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ADVANCED MICROECONOMICS (56278)

University of Hull Business School, Hull, England, UK.

January 12, 2016

Abstract

This monograph presents major elements of advanced microeconomic models for systematic

thinking about the working of modern markets. Problems of consumers and producers are

analysed concisely in partial, general equilibrium and game theoretic frameworks relating them

to the micro level decision making processes with due consideration on the structure of markets

and pulic policies. Exercises and assignments in workbook anticipate reading of relevant journal

articles.

JEL Classi…cation: D

Keywords: microeconomic models

H U 6 7 R X , H u ll, U K . e m a il: K .R .B h a tta ra i@ hu ll.a c .u k

1

Contents

1 L1: Axioms and optimisation 8

1.1 Microeconomic Theory: Milestones . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.2 Axioms and Consumption Set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.3 Optimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.3.1 Consumer optimisation: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

1.3.2 Producer optimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.4 A simple computable general equilibrium model with labour leisure choice . . . . . . 12

1.5 Methods for constructing Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

1.5.1 Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

1.5.2 Converse and contrapositive . . . . . . . . . . . . . . . . . . . . . . . . . 15

1.5.3 Equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

1.5.4 Mathematical induction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

2.1 Properties of an indirect utility function . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.1.1 Price elasticities and the elasticity of substitution . . . . . . . . . . . . . . . . 17

2.1.2 Consumer optimisation model: a numerical example . . . . . . . . . . . . . . 18

2.1.3 Econometric issues in estimation of demand functions and elasticities of demand 19

2.1.4 Restrictions in estimating a demand function: . . . . . . . . . . . . . . . . . . 19

2.2 Exercise 1: Consumer’s problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2.2.1 Marshallian demand functions from the CES preferences: . . . . . . . . . . . 22

2.2.2 Compensated and uncompensated demands . . . . . . . . . . . . . . . . . . . 23

2.2.3 Expenditure functions with the CES utility functions . . . . . . . . . . . . . . 23

2.3 Slutskey equation ( Decomposition of substituion and income e¤ects): Duality on

consumer optimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.3.1 Comparative static analyis with matrix . . . . . . . . . . . . . . . . . . . . . 26

2.4 Exercise on Consumption and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . 29

2.4.1 Indirect utility and expenditure functions: Roy’s Identity . . . . . . . . . . . 30

2.4.2 Dual of the consumer’s optimisation problem . . . . . . . . . . . . . . . . . . 30

2.4.3 Shephard’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

2.4.4 Calibration of the constant elasticity of substitution (CES) demand function 32

2.4.5 Exercise 1.2: comparative static analysis of consumer choice . . . . . . . . . . 35

2.4.6 Exercise 2: Indirect utility function, Shephard’s Lemma and Roy’s Identity . 36

2.4.7 Duality in consumption and Slutskey decomposition . . . . . . . . . . . . . . 37

2.4.8 Problem 4: CES Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

2.4.9 Extra example on Shephard’s Lemma and Roy’s identity . . . . . . . . . . . . 39

2.4.10 Indierct utility function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

2.4.11 Expenditure function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

2.4.12 Duality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

2.4.13 Shephard’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

2.4.14 Roy’s Identity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2.5 Revealed Preference Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

2.5.1 Slutsky equation from the Revealed Preference Theory . . . . . . . . . . . . . 44

2.5.2 Further Developments in Consumer Theory . . . . . . . . . . . . . . . . . . . 45

2

2.5.3 Emprical analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

3.0.4 Popular production functions . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

3.1 Supply function: an example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

3.1.1 Properties of a pro…t function . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

3.1.2 Production function and its scale properties . . . . . . . . . . . . . . . . . . . 52

3.1.3 Variable returns to scale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3.1.4 Cost function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

