing power. E3 the
new equilibrium where firm produces Q2 units of output is however not the profit
maximizing level as with reduction in the wage rate the marginal cost of the firm
reduces and firm’s profit maximizing level of output increases to Q3 which is the
final equilibrium showing the impact of reduced wage rate in both the product
market and factor market. It is being shown in Figure 9.5.

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NOTES

Fig. 9.5

The impact of all these three effects shifts the VMP curve. Because of
the substitution effect more of labour is being used with lesser units of capital
that reduces the marginal physical productivity of labour and shifts the MPP or
VMP curve to the left. Output effect and profit maximizing effect that brings
increase in both the labour and capital shifts the MPP or VMP curve to the right
as it increases the productivity because both the factors are increased. Thus, the
final shift in the VMP curve is to the right with reduced wage rate as shown in
Figure 9.6.
The demand curve in case of more than one variable factor is thus the loci
of equilibrium points joining the wage rate and shifting VMP curves.

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NOTES Step 2: Demand for Factor of Production by the Industry

All similar firms when combined together form the industry. In the product
market horizontal summation of the demand of all firms is equal to the demand
of the industry but the same is not the case in factor market. It can be explained
using Figure 9.7:

Fig. 9.7

Initially with wage rate OW1, firm is using OL1 units of labour and if we
assume that there are ‘n’ firms in the industry then the total demand of labour
is horizontal summation of the demand of labour by all the firms that is n*OL1.
If wage rate reduces to OW2 then all firms demand more of labour and produce
more of the commodity. With increased supply the price of the commodity in
the product market reduces which shifts the VMP curve to the left and hence at
reduced price the demand of labour is OL2’ and not OL2. Thus, cs demand for
the whole industry is n*OL2’. So we see that in factor market the demand of
the industry is not simply the horizontal summation as is the case in the product
market because of interaction between factor market and product market.

Step 3: Supply of a Variable Factor of Production by a Single Individual

Supply of labour by one individual is backward bending showing that initially

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increase in the wage rate the individual substitutes leisure for work and reduces NOTES
the supply of labour to enjoy the wage that he has earned. It is explained with
the help of indifference curve analysis.

Fig. 9.8

Figure 9.8 has leisure hours on X axis measured from left to right and
hours worked from right to left, and money income on Y axis. When wage rate
is W1 the income-leisure line is AM1 and individual is at equilibrium e1 where
IC1 is tangent to AM1 where he is having OL1 leisure hours and working for AL1
hours. Now if wage rate increases then income-leisure line pivots to AM2 where
individual moves to new equilibrium at e2 working for more number of hours
that is AL2 to earn higher income. With further increase in wage rates individual
moves further to e3 where he reduces hours worked and increases leisure hours
to OL3. Joining the successive equilibrium points we get the wage offer curve
which shows that initially with increase in wage rate, an individual works more to
earn higher income and with further increase in the wage rate consumer reduces
hours worked to enjoy the income that he has earned. Figure 9.8 can also be
presented as Figure 9.9.
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NOTES

Fig. 9.9

Thus, the supply curve of labour by an individual is backward bending as

initially Income effect is stronger that forces the individual to work more and
earn higher income. with further increase in wage rate substitution effect becomes
stronger that forces the individual to work less and substitute leisure for work.

Step 4: Market Supply curve of a Factor of Production (Labour)

The individual supply curve of labour is backward bending but for the market
as a whole the supply curve (Figure 9.10) is upward sloping because of the
following reasons:
1. Geographical Mobility – With increased wage rate labour may move from
location to another thereby increasing the supply with increase in the wage
rate.
2. Occupational Mobility – Individuals may also shift from one occupation
to another with increase in the wage rate thereby increasing the supply.
3. Retired individuals may also join the work force with increased wage rate.
4. Youngsters too join the work force as part time with increase in the wage
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NOTES

Fig. 9.10

Step 5: Determination of Equilibrium Factor Price

As in the product market the price of the commodity is determined by the

intersection of market (industry) demand and supply curve, similarly the factor
price too is determined by the intersection of the industry demand and supply
curve of the factor of production. Taking the case of labour the equilibrium wage
rate is determined in the following manner (Figure 9.11):

Fig. 9.11

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NOTES The market demand for labour which is obtained from step 2 above is
downward sloping. The market supply curve of labour obtained from step 4 above
is upward sloping. The intersection of these two curves gives the equilibrium
factor price (wage rate in this case) which is OW* and OL* units of labour would
be demanded and supplied.
Thus, marginal productivity theory explained how the pricing of factors
of production is done in factor market and how it is different from the pricing of
commodities in the product market. However, the theory suffers from various
limitations which are given below:

Limitations of the Marginal Productivity Theory

1. Different units of factors of production are not homogeneous- The

theory assumed that all units of a particular factor of production are same
in efficiency, however this assumption is not always true, for instance a
labour may be more efficient in working than some other labour and vice
versa.
2. Factors of production cannot be easily substituted for each other-
The theory is based on the premise that two factors of production can be
easily substituted for each other to carry on the production such that if
labour is not available then capital can be substituted for labour to carry
on the production, however this is not always the case as production of a
particular commodity requires a particular proportion of different factors
of production.
3. Criticism by Keynes- Economist Keynes criticized the marginal
productivity theory. The theory stated that if employment has to be increased
then wages must be lowered as it would attract more labour, however this
can be true for a firm or a particular industry but it is not applicable to the
entire economy as it is the aggregate demand that determine the level of
employment in an economy and not only the wages.
4. Assumption of perfect competition- Marginal Productivity theory
assumed perfect competition in both the product market and factor market.

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However this assumption in itself is faulty as there is usually presence of NOTES

imperfect competition in the markets, so the theory needs modification to
incorporate the imperfections.
5. Difficulty in measuring productivity -The foundation of the theory lies
in the productivity which in itself is difficult to measure as it assumes all
the other factors to be constant except the efficiency which however is not
true. Efficiency is in fact dependent on various factors simultaneously.

9.4 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. Demand for factors of production is Direct demand.
2. Factors of Production are always jointly demanded.
3. Marginal Physical Product refers to addition made to total output by
employing one additional factor of production.
4. Marginal Productivity theory assumes perfect competition in both product
and factor markets.
Ans. 1(F), 2(T), 3(T), 4(T)

Exercise 2: Fill in the Blanks

1. Marginal Physical Productivity theory was given by _ _ _ _ _ _ _ _ .

2. In case of perfect competition in product and factor market the value of
marginal revenue product and value of marginal product is _ _ _ _ _ _ _ .
3. The price of a factor production is dependent on its _ _ _ _ _ _ _ _ _ _ .
Ans. 1. Clark 2.same 3. productivity

Exercise 3: Questions

1. Explain the different concepts of Productivity.

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NOTES 3. How is Marginal Revenue Product different in case of Perfect competition

and imperfect Competition in the product market? Explain using an
example.
4. How are the prices of factors of production determined using Marginal
Productivity Theory?

9.5 ECONOMIC RENT

The concept of Economic rent was first given by David Ricardo (1772– 1823)
“Rent is that portion of the produce of earth which is paid to landlord for the use
of original and indestructible powers of the soil.”
Ricardo gave two reasons for the existence of rent:
1. Scarcity of resources and
2. Alternative use of the resources
Modern Economists like Joan Robinson, etc., however were of the opinion
that rent is not only attributable to land but any and every factor of production
can earn rent, whereby it is defined as the excess of actual earnings over the
amount that is needed to keep the factor of production in its present use, the
latter being termed as transfer earning. To understand the concept of Economic
rent the concept of transfer earnings needs to be understood. It is the minimum
amount that is to be paid to a factor of production to prevent it from moving to
an alternative.
Example: If a worker is being paid Rs 2000 per day for working as an
executive whereas for working as an officer he would have been paid Rs 1500,
thus Rs 1500 is the transfer earnings. Thus, rent in this case can be calculated as:
Economic Rent = Actual Earnings – Transfer Earnings
= Rs 2000 – Rs 1500
= Rs 500

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The amount of economic rent depends upon the elasticity of supply of the NOTES
factor of production such that there can be following three cases:
1. Perfectly Inelastic Supply – If a factor of production is perfectly
inelastic then its transfer earnings are zero as it has no opportunity cost
or alternative use, thus whatever the factor earns it is all economic rent.
It is shown in Figure 9.12.
Such a situation is usually found in case of specialists like singers,
professionals etc., who earn all the rent in the form of economic surplus.
2. Perfectly Elastic Supply – When a factor of production is perfectly
elastic then it can be easily shifted to its alternative and hence whatever
it earns is the transfer earning and it is equal to actual earnings and hence
economic rent is zero Figure 9.13. It takes place in case of unskilled
labourer, rickshaw pullers, etc.
3. Relatively Inelastic Supply – When the supply is relatively inelastic
then a part of actual earning is paid to prevent its transfer to the
alternative use and the remaining that is in excess is the economic
rent. Thus, here actual earnings are more than the transfer earnings as
is shown Figure 9.14.

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NOTES

Fig. 9.13

Fig. 9.14

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Factor Pricing

The size of economic rent received by an owner of a factor of production NOTES

is determined by the elasticity of supply for that particular good or service.
(a) If the elasticity of supply is neither elastic nor inelastic, the supply
curve will slope upward, and the supplier’s income would be split
between economic rent and opportunity cost.
(b) If the elasticity of supply is inelastic, the supply curve would be
perfectly vertical, and the supplier’s entire income would be comprised
of economic rent. For example, if the supply were a particular plot of
land, or a
(c) If the elasticity of supply is elastic, the supply curve would be perfectly
horizontal, and the supplier’s entire income would be comprised of
opportunity cost.

9.6 SELF ASSESSMENT QUESTIONS

Check your progress

Exercise 1: True and False
1. Marginal Physical Product refers to addition made to total output by
employing one additional factor of production.
2. Economic Rent arises only to land.
Ans. 1. (T), 2. (F)

Exercise 2: Fill in the Blanks

1. Economic rent concept arises because of ……………… of resources.

2. In case of monopoly in product market and perfect competition in the
factor market the ……………… curve is used.
3. The price of a factor production is dependent on its ……………… .
Ans. 1. Scarcity 2.MRP 3. Productivity

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NOTES
9.7 LEARNING OUTCOME

In this lesson you have learnt the following:

Factor Price determination is not as simple as commodity pricing as apart
from demand and supply there are various other factors that have an impact on
the prices that the factors of production command in the market. Moreover, there
is an interaction between the product market and factor market that determines
the demand of any factor of production as factor’s demand is indirect or derived
from the demand of the commodity that it produces. Also, the demand for
factors of production being joint demand the prices, availability, efficiency and
substitutability of other factors of production also impact the prices of a particular
factor of production. Various economists have given various theories to determine
the factor prices the most prevalent is the Clark’s Marginal productivity theory
that assumes perfect competition in both the product market and factor market
and based on various other assumptions determine that the price of a variable
factor of production is determined by the intersection of the market demand and
market supply of that factor.
The concept of economic rent as given by traditional economists and
modern economists too had been explained where rent is defined as the excess
of actual earnings over the transfer earnings and can be earned by any and all
factor of production whose supply is not perfectly elastic.

9.8 TERMINAL QUESTIONS

1. Explain the concept of economic rent. How does elasticity of supply of

factor affect economic rent?
2. Critically examine the marginal productivity theory of factor pricing.
3. What is the reason behind supply of labour to be backward bending?
Explain by using suitable diagram.

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UNIT IV: INTERNATIONAL TRADE

LESSON 10 INTERNATIONAL TRADE AND

ABSOLUTE ADVANTAGE
LESSON 11 COMPARATIVE ADVANTAGE AND
TERMS OF TRADE
LESSON 12 TRADE BARRIERS AND THE DEBATE
BETWEEN FREE TRADE AND
PROTECTIONISM
International Trade and Absolute Advantage

LESSON 10 NOTES

INTERNATIONAL TRADE AND

ABSOLUTE ADVANTAGE
Dyuti Agrawal
Assistant Professor
University of Delhi

Structure
10.1 Introduction
10.2 Learning Objectives
10.3 What is trade?
10.4 Why do people trade?
10.5 Theory of Absolute Advantage
10.6 Glossary
10.7 Answer to In-Text Questions
10.8 Learning outcomes
10.9 Terminal Questions
10.10 Solutions to Terminal Questions

10.1 INTRODUCTION

Let us look at our typical day. We wake up in the morning and get dressed in
clothes that have been stitched in Bangladesh. We have a cup of tea that has been
grown on a tea estate in Assam. We decide to study economics from a book that
has been written by an author in the United States and make notes in a notebook
that has been made in a factory in Maharashtra.
Every day, we rely on many people, most of whom we have never met, to
provide us with the goods and services that we enjoy. Such interdependence is
possible because people trade with one another.

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NOTES
10.2 LEARNING OBJECTIVES

• To understand the meaning of trade

• To analyse why trade occurs
• To explain the Theory of Absolute Advantage
• To understand how everyone can gain from trade
• To discuss diagrammatically how people can consume more than they are
able to produce

10.3 WHAT IS TRADE?

The exchange of goods, services or resources between economic agents is called

trade. Trade that occurs between two countries is called international trade and
the trade that occurs between two regions of the same country is called inter-
regional trade or domestic trade.

10.4 WHY DO PEOPLE TRADE?

People trade because there are gains from trade, that is, when countries sell goods
and services to one another, this exchange is to their mutual benefit. This means
that if there are 2 parties trading with each other, then trade makes them better
off than they were before trading. But how does that happen? Let us understand
this with the help of an example.
Example 1: Two parties and each party can produce only one good.
Consider that there are only two goods in the world – milk and potatoes.
Further, consider there are only two people in the world – Usha, who owns a
cow; and Raj who is a potato farmer.

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Case I: Usha can produce only milk and Raj is able to produce only potatoes. NOTES
Therefore, without trade, Usha consumes only milk and Raj consumes only
potatoes. Suppose after some time, Usha gets bored of just being able to drink
milk and Raj gets bored of just eating potatoes. However, if both start trading with
each other, both will be able to have both milk and potatoes. So, their consumption
set increases. This makes both better off. Hence, trade is advantageous.
Example 2: Two parties and each party can produce two goods.
Consider two countries – United States and Colombia.
One can assume that in Colombia, which is a developing nation, workers
are less efficient than their U.S. counterparts at making sophisticated goods such
as computers. This means that a given amount of resources used in computer
production yields fewer computers in Colombia than in the United States.
Also, around Valentine’s Day (which falls in February), there is a lot of
demand for roses in the United States. However, the climate is not as conducive
for growing roses in the United States as it is in Colombia. For one thing, it is a
lot easier to grow February roses in the Southern Hemisphere, where it is summer
in February rather than the winter that is there in Northern Hemisphere.
Hence, more resources are required to grow roses in the United States than
in Colombia, in the form of heated greenhouses, which is at a great expense in
terms of energy, capital investment, and other scarce resources. Those resources
could be used to produce other goods, like computers. Inevitably, there is a
tradeoff. To produce winter roses, the U.S. economy must produce fewer of
other things, such as computers. Economists use the term opportunity cost to
describe such trade-offs: The opportunity cost of roses in terms of computers is
the number of computers that could have been produced with the resources used
to produce a given number of roses.
Suppose, that the United States currently grows 10 million roses for sale
on Valentine’s Day and that the resources used to grow those roses could have
produced 100,000 computers instead. Then the opportunity cost of those 10
million roses is 100,000 computers. (Conversely, if the computers were produced

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NOTES instead, the opportunity cost of those 100,000 computers would be 10 million
roses.)
Furthermore, since we have assumed that Colombian workers are likely to
be less efficient than their U.S. counterparts at making capital intensive goods like
computers, a given amount of resources used in computer production yields fewer
computers in Colombia than in the United States. So, the trade-off in Colombia
might be something like 10 million winter roses for only 30,000 computers.
This difference in opportunity costs offers the possibility of a mutually
beneficial rearrangement of world production. Let the United States stop growing
winter roses and devote the resources this frees up to producing computers;
meanwhile, let Colombia grow those roses instead, shifting the necessary
resources out of its computer industry. The resulting changes in production can
be shown in the form of Table 10.1.
Table 10.1 Hypothetical Changes in Production

Roses (in millions) Computers (in thousands)

United States -10 +100
Colombia +10 -30
Total 0 +70

We see that the world is producing just as many roses as before, but it is
now producing more computers. So, this rearrangement of production, with the
United States concentrating on computers and Colombia concentrating on roses,
increases the size of the world’s economic pie. Because the world as a whole is
producing more, it is possible in principle to raise everyone’s standard of living.
Hence, we see that trade can make people better off, and that is why people trade.

10.5 THEORY OF ABSOLUTE ADVANTAGE

The concept of absolute advantage was developed by 18th-century economist

Adam Smith in his book The Wealth of Nations, which was published in 1776,

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to show how countries can gain from trade by specializing in producing and NOTES
exporting the goods that they can produce more efficiently than other countries.
According to this theory, a country, person or firm that can produce a good
more cheaply than others is said to have an absolute advantage in producing
that good. Here, when we say ‘more cheaply’ we mean, being able to produce
one unit of the good with the least quantity of inputs or given a quantity of input,
producing the highest quantity of output. The theory further propounds that a
country, firm or person should specialize in the production of that commodity
in which it has an absolute advantage and trade it for the commodity in which
the other country, person or firm has an absolute advantage. In such a case, trade
can be beneficial for both the parties. Note, here when we say a country should
specialize in a particular commodity, we mean that it should allot all or most
of its resources towards the production of that good. The Theory of Absolute
advantage is applicable when there are absolute differences in the costs of
production of the goods in different countries.
In-Text Questions 1
1. Fill in the blanks by choosing one correct option.
If a nation has an absolute advantage in the production of a good,
____________.
a. It can produce that good at a lower opportunity cost than its trading
partner.
b. It can produce that good using fewer resources than its trading
partner.
c. It can benefit by restricting imports of that good.
d. It will specialize in the production of that good and export it.
e. None of the above is true.

Let us understand this further with the help of an example. Let us consider
another case of the example 1 discussed earlier.
Case II: Both Usha and Raj can produce milk as well as potatoes.

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NOTES Let, for simplicity, consider that there are only 2 units of input/factor(s)
of production/resources (input can be in the form of labour, time or anything
else). Let, for these 2 units of input, Usha produces 6 units of milk or 2 units of
potatoes. Further, for the same 2 units of input, assume that Raj produces 4 units
of milk or 10 units of potatoes. This means, if Usha used all the inputs available
to her towards production of milk, she would be able to produce 6 units of milk
and if she puts all her inputs towards production of potatoes, she will be able
to produce 2 units of potatoes. Similarly, if Raj used all the inputs available to
him towards production of milk, he would be able to produce 4 units of milk
and if he put all his inputs towards production of potatoes, he would be able to
produce 10 units of potatoes.
These production possibilities are represented in Table 10.2.
For 2 units of inputs/factor(s) of production-
Table 10.2 Production possibilities available to Usha and Raj if they have 2 units of input.

Milk Potatoes
Usha 6 2
Raj 4 10

As it can be seen by comparing the quantity of milk for Usha and Raj in
Table 10.2 (second column), Usha produces more amount of milk than Raj (6 >
4). This means, Usha has an absolute advantage in producing milk. Also, we see
that Raj produces more quantity of potatoes as compared to Usha (10 > 2) and
hence, Raj has an absolute advantage in producing potatoes. Thus, according to
the Absolute Advantage Theory, Usha should produce only milk and Raj should
produce only potatoes and then trade with each other.

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In-Text Questions 2 NOTES

2. The following table shows the units of output a worker can produce per
month in Australia and Korea. Use this table to answer the question.
Food Electronics
Australia 20 5
Korea 8 4

Which of the following statements about absolute advantage is true?

a. Australia has an absolute advantage in the production of food while
Korea has an absolute advantage in the production of electronics.
b. Korea has an absolute advantage in the production of food
while Australia has an absolute advantage in the production of
electronics.
c. Australia has an absolute advantage in the production of both food
and electronics.
d. Korea has an absolute advantage in the production of both food
and electronics.