3.2 CES and Cobb-Douglas production functions . . . . . . . . . . . . . . . . . . . . . . 54

3.3 Comparative static: derivation of the CES cost function. . . . . . . . . . . . . . . . . 56

3.3.1 Exercise 5: cost minimisation . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

3.3.2 Properties of a cost function . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

3.3.3 Exercise 6 : CES and Cobb-Douglas supply functions . . . . . . . . . . . . . 62

3.3.4 Short run supply function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

3.3.5 Hotelling’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

3.3.6 Exercise 7: Minimising the cost with Cobb-Douglas and CES production

function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

3.4 Consumer and producer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

3.4.1 Pro…t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

3.4.2 Linear programming problem of a …rm . . . . . . . . . . . . . . . . . . . . . . 71

3.4.3 Duality in Linear Programming . . . . . . . . . . . . . . . . . . . . . . . . . . 73

3.5 Input-Output Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

3.5.1 Numerical Example of Input Output Model . . . . . . . . . . . . . . . . . . . 76

3.5.2 Impact analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

3.5.3 Exercise 10: Input Output Model . . . . . . . . . . . . . . . . . . . . . . . . 80

4.1 De…nition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

4.1.1 Cournot, Stackelberg and Cartel: which is better of consumer welfare? . . . . 87

4.1.2 Price-Leadership by …rm 1 in Stackelberg equilibrium . . . . . . . . . . . . . 88

4.2 Dixit-Stiglitz Model of Monopolistic Competition . . . . . . . . . . . . . . . . . . . . 90

4.2.1 Monopolistic competition and Trade . . . . . . . . . . . . . . . . . . . . . . . 91

4.2.2 Monopolistic competition in an industry with two …rms . . . . . . . . . . . . 92

4.3 Natural Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

4.3.1 Bertrand Game of price competition . . . . . . . . . . . . . . . . . . . . . . . 97

4.4 Price War: stability analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

4.5 Monopolistic competition and trade . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

4.5.1 Monoply, Oligopoly and tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.6 Tripoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