At this juncture, we shall analyze how both parties will be better off
according to the theory of absolute advantage. For this, let us dive deeper.
Since in our example, 2 units of input Usha produces 6 units of milk or 2

units of potatoes, therefore in 1 unit of the input, she will produce 3 units of

milk and 1 unit of potatoes. Similarly, if in 2 units of input Raj produces 4

units of milk or 10 units of potatoes, then in 1 unit of the input, he will produce

units of milk and units of potatoes.

This can be represented in Table 10.3.
For 1 unit of inputs/factor(s) of production-

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NOTES Table 10.3 Production possibilities available to Usha and Raj if they have 1 unit of input.

Milk Potatoes
Usha

Raj

Diagrammatically, we can show this in the form of Production Possibilities

Frontiers (PPF). A Production Possibilities Frontier, as you may recall, is a graph
that shows the combinations of output (in our case, milk and potatoes) that can
possibly be produced given the available factors of production and the available
production technology.
The analysis through which we have formed Table 10.3 implicitly assumes
that there is constant marginal opportunity cost, that is, a constant amount of one
commodity needs to be sacrificed in order to gain an additional unit of the other
commodity. This means the rate at which one good can be traded for the other
does not depend on the amount that was being produced. Hence, if Usha uses one
less unit of input to produce milk and one more unit of input to produce potatoes,
she decreases her output of milk by 3 and increases her output of potatoes by
1, regardless of how much she is already producing. Same is the case for Raj.
This results in a straight line PPF as shown in Figure 10.1(a), Figure 10.1(b)
and Figure 10.1(c).
Figure 10.1(a) shows the PPF for Usha, Figure 10.1(b) shows the PPF for
Raj and Figure 10.1(c) shows the PPF of both of them on the same graph. In all
3 figures, we are measuring the quantity of milk produced on the X axis and we
are measuring the quantity of potatoes produced on the Y axis.
Given that Usha produces 6 units of milk if she puts all its resources/inputs
towards milk production (and therefore doesn’t produce potatoes), the X intercept
of her PPF will be (6, 0), represented by in Figure 10.1(a). Alternatively, if
Usha produces only potatoes, she will be able to produce 2 potatoes, hence, the
Y intercept of her PPF is (0, 2) represented by . . Further, since we know the
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of Usha’s PPF to be x + 3y = 6 where x is the quantity of milk produced and NOTES

y is the quantity of potatoes produced. Any combination of milk and potatoes
that falls on this line is the maximum that can be produced by Usha given her
factors of production.
Similarly, given that Raj produces 4 units of milk if he puts all his resources/
inputs towards milk production (and therefore doesn’t produce potatoes), the
X intercept of his PPF will be (4, 0), represented by in Figure 10.1(b).
Alternatively, if Raj produces only potatoes, he will be able to produce 10
potatoes, hence, the Y intercept of his PPF is (0, 10) represented by . Further,
since we know the x and y intercepts, and the PPF is a straight line, we can
calculate the equation of Raj’s PPF to be 5x + 2y = 20 where x is the quantity
of milk produced and y is the quantity of potatoes produced. Any combination
of milk and potatoes that falls on this line is the maximum that can be produced
by Raj given his factors of production.

Fig. 10.1(a) Combinations of milk and potatoes that Usha can produce
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NOTES

Fig. 10.1(b): Combinations of milk and potatoes that Raj can produce

Fig. 10.1(c): Combinations of milk and potatoes that Usha and Raj can produce,
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International Trade and Absolute Advantage

It is likely that each individual will prefer to consume some combination of NOTES
both goods and not just one good (either milk or potatoes). Let us, for instance,
suppose that if there was no trade. Usha would produce and consume 3 units of
milk and 1 unit of potatoes. Similarly, Raj would produce and consume 2 units of
milk and 5 units of potatoes. Keep in mind that without trade they will consume
whatever they produce.
Alternatively, suppose Usha produces only milk, in which she has an
absolute advantage, and Raj produces only potatoes, in which he has an absolute
advantage and then they trade with each other. Say, they exchange 2 units of milk
for 4 units of potatoes. Usha will have 4 units of milk and 3 units of potatoes to
consume. Raj will have 2 units of milk and 7 units of potatoes to consume. This
is more than what they had before trade, because each person gets more of one
good and no less of the other. Thus, we can see that both parties are better off
by following the theory of absolute advantage. This is shown in tabular form in
Table 10.4 below.
Table 10.4 Gains from trade for Usha and Raj

Usha Raj
Milk Potatoes Milk Potatoes
Without trade Production and 3 1 2 5
consumption
After trade Production 6 0 0 10
Trade Gives 2 Gets 3 Gets 2 Gives 3
Consumption 4 3 2 7
Gains from +1 +2 0 +2
trade

Additionally, Figure 10.2(a) and Figure 10.2(b) show the production and
consumption of Usha and Raj before and after trade. The proposed trade between
Usha and Raj offers each of them a combination of milk and potatoes that would
be impossible in the absence of trade. In Figure 10.2(a), after trade, Usha gets to
consume at point B* which is above her PPF, rather than point B which is on her
PPF. Hence, through trade, she is able to consume more than she would have ever
been able to produce. Correspondingly, in Figure 10.2(b), Raj gets to consume at
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NOTES point A* after trade, which lies above his PPF. Hence, he too is able to consume
a bundle of goods that was impossible for him to consume without trade.

Fig. 10.2(a): Usha’s production and consumption before and after trade

Fig. 10.2(b): Raj’s production and consumption before and after trade
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NOTES
10.6 GLOSSARY

• Absolute Advantage: Absolute advantage is the ability of an individual,

company, region, or country to produce a greater quantity of a good or
service with the same quantity of inputs per unit of time, or to produce the
same quantity of a good or service per unit of time using a lesser quantity
of inputs, than its competitors.
• Gains from Trade: It is the increase in total production due to specialization
allowed by trade. When countries sell goods and services to one another
and this exchange is to their mutual benefit, they are said to have gains
from trade.
• Opportunity Cost: It is the cost of the next best alternative. It represents the
potential benefits that a party misses out on when choosing one alternative
over another.
• Specialization: Specialization is when an individual or a country allocates
most or all of its resources towards the production of a particular good or
service.

10.7 ANSWERS TO IN-TEXT QUESTIONS

In-Text Question -1

Answer: The correct answer is b. because that is the definition of absolute

advantage.
Let us look at why the other options are incorrect.
Option c. is incorrect because the Absolute Advantage Theory does not
make any comments about restricting imports (and hence trade). On the contrary,
it encourages trade if the countries have an absolute advantage. Its proponent,
Adam Smith, extolled the virtues of free trade.

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NOTES Option a. is not the correct answer because absolute advantage, by

definition, looks at the lowest absolute cost of producing a good, which means,
producing a good with the least inputs, or conversely, producing the most amount
of goods with a unit of input. It does not consider the opportunity cost.
Finally, option d. is incorrect too. This is because the Absolute Advantage
Theory propounds that a country with absolute advantage in a particular good
should specialize in that good and export it. It does not say that the country will
specialize in it and export it. It is a theory, not a law.

In-Text Question -2

Answer: The correct answer is c. because the amount of food that Australia
produces (20 units) is more than that of Korea (8 units). Similarly, the amount of
electronics that Australia produces (5 units) is more than the amount of electronics
that Korea produces (4 units). Hence Australia has an absolute Advantage in
both the goods.

10.8 LEARNING OUTCOMES

In this lesson you have been taught-

• The exchange of goods, services or resources between economic agents
is called trade.
• People trade because there are gains from trade.
• A country, person or firm that can-
o Produce one unit of the good with the least quantity of inputs or, in
other words,
o Given a quantity of input, produce the highest quantity of output is said
to have an absolute advantage in producing that good.
• According to the theory of absolute advantage, a country, firm or person
should specialize in the production of that commodity in which it has

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an absolute advantage and trade it for the commodity in which the other NOTES
country, person or firm has an absolute advantage.

10.9 TERMINAL QUESTIONS

Q.1 Consider two people, Frank and Ruby. Each of them works 8 hours per day
and can devote this time to producing wheat or rice or a combination of the
two. Table A shows the amount of time each person requires to produce
1 kilogram of each good. Frank can produce one kilogram of wheat in 15
minutes and a kilogram of rice in 60 minutes. Ruby can produce a kilogram
of wheat in 10 minutes and a kilogram of rice in 20 minutes. Table B shows
the amounts of wheat or rice Frank and Ruby can produce if they devote
all 8 hours to producing only that good.
Table A

Time (in minutes) needed to make

one kilogram of:
Wheat Rice
Frank 60 15
Ruby 20 10

Table B

Amount (in kilograms) produced

in 8 hours:
Wheat Rice
Frank 8 32
Ruby 24 48

(a) Does Frank have an absolute advantage in any of the goods?

(b) Does Ruby have an absolute advantage in any of the goods?
(c) Draw the PPF for Frank.
(d) Draw the PPF for Ruby.
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NOTES Q.2 Let, for the same amount of labour (say L units), India produces 10 units
of wheat, and 5 units of computers and USA produces 7 units of wheat
and 11 units of computers.
a) Does India have an absolute advantage in producing any of the two
goods?
b) Does the USA have an absolute advantage in producing any of the
two goods?
c) What should the countries do based on the theory of Absolute
Advantage?
Q.3 Angela is a college student. She takes a full load of classes and has only 5
hours per week for her hobby. Angela is artistic and can make 2 clay pots
per hour or 4 coffee mugs per hour.
(a) Draw Angela’s production possibilities frontier for pots and mugs.
(b) What is Angela’s opportunity cost of 1 pot? 10 pots?
(c) What is Angela’s opportunity cost of 1 mug? 10 mugs?
(d) Why is her production possibilities frontier a straight line instead of
being bowed out?