4.7 Multinational Company: Microeconomic Theory of FDI . . . . . . . . . . . . . . . . 110

4.8 Predatory pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114

4.8.1 FDI under uncertainty: Dixit and Pindyk (1994) approach . . . . . . . . . . 114

4.9 General equilibrium model of a multinational …rm:Batra and Ramachandran(1980) . 116

4.9.1 Empirical evidence on growth e¤ects of FDI . . . . . . . . . . . . . . . . . . . 119

4.9.2 Exercise 9: markets and competition . . . . . . . . . . . . . . . . . . . . . . . 119

3

4.9.3 General equilibrium with production . . . . . . . . . . . . . . . . . . . . . . . 122

5.1 What is a general equilibrium? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

5.1.1 Existence, uniqueness and stability of general equilibrium . . . . . . . . . . . 124

5.2 Two fundamental theorems of welfare economics . . . . . . . . . . . . . . . . . . . . 127

5.3 Pure exchange general equilibrium model . . . . . . . . . . . . . . . . . . . . . . . . 129

5.3.1 Exercise 11: Ricardian trade model . . . . . . . . . . . . . . . . . . . . . . . . 133

5.4 Simplest general equilibrium model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

5.5 General equilibrium with production . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

5.5.1 A numerical example for the general equilibrium tax model . . . . . . . . . . 137

5.6 Social Welfare Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

5.7 Exercise 12: Social Welfare and General Equilibrium . . . . . . . . . . . . . . . . . . 146

5.8 Two sector model of nessecity and luxury goods (income distribtuion) . . . . . . . . 149

5.9 General equilibrium model of Trade: Ricardian Comparative Advantage Theory . . 153

5.9.1 Two Country Ricardian Trade Model . . . . . . . . . . . . . . . . . . . . . . 153

5.9.2 Autarky or Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

5.10 Exercise 12’: migration and factor mobility . . . . . . . . . . . . . . . . . . . . . . . 162

5.11 General equilibrium with taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

5.12 Exercise 13: Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . 168

6.1 Formal de…nitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

6.1.1 Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

6.1.3 Extensive form Game ( ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

6.2 Story of GAME made easy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

6.3 Types of games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

6.4 Bargaining game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

6.4.1 Coalition and Shapley Values of the Game . . . . . . . . . . . . . . . . . . . 187

6.5 Pivotal player in a voting game in Nepal . . . . . . . . . . . . . . . . . . . . . . . . . 190

6.5.1 Model of fruitless bargaining and negotiation . . . . . . . . . . . . . . . . . . 191

6.5.2 Model of commitment, credibility and reputation . . . . . . . . . . . . . . . . 191

6.5.3 Endogenous intervention: change in beliefs . . . . . . . . . . . . . . . . . . . 192

6.6 Equivalence of Core in Games and Core in a General Equilibrium Model . . . . . . . 194

6.7 Labour Market and Search and Matching Model . . . . . . . . . . . . . . . . . . . . 196

6.8 Exercise 14: Search Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

7 L7: Game theory: Principal Agent and Mechanism Games and Auctions 200

7.1 Original Ideas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

7.1.1 Full information scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201

7.1.2 Incomplete information scenario . . . . . . . . . . . . . . . . . . . . . . . . . 201

7.1.3 Impacts of Assymetric (incomplete) Information on Markets . . . . . . . . . . 205

7.1.4 Adverse Selection (hidden information) Problem . . . . . . . . . . . . . . . . 206

7.1.5 Signalling and Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

7.1.6 Education Level- A Signal of Productive Worker . . . . . . . . . . . . . . . . 209

4

7.2 Spence model of education . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

7.3 Popular Principal Agent Games . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212

7.4 Exercise 15: Principal Agent Problem . . . . . . . . . . . . . . . . . . . . . . . . . . 217

7.5 Mechanism Design for Price Discrimination: Low Cost Airlines Example . . . . . . . 217

7.5.1 Mechanism for e¢ cient contract for a CEO . . . . . . . . . . . . . . . . . . . 221

7.5.2 E¢ cient contracts of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222

7.5.3 Mechanism for Poverty Alleviation . . . . . . . . . . . . . . . . . . . . . . . . 224

7.6 Repeated Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226

7.7 Moral Hazard and Adverse Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

7.8 Auction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

7.9 Exercise 16 :Optimal production of a multiproduct …rm . . . . . . . . . . . . . . . . 233

7.9.1 A Microeconomic Model of FDI . . . . . . . . . . . . . . . . . . . . . . . . . . 236

8.1 Allais’paradox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

8.1.1 Uncertainty of Good Times and Bad Times . . . . . . . . . . . . . . . . . . . 243

8.1.2 Optimal Demand for Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 245

8.2 Expected utility theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

8.2.1 Measure of risk aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

8.2.2 St Petersberg Paradox (Bernoulli Game) and Allais Paradox . . . . . . . . . 249

8.2.3 Non-linear pricing Scheme . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

8.2.4 Job market applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

8.2.5 Insurance market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

10 L10: Impact of Taxes and Public Goods in E¢ ciency, Growth and Redistribu-

tion: A General Equilibrium Analysis 263

10.1 First best principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

10.1.1 E¢ ciency in consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

10.1.2 E¢ ciency in production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

10.1.3 E¢ ciency of Trade (Exchange) . . . . . . . . . . . . . . . . . . . . . . . . . . 264

10.1.4 A simple numerical example of optimal tax or optimal public spending . . . . 265

10.1.5 E¢ ciency in public goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

10.1.6 Theory of second best . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

10.1.7 Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

10.1.8 Samuelson and Nash on Sharing Public Good . . . . . . . . . . . . . . . . . . 268

10.1.9 Sameulson’s Theorem on Public Good . . . . . . . . . . . . . . . . . . . . . . 269

10.1.10 Negative externality in production . . . . . . . . . . . . . . . . . . . . . . . . 270

10.2 Negative externality and Pigouvian tax . . . . . . . . . . . . . . . . . . . . . . . . . 271

10.3 Carbon Emmission in the UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

10.3.1 A model of growth, …scal policy and welfare . . . . . . . . . . . . . . . . . . . 278

10.4 Fiscal Policy, Growth and Income Distribution in the UK . . . . . . . . . . . . . . . 280

10.4.1 Middle income hypothesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286

10.4.2 Current Fiscal Policy Context . . . . . . . . . . . . . . . . . . . . . . . . . . . 287