10.10 SOLUTIONS TO TERMINAL QUESTIONS

Solution 1

(a) No, Frank does not have an absolute advantage in producing any of the
goods as compared to Ruby.
Table B shows that Frank produces 8 kg of wheat in 8 hours which is less
than the 24 kg of wheat that Ruby produces in the same time. Hence, he
does not have an absolute advantage in producing wheat. Further, from
Table B we see that Frank produces 32 kg of rice in 8 hours as compared
to 48 kg that Ruby produces. Since 32 < 48, he does not have an absolute
advantage in producing rice either.
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The same conclusion is reached when we analyze the same data written in NOTES
the form of Table A. Table A indicates that Frank takes more time (which is
out only input/ factor of production, in this case) to produce one kilogram
of wheat as compared to Ruby (60 mins/kg for Frank versus 20 mins/kg
for Ruby). Hence, Frank does not have an absolute advantage in producing
wheat. Similarly, Frank takes 15 minutes to produce a kilogram of rice
which is more than the 10 minutes that Ruby takes to produce the same
one kilogram of rice. Hence, Frank does not have absolute advantage in
producing rice either.
(b) As a corollary to Solution 1(a), Ruby has an absolute advantage in
producing both wheat and rice.
(c) Frank’s PPF is-

Fig. A: Frank’s PPF

(d) Ruby’s PPF is-

Fig. B: Ruby’s PPF Self-Instructional

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NOTES Solution 2

The information in the question can be represented in the form of the following
table-
Table C

Wheat Computers
India 10 5
USA 7 11

(a) Since India produces more amount of wheat (10 units) as compared to
USA (7 units) in the same amount of inputs (labour), India has an absolute
advantage in producing wheat.
(b) Since USA produces more amount of computers (11 units) as compared to
India (5 units) in the same amount of inputs (labour), USA has an absolute
advantage in producing computers.
(c) According to the theory of absolute advantage, India should specialize in
the production of wheat and trade it with USA which should specialize in
the production of computers.
Solution 3. The information given in the question can be represented in
tabular form as-
Table D

Amount produced in one hour

Pots Mugs
2 4

(a) Table D shows the number of pots or mugs she can make in 1 hour.
However, she has a total of 5 hours. Therefore, in 5 hours she will be able
to make 5 times the number of pots or mugs she made in 1 hour. Therefore-
Table E

Amount produced in 5 hours

Pots Mugs
10 20
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This implies, on a graph where X axis shows the quantity of pots Angela NOTES
made and Y axis shows the quantity of mugs that she produced, the X intercept
of her PPF will be 10 and the Y intercept will be 20. Thus, her PPF is-

Fig. C: Angela’s PPF

(b) From Table D, it can be inferred that the opportunity cost for 2 pots is 4
mugs.

This implies that the opportunity cost for 1 pot will be mugs.
This further implies that the opportunity cost of 10 pots will be 2 x 10 =
20 mugs.
(c) Similarly, from Table D, it can be inferred that the opportunity cost of 4
mugs is 2 pots.

This implies that the opportunity cost for 1 mug will be pot.

This further implies that the opportunity cost of 10 mugs will be

pots.
(d) Typically, a PPF is drawn bowed out (that is, concave shaped, or convex
to the origin) because typically there are increasing marginal opportunity
costs. This means, more and more units of one commodity need to be

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NOTES sacrificed in order to gain an additional unit of the other commodity. In

other words, the rate at which society could trade one good for the other
depended on the amounts that were being produced. However, Angela’s
resources can be moved from the production of one good to another at a
constant rate. This means, a constant amount of pots needs to be sacrificed
in order to gain an additional unit of mugs (and vice versa). Therefore, her
PPF is a straight line.

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Comparative Advantage and Terms of Trade

LESSON 11 NOTES

COMPARATIVE ADVANTAGE AND

TERMS OF TRADE
Dyuti Agrawal
Assistant Professor
University of Delhi

Structure
11.1 Introduction
11.2 Learning Objectives
11.3 Theory of Comparative Advantage
11.4 Sources of Comparative Advantage
11.5 Terms of Trade (TOT)
11.6 Types of Terms of Trade
11.7 Glossary
11.8 Answer to In-Text Questions
11.9 Learning Outcomes
11.10 Terminal Questions
11.11 Solutions to Terminal Questions

11.1 INTRODUCTION

The purpose of this lesson is to demonstrate how everyone can gain from trade.
Trade allows people to specialize in the production of goods for which they have
a comparative advantage and then trade it for goods that other people produce.
Because of specialization, total output rises, and through trade, we are all able
to share in the bounty. This is as true for countries as it is for individuals.

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NOTES
11.2 LEARNING OBJECTIVES

• To understand the Theory of Comparative Advantage

• To explain how everyone can gain from trade
• To discuss diagrammatically, how people can consume more than they are
able to produce through trade
• To describe the sources of Comparative Advantage
• To understand the meaning of Terms of Trade
• To discuss the types of Terms of Trade

11.3 THEORY OF COMPARATIVE ADVANTAGE

The concept of Comparative Advantage was given by David Ricardo in the year
1817 to show how countries can gain from trade by specializing in goods that
they can produce more efficiently than other countries.
According to David Ricardo, it is not the absolute but the comparative
differences in costs that determine trade relations between two countries.
Production costs differ in countries because of geographical division of labour
and specialization in production. Due to differences in climate, natural resources,
geographical situation and efficiency of labour, a country can produce one
commodity at a lower cost than the other. Hence, comparatively, that country
will have an advantage in producing that commodity vis-a-vis another country.
A country is said to have a comparative advantage in producing a good
if the opportunity cost of producing that good in terms of the other good is lower
in that country as compared to the other country. Recall that opportunity cost
refers to the cost of the next best alternative. It represents the potential benefits
that a party misses out on when choosing one alternative over another.
Ricardo shows that trade is possible between the two countries even when
a country does not have an absolute advantage in the production of any of the
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than in the other. The theory propounds that a country, firm or person should NOTES
specialize in the production of that commodity in which it has a comparative
advantage and trade it for the commodity in which the other country, person or
firm has a comparative advantage. In such a case, trade can be beneficial for
both the parties.
Let us understand this with the help of an example. Consider two people,
Frank and Ruby. Each of them works 8 hours per day and can devote this time
to producing wheat or rice or a combination of the two. If Frank produces only
wheat, he can produce 8 kilograms of wheat and if Frank produces only rice, he
can produce 32 kilograms of rice. Similarly, if Ruby produces only wheat, she
can produce 24 kilograms of it and if she produces only rice, she can produce
48 kilograms of it. Table 11.1 shows this in tabular form.
Table 11.1

Amount (in kilograms)

produced in 8 hours:
Wheat Rice
Frank 8 32
Ruby 24 48

For Frank-
• Opportunity cost for 8 kg of wheat = 32 kg of rice

=> opportunity cost for 1 kg of wheat = kg of rice eq. (1)

=> opportunity cost for 1 kg of rice = kg of wheat (reciprocal of eq. (1))

For Ruby-
• Opportunity cost for 24 kg of wheat = 48 kg of rice

=> opportunity cost for 1 kg of wheat = kg of rice eq. (2)

=> opportunity cost of 1 kg of rice = kg of wheat (reciprocal of eq. (2))

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NOTES This can be represented in tabular form as given in Table 11.2.

Table 11.2 Opportunity cost of producing wheat and rice for Frank and Ruby

Opportunity Cost of wheat Opportunity cost of rice

Frank 4

Ruby 2

Ruby has a lower opportunity cost in producing wheat as 2 < 4 (compare

quantities in second column of Table 11.2). Hence Ruby has a comparative
advantage in producing wheat.

Frank has a lower opportunity cost of producing rice as (compare

quantities in third column of Table 11.2). Hence Frank has a comparative
advantage in producing wheat.
Therefore, according to the theory of comparative advantage, Ruby should
specialize in producing wheat and Frank should specialize in producing rice.
In-Text Question
1. Suppose a country’s workers can produce 4 watches per hour or 12
rings per hour. If there is no trade,
a. The domestic price of 1 ring is 3 watches.
b. The domestic price of 1 ring is 1/3 of a watch.
c. The domestic of 1 ring is 4 watches.
d. The domestic price of 1 ring is 1/4 of a watch.
e. The domestic price of 1 ring is 12 watches.
2. State true or false: If Germany’s productivity doubles for everything it
produces, this will not alter its prior pattern of specialization because
it has not altered its comparative advantage.
3. State true or false: If gains from trade are based solely on comparative
advantage, and if all countries have the same opportunity costs of
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Now, let us see how both parties will be better off by following the theory NOTES
of comparative advantage.
The PPFs of Frank and Ruby are shown in Figure 11.1(a) and Figure
11.1(b), respectively. The PPFs are straight lines instead of being bow shaped
for reasons discussed in the previous chapter. Y axis represents the quantity of
wheat and X axis represents the quantity of rice.
Given that Frank produces 8 kg of wheat if he puts all its resources/inputs
towards wheat production, the Y intercept for his PPF will be 8. Alternatively,
if he produces only rice, he will be able to produce 32 kg of rice, hence, the X
intercept of his PPF will be 32. Further, since we know the x and y intercepts,
and the PPF is a straight line, we can calculate the equation of Frank’s PPF to
be x + 4y = 32. Any combination of wheat and rice that falls on this line is the
maximum that Frank can produce given his factors of production.
Similarly, we have calculated the equation of Ruby’s PPF to be x + 2y = 48.

Fig. 11.1(a): Frank’s PPF

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NOTES It is likely that each individual will prefer to consume some combination
of both the goods. Let us say, without trade, Frank produces and consumes 4 kg
of wheat and 16 kg of rice. This bundle lies on his PPF as it satisfies the equation
x + 4y = 32, where x represents quantity of rice and y represents quantity of
wheat. Also, suppose, Ruby produces and consumes 12 kg of wheat and 24 kg
of rice before trade. This bundle lies on Ruby’s PPF as well, since it satisfies the
equation of her PPF, x + 2y = 48.
Now, let us look at an alternative that is available if the two decide to trade
with each other. Recall, when an individual or a country allocates most or all of
its resources towards the production of a particular good or service, they are said
to specialize in the production of that good or service. Suppose Frank decides
to specialize in the production of rice, in which he has a comparative advantage
such that he produces only rice, and no wheat. Also suppose, Ruby decides to
specialize in the production of wheat, in which she has a comparative advantage,
such that, she produces 18 kg of wheat and 12 kg of rice. Further, say, they trade
such that Ruby gives 5 kg of wheat for 15 kg of rice from Frank. Frank will have
5 kg of wheat and 17 kg of rice to consume. Ruby will have 13 kg of wheat and
27 kg of rice to consume. This is more than what they had before trade, because
each person gets more of one good and no less of the other. Thus, we can see
that both parties are better off by following the theory of comparative advantage
and have gains from trade. This is shown in tabular form in Table 11.3 below.
Table 11.3 Gains from trade for Frank and Ruby

Frank Ruby
Wheat Rice Wheat Rice
Without Production and 4 16 12 24
trade consumption
After trade Production 0 32 18 12
Trade Gets 5 Gives 15 Gives 5 Gets 15
Consumption 5 17 13 27
Gains from +1 +1 +1 +3
trade

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This has been shown diagrammatically in the form of Figure 11.2(a) and NOTES
Figure 11.2(b). Figure 11.2(a) shows Frank’s production and consumption without
trade and with trade. Figure 11.2(b) shows Ruby’s production and consumption
with and without trade. In Figure 11.2(a), point A shows Frank’s consumption
and production bundle without trade and point A’ and A* show his production and
consumption bundles respectively after trade. In Figure 11.1(b), point B shows
Ruby’s consumption and production bundle without trade and point and point B’
and B* show her production and consumption bundles after trade. Since A* lies
above Frank’s PPF and B* lies above Ruby’s PPF, Figures 11.2(a) and 11.2(b)
show that through trade both Frank and Ruby are able to consume a bundle of
wheat and rice that they could not have ever produced.