10.5 Features of Dynamic Tax Model of UK . . . . . . . . . . . . . . . . . . . . . . . . . . 291

10.5.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291

5

10.5.2 Production Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292

10.5.3 Trade arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292

10.5.4 Government sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293

10.5.5 General Equilibrium in a Growing Economy . . . . . . . . . . . . . . . . . . . 293

10.5.6 Procedure for Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

10.5.7 Data for the Benchmark Economy . . . . . . . . . . . . . . . . . . . . . . . . 294

10.5.8 Results on Redistribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295

10.5.9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298

11.1 Capital market: models and issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310

11.1.1 Risk management in asset markets . . . . . . . . . . . . . . . . . . . . . . . . 313

11.1.2 Industrial regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

11.1.3 IO Approach to pricing and industrial concentration . . . . . . . . . . . . . . 316

11.1.4 Signalling and Incentive Compatibility in the Financial Markets . . . . . . . 320

11.1.5 Moral hazards in the …nancial market . . . . . . . . . . . . . . . . . . . . . . 321

12.1 General equilibrium and game theoretic analysis of …nancial sector . . . . . . . . . . 327

12.1.1 CGE Modelling of energy sector policies . . . . . . . . . . . . . . . . . . . . . 327

12.1.2 CGE Modelling of tax policies . . . . . . . . . . . . . . . . . . . . . . . . . . 327

12.1.3 Comparative Static Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329

12.2 Dynamic CGE model of the energy and emmission . . . . . . . . . . . . . . . . . . . 335

13.0.1 Theory of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338

13.0.2 Measures of concentration and performance . . . . . . . . . . . . . . . . . . . 339

13.0.3 Regulation for solve the moral hazard problems in the …nancial markets . . . 340

13.0.4 Regulation by mechanism design by banks . . . . . . . . . . . . . . . . . . . . 341

13.0.5 Participation and incentive compatible constraints . . . . . . . . . . . . . . . 341

13.0.6 Solving the mechanism design problem of a bank . . . . . . . . . . . . . . . . 342

13.0.7 IO Approach to pricing and industrial concentration (HHI) . . . . . . . . . . 343

13.0.8 Why regulation? Welfare e¤ects of monopoly . . . . . . . . . . . . . . . . . . 344

13.0.9 Optimal advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344

13.0.10 Marginal productivity theory and tax credit . . . . . . . . . . . . . . . . . . . 345

13.0.11 Capital stock with and without capital income tax . . . . . . . . . . . . . . . 346

13.0.12 Technological development, human capital and tax rules . . . . . . . . . . . . 346

13.0.13 Dixit-Stiglitz Model of Monopolistic Competition . . . . . . . . . . . . . . . . 348

13.0.14 Market under imperfect competition and average cost pricing . . . . . . . . . 349

13.0.15 Krugman (1980): Trade and scale economy and regulation . . . . . . . . . . . 351

13.0.16 Regulation by non-linear pricing Mechanism . . . . . . . . . . . . . . . . . . . 352

13.1 Articles and Texts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357

13.1.1 Best twenty articles in 100 years in the American Economic Review . . . . . 357

13.1.2 Ten Best articles in the Journal of European Economic Association . . . . . . 358

13.1.3 Best 40 articles in the Journal of Economic Perspectives . . . . . . . . . . . . 359

6

14 Real Analysis 368

14.1 Methods for constructing Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

14.1.1 Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

14.1.2 Boundedness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

14.1.3 Convex Hull . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

14.1.4 Correspondence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

14.1.5 Fixed Point Theorems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

14.2 SETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

14.2.1 Relations and functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

14.3 Limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

15.1 GAMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

15.2 MATLAB . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

15.3 Econometric and Statistical Software . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

15.3.1 Quality ranking of journals in Economics . . . . . . . . . . . . . . . . . . . . 382

15.4 Core texts in Economic Theory and Equivalent reading . . . . . . . . . . . . 384

16 Schedule 386

16.1 Sample class test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

16.2 Sample …nal exam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391

17.1 Tutorial 1:Consumers’problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396

17.2 Tutorial 2: Dual of the consumer problem . . . . . . . . . . . . . . . . . . . . . . . 396

17.3 Tutorial 3: Dual of the producer’s problem . . . . . . . . . . . . . . . . . . . . . . 398

17.4 Tutorial 4: Markets, Price War and Stability Analysis . . . . . . . . . . . . . . . . 399

17.5 Tutorial 5: Ricardian General Equilibrium Trade Model . . . . . . . . . . . . . . . 400

17.6 Tutorial 6: General equilibrium with production . . . . . . . . . . . . . . . . . . . 401

17.7 Tutorial 7:Monopoly and monopolistic competition and taxes . . . . . . . . . . . . 403

17.8 Tutorial 8:Moral Hazard and Insurance . . . . . . . . . . . . . . . . . . . . . . . . . 405

17.9 Tutorial 9:Coalition, Bargaining, Signalling, Contract, Auction and Mechanism . . 407

17.10Tutorial 10: E¢ ciency and Social Welfare . . . . . . . . . . . . . . . . . . . . . . . 409

17.11Basic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410

17.11.1 Four rules of di¤erentiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410

17.11.2 Unconstrained optimisation: using Hessian determinants . . . . . . . . . . . . 410

17.11.3 Constrained optimisation: Bordered Hessian Determinants . . . . . . . . . . 412

17.11.4 Linear Programming approach to input-output model . . . . . . . . . . . . . 413

7

1 L1: Axioms and optimisation

Rational economic agents use available resources to achieve their objectives in the best possible

way. Microeconomics is about choices of these rational individuals who make decisions regarding

the allocation of resources, particularly on how much to consume or invest, how to produce and how

to interact in the markets remaining within the limits of resources they possess. It is also concerned

about the consumption and saving or current or future consumption at the individual level and

about the e¢ ciency welfare consequences of public policies that a¤ect them. Game theories have

been applied increasingly in recent yeats to study strategic economic behavior of consumers and

producers. Main elements of microeconomic theory thus consists of:

1. Consumer choice and demand for products and supply of labour and capital: demand func-

tions.

2. Producer’s choice of products and demand for inputs: production, cost, pro…t and supply

functions.

3. Analysis of prices in perfect and imperfect markets with complete and incomplete information.

4. General equilibrium analysis - determination of price system and optimal allocations.

global economy.

6. Competition and market power; game theory

7. Innovations and adoption new technologies, research and development.

8. Analysis of e¢ ciency and public policies; social welfare function, market failure, negative and

positive externalities

Good undestanding of microeconomic theories will lead to better policies and regulations for

the e¢ cient functioning of the market economy. These policies particularly focus on competition,

adoption of better technology, governance and information, correcting externality and good environ-

ment, social insurance, more equal distribution of income and identi…cation of cases for govermen

intervention. For recent policies see relevant web page of the government such as in the Department

for Business Innovation & Skills https://www.gov.uk/government/organisations/competition-and-

markets-authority.

Analysis of all above are based on axioms or generally accepted truth about the behavior of

economic agents that include axioms of completeness, transitivity, continuity, monotonicity and

convexity.

The existing knowledge in microeconomis is the result of hard work of many prominent economic

thinkers: such as Smith (1776), Ricardo (1817), Cournot (1838), Bertrand (1883), Edgeworth

(1925), Pareto (1896), Marshall (1890), Walras (1900), Veblen (1904), Slutskey (1915), Hicks

(1939), Samuelson (1947), von Neumann and Morgenstern (1944), Nash (1950), Neumann (1957),

Arrow (1953), Debreau (1959), Stigler (1961), Kuhn (1953), Shapley (1953), Robinson (1963),

8

Shelten ( 1965), Aumann (1966) Scarf (1967), Shapley and Shubik (1969), Harsanyi (1967), Spence

(1974),Kahneman and Tversky (1979), Kreps (1990), Fundenberg and Tirole (1991) and Binmore

(1992), Varian (1992), Osborne and Robinstein (1994), MasColell, Whinston and Green (1995),

Starr (1997) Gravelle and Rees (2004), Rasmusen (2006), Snyder and Nicholson (2011). Studies by

Cobb and Douglas (1928), Arrow (1963), Jorgenson (1963), Diamond and Mirrlees (1971), Alchian

and Demsetz (1972), Ross (1973), Dixit and Stiglitz (1977), Deaton, and Muellbauer (1980), Krug-

man (1980), Shiller (1981), Grossman and Stiglitz (1980), listed in the best 20 articles published in

AER in last 100 years, relate to microeconomic issues.

http://www.eea-esem.com/eea-esem/2014/prog/list_sessions.asp

http://editorialexpress.com/conference/MMF2014/program/MMF2014.html

https://www.aeaweb.org/aea/2015conference/program/preliminary.php

http://www.webmeets.com/RES/2013/prog/list_sessions.asp

http://nobelprize.org/nobel_prizes/economics/laureates/; http://www.economicsnetwork.ac.uk/

http://cepa.newschool.edu/het/schools/game.htm;

http://www.hull.ac.uk/php/ecskrb/Confer/research.html;

http://homepage.newschool.edu/het/alphabet.htm

http://editorialexpress.com/conference/GAMES2012/program/GAMES2012.html

http://www.eea-esem.com/EEA-ESEM/2012/prog/list_sessions.asp

It is becoming sophisticated with the recent development of mathematical techniques and com-

putational abilities. This monograph gradually develops these concepts so that all parts of the mod-

ern economies could be integrated into a dynamic general equilibrium model of modern economies

towards end of this workbook. Axioms and a general summary is in this section. Then behavior

of consumers and produced are analysed in the …rst two chapters followed by partial equilibrium

analysis under perfectly and imperfectly competitive markets in section 4. Basic principles of gen-

eral equilibrium models explained in section 5 followed by a short discussion of strategic models in

chapters 6 and 7 and uncertainty and asymmetric information in section 8. Impacts of taxes on

public goods and externalities are presented in section 10 followed by details of the dynamic general

equilibrium model in section 11. Each section have takes problem solving approach to learning and

contains exercises at the end. The last part contains details on the software used for empirical

testing of various microeconomic theories with some listing of seminal articles and popular text

books.

Let X = (x1; x2; :::::xn ) be quantities of n commodities in nonnegative orthant of X 2 Rn The

consumption set X ful…lls following properties. These concepts date back to Pareto (1896), Marshall

(1890), Slutskey (1915), Hicks (1939), Samuelson (1947), Debreau (1959) and others.

1. 0 6= X Rn

2. X is closed

3. X is convex

4. 0 X

Axioms of Consumer Choice

9

Axiom 1: Completeness

Axiom 2: Transitivity

Axiom 3: Continuity

Axiom 4: Monotonicity

For x0 Rn and for all " > 0 there exist some x 2 B" (x0 ) \ Rn such that x > x0 . More is

prefered for less.

Axiom 5: Convexity

Demand and supply of the market system are based on above axioms. Think of a simple problem

of households and …rms in a market economy.