Fig. 11.2(a): Frank’s production and consumption before and after trade

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NOTES Notice from Table 11.1 that Ruby has an absolute advantage in producing
both the goods. Hence, the theory of absolute advantage will not suggest trade.
However, we can see that both Ruby and Frank are better off through trade. This
is because Ruby has a comparative advantage in producing one good and Frank
has a comparative advantage in producing the other.
Observe that though it is possible for one person to have an absolute
advantage in both goods (as Ruby does in our example), it is impossible for one
person to have a comparative advantage in both goods. Because the opportunity
cost of one good is the inverse of the opportunity cost of the other, if a person’s
opportunity cost of one good is relatively high, the opportunity cost of the
other good must be relatively low. Comparative advantage reflects the relative
opportunity cost. Unless two people have the same opportunity cost, one person
will have a comparative advantage in one good, and the other person will have
a comparative advantage in the other good.
Therefore, even if countries do not have absolute advantage in producing
any good, they can still trade because they will have a comparative advantage
in producing some good(s).
In-Text Questions
4. Which of the following statements is true?
a. Self-sufficiency is the road to prosperity for most countries.
b. A self-sufficient country consumes outside its production
possibilities frontier.
c. A self-sufficient country at best can consume on its production
possibilities frontier.
d. Only countries with an absolute advantage in the production of
every good should strive to be self-sufficient.
5. Suppose the world consists of two countries – the United States and
Mexico. Furthermore, suppose there are only two goods – food and
clothing. Which of the following statements is true?
a. If the United States has an absolute advantage in the production
of food, then Mexico must have an absolute advantage in the
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b. If the United States has a comparative advantage in the production NOTES

of food, then Mexico must have a comparative advantage in the
production of clothing.
c. If the United States has a comparative advantage in the production
of food, it must also have a comparative advantage in the
production of clothing.
d. If the United States has a comparative advantage in the production
of food, Mexico might also have a comparative advantage in the
production of food.
e. None of the above is true.
6. State true or false: If Japan has an absolute advantage in the production
of an item, it must also have a comparative advantage in the production
of that item.
7. State true or false: The gains from trade can be measured by the increase
in total production that comes from specialization.
8. State true or false: Talented people that are the best at everything have
a comparative advantage in the production of everything.

11.4 SOURCES OF COMPARATIVE ADVANTAGE

1. Endowment of natural resources: When the good is a natural resource,

countries can have a comparative advantage in the good if they are richly
endowed with it. For instance, nations that have ample oil resources can
typically produce oil at a low cost. Saudi Arabia, being able to produce
oil inexpensively, holds a comparative advantage in the oil industry and
exports oil to generate revenue for importing goods. Similarly, countries
with extensive forest coverage often serve as the primary exporters of
timber, paper, and related products. The quantity of available exports also
depends on domestic demand. Canada, with its vast forested areas, has a
significant supply of lumber for export to the United States. This is partly
because its relatively small population consumes a limited portion of the
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NOTES 2. Factor endowments- the Heckscher-Ohlin theory: According to the

Heckscher-Ohlin theory, countries that possess an abundance of a specific
factor of production, such as capital or labour, will have a comparative
advantage in producing goods that require the abundant factor. For example,
countries with plentiful capital relative to labour tend to have high wages
and lower rent and can efficiently produce capital-intensive goods like
automobiles and chemicals. On the other hand, countries with an abundance
of labour relative to capital tend to have lower wages and higher rent and
can produce labour intensive goods such as textiles and sporting goods at
a lower cost.
The theory emphasizes the importance of the relative availability of factors
of production within a country, rather than the absolute amount of those
factors. For instance, even if a small country has less total capital than
a larger country, it can still have a higher capital-to-worker ratio and a
comparative advantage in producing capital-intensive goods.
Consider 2 countries – A and B. Say, country A has an abundance of capital
and country B has an abundance of labour. Further, let X be a capital
intensive good, and Y be a labour intensive good.
Since country A has an abundance of capital and country B has an
abundance of labour. Therefore, the capital-labour ratio of country A will
be greater than that of country B.

Now, since country A has a higher supply of capital relative to labour, the
price of capital relative to labour is lower in it as per the theory of supply
and demand. The price of labour is measured in wages (denoted by w)
while the price of capital is rent (denoted by r). So, the rent to wage ratio
will be lower in country A compared to country B.

Because the rent to wage ratio of country A is lower, therefore, its ratio
of cost of production for capital intensive good (good X) to the labour
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the relative cost of production of good X to good Y is lower in country A, NOTES

so the relative prices will be lower for country A too.

Since is lower for country A, opportunity cost of producing X will

be lower for it as compared to country B. So, it will have a comparative
advantage in producing good X and country B will have a comparative
advantage in producing good Y. Hence, the relative difference in the factor
prices allows for the relative difference in product prices and thus provides
a source for comparative advantage.
3. Economies of scale: Economies of scale refer to the cost advantage
experienced by a firm when it increases its level of output. This is the
idea that, as a company grows and it needs to make more of a product, the
average cost of making each item falls. Suppose country A has economies
of scale in producing a good. So, the cost of producing the good decreases
for it. It can decrease such that the opportunity cost of producing that
good can become lower than that of another country, giving country A a
comparative advantage in producing that good.
4. Technology: Technology can be a source of comparative advantage. A
country which is technologically advanced will be able to produce a
technology intensive good at a lower price and hence have a comparative
advantage in it, as per the Heckscher-Ohlin Model.

11.5 TERMS OF TRADE (TOT)

• The terms of trade refer to the rate at which the goods of one country
exchange for the goods of another country.
• It is a measure of the purchasing power of exports of a country in terms
of its imports and is expressed as the relation between export prices and
import prices of its goods.
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NOTES • When the export prices of a country rise relative to its import prices, its
terms of trade are said to have improved. The country gains from trade
because it can have a larger quantity of imports in exchange for a given
quantity of exports.
• On the other hand, when its imports prices rise relative to its export prices,
its terms of trade are said to have worsened. The country’s gains from trade
are reduced because it can have a smaller quantity of imports in exchange
for a given quantity of exports than before.
• If TOT is above 100, it is said that the TOT is favourable and if it is below
100, it is said to be unfavourable.

11.6 TYPES OF TERMS OF TRADE

The types of terms of trade are given in Figure 11.3.

Net Gross Single Doube Real

Incom Utilit
Barte Barte Factor Factor Cost
e TOT y TOT
r TOT r TOT al TOT al TOT TOT

Fig. 11.3

1. Net Barter TOT/Commodity TOT

• Concept given by Taussig.
• It is the ratio of the price of a country’s exports to the price of the
country’s imports.

x 100 where = Commodity TOT

= Price of exports
= Price of imports

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If we compare current year prices with the base year prices, then, NOTES

x 100 where = Commodity TOT

= Price of exports in current year
= Price of exports in base year
= Price of imports in current year
= Price of imports in base year
In-Text Questions
9. Take 1971 as the base year and let India’s both export prices and import
prices be 100 in the base year. If we find that by the end of 1981 its
index of export prices had fallen to 90 and the index of import prices had
risen to 110, what will be the Commodity TOT? What does it imply?

2. Gross Barter TOT

• Given by Taussig
• The gross barter terms of trade are the ratio between the quantities of
a country’s imports and exports.

x 100 where = Gross Barter TOT

= Quantity of imports in current year
= Quantity if imports in base year
= Quantity of exports in base year
= Quantity of exports in current year

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NOTES In-Text Questions

10. Take 1971 as the base year and let India’s both quantities of imports
and exports as 100 in 1971. If we find that the index of quantity imports
had risen to 160 and that of quantity exports to 120 in 1981, then, what
would be the Gross Barter TOT? What does it indicate?