1.3 Optimisation

Linear and non-linear programming are applied in order to …nd the optimal solution subject to

constraints. Objectives like the utility or pro…t or social welfare can be function of one or several

variables. Constraints can be one or multiple. Linear programming is applied where the objective

functions and constraints are of the linear form and non-linear optimisation techniques is applied

when objectives or the constraints are non-linear. By duality theorem every maximisation problem

has a corresponding minimisation problem, such as utility maximisation corresponds to expen-

diture minimisation to achieve a certain level of utility, pro…t maximisation corresponds of cost

minimisation given the type technology of production.

Assuming above axioms are satis…ed, the major objective of a consumer is to maximise utility by

consuming x commodities (u (x))

subject to the budget constraint assuming prices (p) and income (y) as given:

p:x y (2)

Constrained optimisation (Lagrangian function) with as a Lagrange multiplier (or shadow

price):

10

First order conditions wrt each xi :

@L (x; ) @u(x)

= p1 = 0 (4)

@x1 @x1

:: (5)

@L (x; ) @u(x)

= pn = 0 (6)

@xn @xn

y p:x = 0 (7)

@u(x)

@u(x) @xi

@xi > 0 and pi > 0 =) = pi > 0. Here there are n + 1 …rst order conditions to solve

for demand for x1; x2; :::::xn goods and . The maximum utility is obtained when all these optimal

values are substituted in the utility function u (x ) :

Thus the marginal rate of substitution between xj and xi should equal their price ratios in

equilibrium:

@L(x; )

@xj pj M Uj M Ui

M RSj;i = @L(x; )

= ; = (8)

pi pj pi

@xi

Marginal utility of xi represents gain from consumption xi and pi represents pain to the con-

sumer. Equilibrium psychologically is thus a point where the gain equals pain.

The major objective of producers is to maximise pro…t. They take prices of commodities (p) and

inputs (w) as given:

Pro…t function is a value function for for all input price w 0 and output levels y 2 Rn+

subject to

f (x) y (10)

Constrained optimisation (Lagrangian) function:

@L (x; )

= w1 f 0 (x1 ) = 0 (12)

@x1

:: (13)

@L (x; )

= wn f 0 (xn ) = 0 (14)

@xn

11

@f (x;)

@xj wj

y f (x) = 0; @f (x;)

= (15)

wi

@xi

A complete view of microeconomic process requires thinking about the general equilibrium in

p

the market. The relative price system pji for i = 1; ::; N and j = 1; ::; N determines the optimal

allocation of resources in the economy. Consider the following example for this purpose.

choice

Consider an economy with two individuals, i = 1; 2 and two commodities x (goods) and y (services).

Both households are endowed with given amount of capital stock k1 ; k 2 and time L1 ; L2 , which

they spend either working or in the form of leisure. Households and …rms optimise taking prices of

commodities (px ; py ) and factors (pL ; pk ) as given. Competition between suppliers and consumers

or producers sets the equilibrium price of commodities and income of households (I1 ; I2 ) More

speci…cally the problems of households and …rms can be stated as:

Household’s problem:

_ g1

max U1 = xa1 1 y1b1 L1 LS1 ; a1 > 0; b1 > 0; g1 > 0: (16)

subject to:

_ _ _

I1 = px x1 + py y1 + pL L1 LS1 ; I1 = pL L1 + pk K 1 (17)

_

x1 0; y1 0; L1 LS1 0:

_ g2

max U2 = xa2 2 y2b2 L2 LS2 ; a2 > 0; b2 > 0; g2 > 0: (18)

subject to:

_ _ _

I2 = px x2 + py y2 + pL L2 LS2 ; I2 = pL L2 + pk K 2 (19)

_

x2 0; y2 0; L2 LS2 0:

Firm’s problem:

subject to:

subject to:

12

Equilibrium conditions:

x = x1 + x2 (24)

y = y1 + y2 (25)

kx + ky = k1 + k 2 (26)

_

L1 + LS1x + LS1y = L1 ; LS1 = LS1x + LS1y (27)

_

L2 + LS2x + LS2y = L2 :::LS2 = LS2x + LS2y (28)

Price normalisation:

px + py + pL + pk = 1 (29)

Questions

1) Derive demand for x and y and leisure (or labour supply) by households 1 and 2 i. e.

determine x1 ; x2 ; y1 ; y2 ; LS1; LS2.

2) Determine the demand for labour and capital by …rms supplying x and y, i,e, evaluate

kx ; ky ; LS1x ; LS1y ; LS2x ; LS2y :

3) Compute the equilibrium relative price system for this economy that are consistent to opti-

misation problems of households and …rms.

4) What are the optimal allocations of resources in this economy?