3. Income TOT
• Given by Dorrance
• It shows a country’s changing import capacity in relation to changes
in its exports.
• Thus, the income terms of trade is the net barter terms of trade of a
country multiplied by its export volume index.

where = Income TOT

= Commodity TOT
= Quantity of exports

=> where = Export price

= Import Price

4. Single Factorial TOT

• Given by Viner
• It admits changes in productivity of factors involved in producing
exports
• It is calculated by multiplying the commodity terms of trade index by
an index of productivity changes in domestic export industries. It can
be expressed as:

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NOTES
where = Single Factoral TOT

= Commodity TOT
= Productivity index of export industries

=> where = Export price

= Import Price

5. Double Factorial TOT

• Given by Viner
• The double factorial terms of trade consider productivity changes both
in the domestic export sector and the foreign exports sector producing
the country’s imports.
• It is calculated by multiplying the commodity TOT with ratio of
domestic export productivity index to domestic import productivity
index.
• Note that domestic imports are essentially foreign country’s exports,
hence by considering domestic import productivity index, double
factorial TOT is also considering the productivity in foreign sector.
• It explains the number of units of domestic factors embodied in our
exports which are exchanged for a unit of foreign factors embodied in
our imports.
• A rise in the index of double factorial terms of trade of a country means
that the productive efficiency of the factors producing exports has
increased relative to the factors producing imports in the other country.
• It is measured using the following formula-

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NOTES

where = Double Factoral TOT

= Commodity TOT
= Export Productivity Index
= Import Productivity Index
=>

6. Real Factorial TOT

• Given by Viner
• This index is calculated by multiplying the single factorial terms of
trade with the reciprocal of an index of the amount of disutility per unit
of productive resources used in producing export commodities.
• Note, there is disutility per unit of productive resources used in producing
export commodities. This is because those factors of production are
being used to produce goods that would be exported and hence will
not be used by the citizens of the country. These factors of production
could have been redirected to produce goods that would be consumed
by the citizens of the nation, thereby providing them with utility.

where = Real Factoral TOT

= Single Factoral TOT
= Index of the disutility per unit of factors of
production engaged in country’s exports

=> where = Export Productivity Index

= Commodity TOT
=> where = Price of exports
= Price of imports

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7. Utility TOT NOTES

• The utility terms of trade index measures “changes in the disutility of
producing a unit of exports and changes in the relative satisfactions
yielded by imports, and the domestic products foregone as the result
of export production.”
• In other words, it is an index of the relative utility of imports and
domestic commodities forgone to produce exports.
• The utility terms of trade index is calculated by multiplying the real
cost terms of trade index (denoted by ) with an index of the relative
average utility of imports and of domestic commodities foregone
(denoted by u).

where u = Index of the relative average utility of imports and

of domestic commodities foregone

= Average utility from imports

= Average utility of domestic commodities forgone

due to export production

If we compare current year prices with the base year prices, then,

where = Average utility from imports in current year

= Average utility of domestic commodities forgone

due to export production in current year

= Average utility from imports in base year

= Average utility of domestic commodities forgone

due to export production in base year
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NOTES • Thus, the utility terms of trade index can be expressed as:

where = Real Factor TOT

=> where = Commodity TOT
= Export Productivity Index

=> where = Price of exports

= Price of imports

11.7 GLOSSARY

• Comparative Advantage: It refers to the ability to produce a good at a

lower opportunity cost than another producer.
• Economies of Scale: Economies of scale refer to the cost advantage
experienced by a firm when it increases its level of output. This is the
idea that, as a company grows and it needs to make more of a product, the
average cost of making each item falls.
• Heckscher-Ohlin Model: The theory says that countries that are rich in
capital will export capital intensive goods and countries that have much
labour will export labour intensive goods. According to it, the main cause
of trade between regions is the difference in prices of commodities based
on relative factor endowments and factor prices. Commodities which use
large quantities of scarce factors are imported because their prices are high
while those using abundant factors are exported because their prices are
low.
• Opportunity Cost: It is the cost of the next best alternative. It represents the
potential benefits that a party misses out on when choosing one alternative
over another.

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• Specialization : When an individual or a country allocates most or all of NOTES

its resources towards the production of a particular good or service.
• Terms of Trade: It refers to the rate at which the goods of one country
are exchanged for the goods of another country.

11.8 ANSWER TO IN-TEXT QUESTIONS

1. b
2. True
3. True
4. c
5. b
6. False
7. True
8. False. A low opportunity cost of producing one good implies a high
opportunity cost of producing the other good.
9. The Commodity TOT will be:

It implies that India’s terms of trade is unfavorable as it is less than 100.

10.

It implies that the terms of trade is favorable.

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NOTES
11.9 LEARNING OUTCOMES

In this lesson you have been taught:

• A country is said to have a comparative advantage in producing a good
if the opportunity cost of producing that good in terms of the other good
is lower in that country as compared to the other country.
• Opportunity cost is the cost of the next best alternative. It represents the
potential benefits that a party misses out on when choosing one alternative
over another.
• Trade is possible between the two countries even when a country does not
have an absolute advantage in the production of any of the commodities
but has a comparative advantage in the production of one commodity than
in the other.
• In a model where there are only two countries and two goods, if one
country has a comparative advantage in one good, the other country will
necessarily have a comparative advantage in the other.
• Endowment of natural resources, factor endowments, economies of scale
and technology are some of the sources of comparative advantage.
• The terms of trade (TOT) refer to the rate at which the goods of one
country exchange for the goods of another country.
• It is a measure of the purchasing power of exports of a country in terms
of its imports and is expressed as the relation between export prices and
import prices of its goods.
• When the export prices of a country rise relative to its import prices, its
terms of trade are said to have improved. The country gains from trade
because it can have a larger quantity of imports in exchange for a given
quantity of exports.

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• On the other hand, when its imports prices rise relative to its export prices, NOTES
its terms of trade are said to have worsened. The country’s gains from trade
are reduced because it can have a smaller quantity of imports in exchange
for a given quantity of exports than before.
• If TOT is above 100, it is said that the TOT is favorable and if it is below
100, it is said to be unfavorable.
• There are various types of terms of trade/ various ways of calculating terms
of trade. Some of them are as follow:
o Gross Barter TOT
o Net Barter TOT
o Income TOT
o Single Factoral TOT
o Double Factoral TOT
o Real Factoral TOT
o Utility TOT

11.10 TERMINAL QUESTIONS

Question 1

You are watching an election debate on television. A candidate says, “We need to
stop the flow of foreign automobiles into our country. If we limit the importation
of autos, our domestic auto production will rise and India will be better off,”
1. Is it likely that India will be better off if we limit auto imports? Explain.
2. Will anyone in India will be better off if we limit auto imports? Explain.
3. In the real world, does every person in the country gain when restrictions
on imports are reduced? Explain.

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NOTES Question 2

Suppose a worker in Germany can produce 15 computers or 5 tons of grain per

month. Suppose a worker in Poland can produce 4 computers or 4 tons of grain
per month. For simplicity, assume that each country has only one worker.
a. Fill out the following table:
Computers Grain
Germany
Poland

b. Graph the production possibilities frontier for each country.

c. What is the opportunity cost of 1 computer in Germany? What is the
opportunity cost of 1 ton of grain in Germany?
d. What is the opportunity cost of 1 computer in Poland? What is the
opportunity cost of 1 ton of grain in Poland?
e. Which country has the absolute advantage in producing computers? Which
country has the absolute advantage in producing grain?
f. Which country has the comparative advantage in producing computers?
Which country has the absolute advantage in producing grain?
g. Each country should tend toward specialization in the production of which
good? Why?
h. What is the range of prices for computers and grain for which both countries
would benefit?
i. Suppose Germany and Poland settle on a price of 2 computers for 1 ton of
grain or 1/2 ton of grain for a computer. Suppose each country specializes
in production and they trade 4 computers for 2 tons of grain. Plot the final
consumption points on the graphs you made in part b. above. Are these
countries consuming inside or outside of their production possibilities
frontier?
j. Suppose the productivity of a worker in Poland doubles so that a worker
can produce 8 computers or 8 tons of grain per month. Which country has
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Comparative Advantage and Terms of Trade

the absolute advantage in producing computers? Which country has the NOTES
absolute advantage in producing grain?
k. After the doubling of productivity in Poland, which country has a
comparative advantage in producing computers? Which country has the
absolute advantage in producing grain? Has the comparative advantage
changed? Has the material welfare of either country changed?
I. How would your analysis change if you assumed, more realistically, that
each country had 10 million workers?

Question 3

Evaluate this statement: A technologically advanced country, which is better than

its neighbor at producing everything, would be better off if it closed its borders
to trade because the less productive country is a burden to the advanced country.

Question 4

Take 1971 as the base year and let, India’s both export prices and import prices
be 100 in it. If we find that by the end of 1981 its index of export prices had
risen to 180 and the index of import prices had risen to 150, what will be the Net
Barter TOT? What does it indicate?

Question 5

Take 1971 as the base year and let, India’s both quantities of imports and exports
as 100 in the base year. If we find that the index of quantity imports had risen to
130 and that of quantity exports to 180 in 1981, then, what would be the Gross
Barter TOT? What does it imply?

11.11 SOLUTIONS TO TERMINAL QUESTIONS

Solution 1

1. No. If we import autos, it is because the opportunity cost of producing

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NOTES 2. Yes. Those associated with the domestic auto industry--stockholders of

domestic auto producers and autoworkers.
3. No. When we reduce restrictions on imports, the country gains from the
increased trade but individuals in the affected domestic industry may lose.

Solution 2

a.
Computers Grain
Germany 15 5
Poland 4 4
b. See diagrams below:

c. 1/3 ton grain. 3 computers

d. 1 ton grain. 1 computer
e. Germany because one worker can produce 15 computers compared to 4.
Germany because one worker can produce 5 tons of grain compared to 4.
f. Germany because a computer has the opportunity cost of only 1/3 ton of
grain compared to 1 ton of in Poland. Poland because a ton of grain has the
opportunity cost of only 1 computer compared to 3 computers in Germany.
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g. Germany should produce computers while Poland should produce grain NOTES
because the opportunity cost of computers is lower in Germany and the
opportunity cost of grain is lower in Poland. That is, each has a comparative
advantage in those goods.
h. Grain must cost less than 3 computers to Germany. Computers must cost
less than 1 ton of grain to Poland.
i. They are consuming outside their production possibilities frontier. See
figures below:

j. Germany because one worker can produce 15 compared to 8. Poland

because one worker can produce 8 compared to 5.
k. Germany has comparative advantage in com­puters. Poland has comparative
advantage in grains. No change in comparative advantage. Poland is better
off, however, because it now has a larger set of choices.
l. It would not change absolute advantage or comparative advantage. It would
change the scale in the previous two graphs by a factor of 10 million.

Solution 3

This is not true. All countries can gain from trade if their opportunity costs of
production differ. Even the least productive country will have a comparative
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NOTES advantage at producing something, and it can trade this good to the advanced
country for less than the advanced country’s opportunity cost.

Solution 4

The Net Barter TOT/ Commodity TOT will be:

This implies an improvement in the terms of trade is favorable as it is

above 100.

Solution 5

The Gross Barter TOT is:

It implies that the terms of trade is unfavorable as it is below 100.

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Trade Barriers and the Debate between Free Trade and Protectionism

LESSON 12 NOTES

TRADE BARRIERS AND THE DEBATE

BETWEEN FREE TRADE AND
PROTECTIONISM
Dyuti Agrawal
Assistant Professor
University of Delhi

Structure
12.1 Introduction
12.2 Learning Objectives
12.3 Trade Barriers
12.4 Types of Trade Barriers
12.5 Free Trade versus Protectionism
12.6 Glossary
12.7 Answer to In-Text Questions
12.8 Learning Outcomes
12.9 Terminal Questions
12.10 Solutions to Terminal Questions
12.11 Recommended Readings

12.1 INTRODUCTION

So far, we have established that there are gains from trade. In this lesson, we
shall explain how the international marketplace achieves these gains from trade
and how the gains are distributed among the various economic participants. We
shall analyze who gains and who loses from free trade among countries, and
how the gains compare to the losses.

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NOTES
12.2 LEARNING OBJECTIVES

• To understand what determines whether a country imports or exports a

good
• To examine who wins and who loses from international trade
• To learn that the gains to winners from international trade exceed the losses
to losers
• To analyze the welfare effects of tariffs
• To examine the arguments people use to advocate trade restrictions

12.3 TRADE BARRIERS

International trade is carried out by both businesses and governments—as long

as no one puts up trade barriers. In general, trade barriers keep firms from selling
to one another in foreign markets. The major obstacles to international trade are
natural barriers, tariff barriers, and non-tariff barriers.

12.4 TYPES OF TRADE BARRIERS

1. Natural Barriers

Natural barriers to trade can be either physical or cultural. For instance, even
though raising beef in the relative warmth of Argentina may cost less than
raising beef in the bitter cold of Siberia, the cost of shipping the beef from South
America to Siberia might drive the price too high. Distance is thus one of the
natural barriers to international trade.

2. Tariff Barriers

A tariff is a tax or duty levied on goods when they enter and leave the national
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Trade Barriers and the Debate between Free Trade and Protectionism

duties. But for practical purposes, a tariff is synonymous with import duties or NOTES
custom duties.
In-Text Questions
1. Which of the following statements about tariffs is true?
a. A tariff increases producer surplus, decreases consumer surplus,
increases revenue to the government, and reduces total surplus.
b. A tariff increases consumer surplus, decreases producer surplus,
increases revenue to the government, and reduces total surplus.
c. A tariff increases producer surplus, decreases consumer surplus,
increases revenue to the government, and increases total surplus.
d. A tariff increases consumer surplus, decreases producer surplus,
increases revenue to the government, and increases total surplus.

3. Non-Tariff Barriers

Non–Tariff Barriers are of many kinds. We shall discuss some of them.

a. Import Quota: Under an import quota, a fixed amount of a commodity
in volume or value is allowed to be imported into the country during a
specified period of time, usually a year. For this purpose, the government
may issue an import license that it may sell either to importers at a
competitive price or just give it to importers on a first-come first-served
basis. Alternatively, the government may limit the value of imports by
providing the importers with a limited amount of foreign exchange for the
purchase of a particular commodity to be imported by them.
b. Voluntary Export Restraints (VERs): A voluntary export restraint (VER)
is an agreement by an exporter country’s exporters or government with
an importing country to limit their exports to it. It is entered into by the
importing country when its domestic industry is suffering from large
imports. The limit on imports may be set in terms of quantity, value or
market share. VERs are seldom ‘voluntary’. They are accepted by exporters
lest they may be restricted to trade by more powerful trade barriers on the
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NOTES to make more profit by exporting less at higher prices, it may agree
voluntarily to restrict its exports. VERs have been used by U.S., EEC and
other industrialized countries to restrict exports of steel, TVs, automobiles,
textiles, etc., from Japan and developing countries.
In-Text Questions
2. Which of the following statements about import quotas is true?
a. Import quotas are preferred to tariff because they raise more
revenue for the imposing government.
b. Voluntary quotas established by the exporting country generate
no deadweight loss for the importing country.
c. For every tariff, there is an import quota that could have generated
a similar result.
d. An import quota reduces the price to the domestic consumers.

12.5 FREE TRADE VERSUS PROTECTIONISM

Free Trade Policy refers to a trade policy without any tariffs, quantitative
restrictions and other policy devices obstructing the movement of goods between
countries. Prof. Jagdish Bhagwati defines free trade policy, “as absence of tariffs,
quotas, exchange restrictions, taxes and subsidies on production, factor use and
consumption”. Thus, the policy of free trade means simply complete freedom of
international trade without any restrictions on the movement of goods between
countries.
The term protection refers to a policy whereby domestic industries are to
be protected from foreign competition. The aim is to impose restrictions on the
imports of low-priced products in order to encourage domestic industries. They
can be protected by either tariff or non-tariff barriers.

Arguments for Free Trade

Typically, when a country opens itself to trade and if the domestic price of a
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price), then, through trade, the country will be importing that commodity. The NOTES
domestic producers will lose out and the producer surplus will decrease. But
the domestic consumers will gain, and the consumer surplus will increase. This
change happens in such a way that the gains of the winners exceed the losses of
the losers thereby giving overall gains to the economy. Thus, there are winners
and losers when a nation opens itself up to trade, but the gains of the winners
exceed the losses of the losers.
In-Text Questions
3. Answer whether the following statement is true or false. If it is false,
explain.
“Trade makes everyone better off.”
4. Answer whether the following statement is true or false. If it is false,
explain.
“If free trade is allowed and a country imports wheat, domestic buyers
of bread are better off and domestic farmers are worse off when
compared to the before-trade domestic equilibrium.”

Some of the other benefits are as follows:

• Increased variety of goods. Goods produced in different countries
are not exactly the same. German beer, for instance, is not the same
as American beer. Free trade gives consumers in all countries greater
variety to choose from.
• Lower costs through economies of scale. Some goods can be produced
at low cost only if they are produced in large quantities—a phenomenon
called economies of scale. A firm in a small country cannot take full
advantage of economies of scale if it can sell only in a small domestic
market. Free trade gives firms access to larger world markets and allows
them to realize economies of scale more fully.
• Increased competition. A company shielded from foreign competitors
is more likely to have market power, which in turn gives it the ability to
raise prices above competitive levels. This is a type of market failure.
Opening up trade fosters competition and gives the invisible hand a
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NOTES • Enhanced flow of ideas. The transfer of technological advances around

the world is often thought to be linked to the trading of the goods that
embody those advances. The best way for a poor agricultural nation
to learn about the computer revolution, for instance, is to buy some
computers from abroad rather than trying to make them domestically.

Arguments for Protectionism

1. The Jobs Argument

To understand this, let us consider the textile market in the imaginary country of
Isoland. Say, before trade, the price of textiles is higher in Isoland than it is in the
rest of the world. That is, before trade, the domestic price is higher than the world
price. So, in our example, when the economy opens up and trade happens with
the rest of the world, the domestic consumers will be able to buy the textiles at a
lower price (i.e., the world price) than they did before the trade. Thus, free trade
in textiles would cause the price of textiles to fall in Isoland, reducing the quantity
of textiles produced in Isoland and thus reducing employment in the Isolandian
textile industry. Some Isolandian textile workers would lose their jobs. Yet free
trade creates jobs at the same time that it destroys them. When Isolandians buy
textiles from other countries, those countries obtain the resources to buy other
goods from Isoland. Isolandian workers would move from the textile industry to
those industries in which Isoland has a comparative advantage. The transition may
impose hardship on some workers in the short run, but it allows Isolandians as a
whole to enjoy a higher standard of living. Opponents of trade are often skeptical
that trade creates jobs. They might respond that everything can be produced more
cheaply abroad. Under free trade, they might argue, Isolandians could not be
profitably employed in any industry. However, the gains from trade are based
on comparative advantage, not absolute advantage. Even if one country is better
than another country at producing everything, each country can still gain from
trading with the other. Workers in each country will eventually find jobs in an
industry in which that country has a comparative advantage.

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In-Text Questions NOTES

5. Answer whether the following statement is true or false. If it is false,

explain.
“If the world price for a good exceeds a country’s before-trade domestic
price for that good, the country should import that good.”
6. Which of the following statements about trade is true?
a. Unrestricted international trade benefits every person in a country
equally.
b. People that are skilled at all activities cannot benefit from trade.
c. Trade can benefit everyone in society because it allows people to
specialize in activities in which they have an absolute advantage.
d. Trade can benefit everyone in society because it allows people to
specialize in activities in which they have a comparative advantage.

2. The National-Security Argument

When an industry is threatened with competition from other countries, opponents

of free trade often argue that the industry is vital to national security. For example,
if Isoland were considering free trade in steel, domestic steel companies might
point out that steel is used to make guns and tanks. Free trade would allow
Isoland to become dependent on foreign countries to supply steel. If a war later
broke out and the foreign supply was interrupted, Isoland might be unable to
produce enough steel and weapons to defend itself. Economists acknowledge that
protecting key industries may be appropriate when there are legitimate concerns
over national security. Yet they fear that this argument may be used too quickly
by producers eager to gain at consumers’ expense. One should be wary of the
national-security argument when it is made by representatives of industry rather
than the defense establishment. Companies have an incentive to exaggerate their
role in national defense to obtain protection from foreign competition. A nation’s
generals may see things very differently. Indeed, when the military is a consumer
of an industry’s output, it would benefit from imports. Cheaper steel in Isoland,
for example, would allow the Isolandian military to accumulate a stockpile of
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NOTES 3. The Infant-Industry Argument

New industries sometimes argue for temporary trade restrictions to help them
get started. After a period of protection, the argument goes, these industries will
mature and be able to compete with foreign firms. Similarly, older industries
sometimes argue that they need temporary protection to help them adjust to new
conditions. Economists are often skeptical about such claims, largely because
the infant-industry argument is difficult to implement in practice. To apply
protection successfully, the government would need to decide which industries
will eventually be profitable and decide whether the benefits of establishing
these industries exceed the costs of this protection to consumers. Yet “picking
winners” is extraordinarily difficult. It is made even more difficult by the political
process, which often awards protection to those industries that are politically
powerful. And once a powerful industry is protected from foreign competition, the
“temporary” policy is sometimes hard to remove. In addition, many economists
are skeptical about the infant-industry argument in principle. Suppose, for
instance, that an industry is young and unable to compete profitably against
foreign rivals, but there is reason to believe that the industry can be profitable
in the long run. In this case, firm owners should be willing to incur temporary
losses to obtain the eventual profits. Protection is not necessary for an infant
industry to grow. History shows that start-up firms often incur temporary losses
and succeed in the long run, even without protection from competition.