5) Evaluate the demand for x and y and leisure by both households and …nd the optimal levels

of their welfare. Is this Pareto optimal allocation?

6) Suggest tax and transfer scheme in this economy in order to improve the distribution system.

7) Explain notions of Hicksian equivalent and compensating variations in order to evaluate the

welfare consequences of tax and welfare reforms proposed above.

8) Write GAMS code to solve the model and few simulation scenarios for comparative static

analysis.

9) Propose reforms in the labour and capital markets for improving the e¢ ciency of allocations

in this economy.

Bhattarai K. and J. Whalley (2003) Discreteness and the Welfare Cost of Labour Supply Tax

Distortions, International Economic Review 44:3:1117-1133, August

Bridel (2011) for a non-technical introduction to the general equilibrium modelling.

Now solve this CGE (computable general equilibrium) model using GAMS. First assign values

for behavioural parameters.

Secondly, download gams at www.gams.com and install in your PC or laptop.

Thirdly write model equations for numerical optimisation routine in GAMS (see GAMS pro-

gramme …le ge2by2.gms and its result …le ge2by2.lst)

13

Table 1: Parameters for the 2 by 2 model with _leisure

_

a1 a2 b1 b2 g1 g2 x y 1x 1y L1 L1 k1 k2

0.5 0.4 0.3 0.4 0.2 0.2 0.2 0.8 0.4 0.1 24 24 40 10

I1 I2 x1 x2 y1 y2 x y u1 u2

3.42 2.01 5.9 2.8 1.7 1.3 8.7 3.1 4.6 2.4

px py pk pl kx ky L1 L2 ls1 ls2

0.289 0.599 0.047 0.064 35.3 14.7 10.7 6.3 13.3 17.7

_ _

ls11 ls12 ls21 ls22 L1 L2 k1 k2

6.7 8.9 6.7 8.9 24 24 40 10

Fourth study

_

the

_

solution of the model systematically: _ _

I1 = pL L1 + pk K 1 (=0.064*24+0.047*40)=3.42; I2 = pL L2 + pk K 2 (= 0:064 24 + 0:047 10) =

2:01:

Fifth check the equilibrium conditions; check that all equilibrium conditions are satis…ed:

_

L1 + LS1x + LS1y = 10:7 + 6:7 + 6:7 = 24 = L1 ; LS1 = LS1x + LS1y (33)

_

L2 + LS2x + LS2y = 6:3 + 8:9 + 8:9 = 24 = L2 :::LS2 = LS2x + LS2y (34)

Sixth, consider tax policy analysis a) introducing VAT in commodities x and y b) introducing

taxes in labour and capital inputs c) set a revenue target and do equal yield tax reforms …nding

model solution when all taxes are i) raised in VAT or ii) by labour income tax or iii) capital income

tax or iv) equally by from these sources.

Seventh, compute the optimal tax rates that maximise revenue (hint make tax rates endogenous

and solve the maximisation routine).

The reader is expected to study the real analysis section in the appendix at this point. It is

important to understand these basic concepts in order to follow literature on economic theory or

to develop concepts in economic theory.

1.5.1 Direct method

a = b; b = c =) a = c: or a = b; c = d =) a:c = b:d

For x; y; z 2 R prove that x + z = y + z =) x = y

14

1.5.2 Converse and contrapositive

A implies B A =) B if it converse B =) A is true then A () B here A and B are equivalent.

If A person lives in Hull (A) then that person lives in Yorkshire (B). A =) B but converse

is not true in this case

B ; A and A < B

Contrapositive implies not A implies not B A =) B

1.5.3 Equivalence

A () B

Example Pythagorus theorem: h2 = p2 + b2

h2 p2 b2 2

h2 = h2 + h2 () sin + cos2 = 1

Revealed preference theory is equivalent to utility maximisation theory in deriving income and

substitution e¤ects.

Example: Sum of the N natural numbers is : P (n) = 1 + 2 + 3 + :::: + n = n(n+1)2

Check if this works for any integer k

P (k) = 1 + 2 + 3 + :::: + k = k(k+1)

2 ; now prove that P (k + 1) = (k+1)(k+2)

2 :

Add and subtract k + 1 from both sides

1 + 2 + 3 + :::: + k + (k + 1) = k(k+1)

2 + (k + 1) = (k + 1) k2 + 1 = (k+1)(k+2)

2 =) P (k + 1)

Thus by mathematical induction P (k) and P (k + 1) are similar.

Maximising the level of utility (satisfaction) from consumption of goods and services is the ultimate

objective of all economic activities. Various speci…cations of utility functions are used to represent

the level of welfare of households from consuming goods and services and leisure in an economy.