4. The Unfair-Competition Argument

A common argument is that free trade is desirable only if all countries play by
the same rules. If firms in different countries are subject to different laws and
regulations, then it is unfair (the argument goes) to expect the firms to compete
in the international marketplace. For instance, suppose that the government of
Neighborland subsidizes its textile industry by giving textile companies large tax
breaks. The Isolandian textile industry might argue that it should be protected
from this foreign competition because Neighborland is not competing fairly.
Would it, in fact, hurt Isoland to buy textiles from another country at a subsidized
price? Certainly, Isolandian textile producers would suffer, but Isolandian textile
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consumers would benefit from the low price. The case for free trade is the same NOTES
as before: The gains of the consumers from buying at the low price would exceed
the losses of the producers. Neighborland’s subsidy to its textile industry may be
a bad policy, but it is the taxpayers of Neighborland who bear the burden. Isoland
can benefit from the opportunity to buy textiles at a subsidized price. Rather than
objecting to the foreign subsidies, perhaps Isoland should send Neighborland a
thank-you note.

5. The Protection-as-a-Bargaining-Chip Argument

Another argument for trade restrictions concerns the strategy of bargaining.

Many policymakers claim to support free trade but, at the same time, argue that
trade restrictions can be useful when we bargain with our trading partners. They
claim that the threat of a trade restriction can help remove a trade restriction
already imposed by a foreign government. For example, Isoland might threaten
to impose a tariff on textiles unless Neighborland removes its tariff on wheat. If
Neighborland responds to this threat by removing its tariff, the result can be freer
trade. The problem with this bargaining strategy is that the threat may not work.
If it does not work, the country faces a choice between two bad options. It can
carry out its threat and implement the trade restriction, which would reduce its
own economic welfare. Or it can back down from its threat, which would cause
it to lose prestige in international affairs. Faced with this choice, the country
would probably wish that it had never made the threat in the first place.
In-Text Questions
7. When U.S. politicians argue that outsourcing or offshoring of technical
support to India by Dell Computer Corporation is harmful to the U.S.
economy, they are employing which of the following arguments for
restricting trade?
a. The infant-industry argument
b. The jobs argument
c. The national-security argument
d. The deadweight-loss argument
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NOTES 8. Which of the following is not employed as an argument in support of

trade restrictions?
a. Free trade destroys domestic jobs.
b. Free trade harms the national security if vital products are imported.
c. Free trade is harmful to importing countries if foreign countries
subsidize their exporting industries.
d. Free trade harms both domestic producers and domestic consumers
and therefore reduces the total surplus.
e. Free trade harms infant industries in an importing country.

12.6 GLOSSARY

• Free Trade: It refers to complete freedom of international trade without

any restrictions on the movement of goods between countries.
• Import Quota: Under an import quota, a fixed amount of a commodity
in volume or value is allowed to be imported into the country during a
specified period of time
• Protectionist Policy/Protectionism: It refers to a policy whereby domestic
industries are to be protected from foreign competition by implementing
various trade barriers.
• Trade Barriers: Trade barriers are devices that keep firms from selling
to one another in foreign markets.
• Voluntary Export Restraint (VER): A voluntary export restraint (VER)
is an agreement by an exporter country’s exporters or government with an
importing country to limit their exports to it.

12.7 ANSWER TO IN-TEXT QUESTIONS

1. a
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3. False. Some gain and some lose but the gains of the winners outweigh the NOTES
losses of the losers.
4. True
5. False. The country should export that good.
6. d
7. b
8. d

12.8 LEARNING OUTCOMES

In this lesson, you have been taught-

• Trade barriers are obstacles to international trade. That is, they keep firms
from selling to one another in foreign markets.
• The major trade barriers are-
o natural barriers
o tariff barriers
o nontariff barriers
• Some major non-tariff barriers are-
o Import quotas
o Voluntary export restraints
• Free Trade Policy refers to a trade policy without any tariffs, quantitative
restrictions and other policy devices obstructing the movement of goods
between countries.
• The term protection refers to a policy whereby domestic industries are to
be protected from foreign competition.
• If the world price of a good is greater than its before-trade domestic price,
the country will export the good.
• If the world price of a good is less than its before-trade domestic price, the
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NOTES • When a country imports a good, the producer surplus decreases and the
consumer surplus increases. So, the consumer wins and the producer loses
when a country imports a good.
• When a country opens itself to trade and it imports a good because the
world price is less than the domestic before-trade price, the gains of the
consumer exceed the losses of the producer when a country imports a good.
• There is a deadweight loss associated with a tariff.
• There is often a debate in policy circles whether to impose trade restrictions
or to allow free trade. Different arguments are made for both.
• Arguments for free trade-
o The gains of the winners exceed the losses of the losers thereby giving
overall gains to the economy.
o Increased variety of goods
o Lower costs through economies of scale
o Increased competition
o Enhanced flow of ideas
• Arguments for restricting trade/arguments against free trade-
o The Jobs Argument- Free trade will cause loss of jobs in the domestic
industry which produces the goods that are being imported.
o The National-Security Argument- Some industries argue that their
product is vital for national security so it should be protected from
international competition. They argue that if a war later broke out and
the foreign supply was interrupted, the country may not be able to
defend itself.
o The Infant-Industry Argument- New industries argue that they need
temporary protection from international competition until they become
mature enough to compete.
o The Unfair-Competition Argument- Opponents of free trade argue
that other countries provide their industries with unfair advantages such
as subsidies, tax breaks, and lower environmental restrictions, thereby
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o The Protection-as-a-Bargaining-Chip Argument- Opponents of NOTES

free trade argue that the threat of trade restrictions may result in other
countries lowering their trade restrictions.
• Response of proponents of free trade to arguments against free trade-
o Response to the Jobs Argument- While free trade does destroy
inefficient jobs in the importing sector, it creates more efficient jobs
in the export sector, industries where the country has a comparative
advantage. This is always true because each country has a comparative
advantage in the production of something.
o Response to the National-Security Argument- The danger of this
argument is that it runs the risk of being overused, particularly when
the argument is made by representatives of industry rather than the
defense establishment.
o Response to the Infant Industry Argument- There is a problem
choosing which new industries to protect, and once protected, temporary
protection often becomes permanent. In addition, the industries that the
government truly expects to be competitive in the future don’t need
protection because the owners will accept short-term losses.
o Response to the Unfair-Competition Argument- The gains of
consumers in the importing country will exceed the losses of the
producers in that country, and the country will gain when importing
subsidized production.
o Response to the Protection-as-a-Bargaining-Chip Argument-
if for some reason it does not work, the threatening country must back
down or reduce trade--neither of which is desirable.
• The arguments made in support of trade restrictions get defeated.
• Countries that restrict trade usually restrict imports rather than exports.
This is because producers lose from imports and gain from exports, and
producers are better organized to lobby the government to protect their
interests. For example, when a country imports a product, consumers win
and producers lose. Consumers are less likely to organize and lobby the
government than the affected producers, so imports may be restricted. Self-Instructional
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NOTES again, consumers are less likely to organize and lobby the government to
restrict exports, so exports are rarely restricted.
• The overwhelming majority of economists find no sound economic
argument in opposition to free trade. The only argument against free trade
that may not be defeated on economic grounds is the national-security
argument. This is because it is the only argument against free trade that is
not based on economics but rather it is based on other strategic objectives.

12.9 TERMINAL QUESTIONS

1. Use the diagram below to answer the following questions.

a. If trade is not allowed, what is the equilibrium price and quantity in

this market?
b. If trade is allowed, will this country import or export this commodity?
Why?
c. If trade is allowed, what is the price at which the good is sold, the
domestic quantity supplied and demanded, and the quantity imported
or exported?

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d. What area corresponds to the consumer surplus if no trade is allowed? NOTES

e. What area corresponds to the consumer surplus if trade is allowed?
f. What area corresponds to the producer surplus if no trade is allowed?
g. What area corresponds to the producer surplus if trade is allowed?
h. If free trade is allowed, who gains and who loses- the consumers or
the producers? What area corresponds to their gain or loss?
i. What area corresponds to the gains from trade?
2. If a foreign country artificially lowers the cost of production for its
producers with lax environmental regulations and direct subsidies and
then exports the products to us, who wins and who loses in our country –
producers or consumers?
3. Use the following diagram to answer the questions below.

i. If free trade is allowed, consumer surplus is the area

a. A.
b. A + B.
c. A + B + C.
d. A + B + C + D + E + F
e. A + B + C + D + E + F + G.
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NOTES ii. If a tariff is placed on this good, consumer surplus is the area
a. A.
b. A + B.
c. A + B + C.
d. A + B + C + D + E + F.
e. A + B + C + D + E + F + G.
iii. Government revenue from the tariff is the area
a. C + D + E + F
b. D + E + F
c. D + E
d. G
e. E
iv. If a tariff is placed on this good, producer surplus is the area
a. G
b. G + C
c. G + C + D + E + F
d. G + C + D + E + F + B
e. G + C + E
v. The deadweight loss from the tariff is the area
a. B + D + E + F
b. B
c. D + E + F
d. D + F
e. E

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Trade Barriers and the Debate between Free Trade and Protectionism

NOTES
12.10 SOLUTIONS TO TERMINAL QUESTIONS

Solution 1

a. Price = $4, quantity = 40 units

b. Export because the world price is above the domestic price, which implies
that this country has a comparative advantage in the production of this
good.
c. Price = $6, quantity supplied = 60 units, quantity demanded = 20 units,
quantity exported 40 units.
d. A + B + C
e. A
f. D + E
g. B + C + D + E + F
h. Consumers lose B + C, producers gain B + C + F.
i. F

Solution 2

Consumers gain, producers lose.

Solution 3

1. d
2. b
3. e
4. b
5. d

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 Principles of Microeconomics II

NOTES
12.11 RECOMMENDED READINGS

• Mankiw, N. G. (2018). Principles of Microeconomics 8th ed.

• Bernheim, B., Whinston, M. (2009). Microeconomics. Tata McGraw-Hill.

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DEPARTMENT OF DISTANCE AND CONTINUING EDUCATION
UNIVERSITY OF DELHI