From abstract functions to linear and non-linear utility functions are popular in the literature. The

Cobb-Douglas and constant elasticity of substitution (CES) utility functions are very popular in

the literature. There are also nested utility function for instance in a general equilibrium models

with many goods one can consider of three levels of nests to capture the intra- period and inter

temporal substitution between consumption and leisure based on relative prices and wage rates in

the economy. The …rst level of nest aggregates the goods and services in composite consumption

good, then the second level nest aggregates these composite goods with leisure. Then there is the

nest of time separable utility functions to arrive at the life time utility for each household. The

consumption shares of various goods are calibrated from the benchmark dataset (Blundell (2014),

Deaton, and Muellbauer (1980), Barker, Blundell and Micklewright (1989) for more in depth study

on demand side parameters of household demand functions). These utility functions are further

modi…ed in order to represent positive or negative externalities in consumption. While recreation

facilities in the neighbourhood generates positive externalities but pollutions reduce utility levles

of households. In dynamic setting most studies apply the time separable utility functions. Aim of

this section is to present popular models used in analysing preferences and demands of households

for various commodities. It shows how to evaluate the welfare as well as the price and substitution

15

e¤ects of changes in prices and the elasticities of demand. Basics of revealed preference theory is

reviewed at the end. Microeconomic theories are often tested econometrically to ascertain their

validities (Houthakker (1950), Richter (1966), Afriat (1967), Kahneman and Tversky (1979),Varian

(1982), McGuinness (1980), Bandyopadhyay (1988), Hey and Orme (1994), Lee and Singh (1994),

Carey (2000), Deolalikar and Evenson (1989) Van Soest and Kooreman (1987), Blundell, and Pre-

ston (2008), Echinique (2011), Varian (2012), Vermeulen (2012), Schmeidler, D. (1989), Blundell

(2014).).

Where preference relations are complete, transitive, continuous, monotonous and convex then

there exists a real valued utility function u : Rn+ =) R and this utility function has following

properties:

u (x) is quasi-concave if and only if % is convex.

u (x) is strictly quasi-concave if and only if % is strictly convex.

v: Rn+ =) R v (p; y) = max u(x) s.t. p:x y

X 2 Rn

1. Continuous

2. Homegenous of degree zero in (p; y)

3. Strictly increasing in y

4. Decreasing in p

5. Quasiconvex in p and y.

6. Roy’s identity

@v (p0 ;y 0 )

0 0 @pi

xi p ; y = @v(p0 ;y 0 )

::::i = 1::m (35)

@y

Numerical Example: Derive demands for (x1 , x2 ) from ratios of marginal utilities (partial

derivative of utility functions) given the prices [(p1 , p2 ) = (2; 4)] and income (a).

@L (x1 ; x2 )

= x2 2 =0 (38)

@x1

@L (x1 ; x2 )

= x1 4 =0 (39)

@x2

16

@L (x1 ; x2 )

= a 2x1 4x2 = 0 (40)

@

From the …rst two FOCs xx21 = 2: Then put this into the last FOC to get: x1 = a

4; x2 = a

8 ;,

2

a

= 16 =) u = x1 x2 = a4 a8 = a32 :

By an envelop theorem evaluating the indirect utility function

@L(x1 ;x2 )

and Lagrange multiplier at the optimal solution: @u a

@a = 16 = @a = : QED. If consumer

income a = 200 then x1 = a4 = 200 a 200

4 = 50; x2 = 8 = 8 = 25: Then u = x1 x2 = 50 25 = 1250:

Now if p1 changes to 4 and p2 to 2 what will be elasticities, cross elasticities and elasticities of

substition between x1 and x2 ?

New demands: x1 = a8 = 200 a 200

8 = 25; x2 = 4 = 4 = 50: Utility is still 1250.

dx1 =x1 dx1 p1 25 2

e1 = = = = 0:5 (41)

dp1 =p1 dp1 x1 2 50

dx2 =x2 dx2 p2 25 4

e2 = = = = 1 (42)

dp2 =p2 dp2 x2 2 50

dx1 =x1 dx1 p2 25 4

e1 = = = =1 (43)

dp2 =p2 dp2 x1 2 50

dx2 =x2 dx2 p1 25 1

e2 = = = = 0:5 (44)

dp1 =p1 dp1 x2 2 25

x1 x1

d x2 = x2

25

= 50

50 25

= = 2 4 =1 (45)

d p2

= p2

4 = 2

p1 p1

e1;a = = = =1 (46)

da=a da x1 4 50

dx2 =x2 dx2 a 1 200

e2;a = = = =1 (47)

da=a da x2 8 25

After the change in price:

e1;a = = = =1 (48)

da=a da x1 8 25

dx2 =x2 dx2 a 1 200

e2;a = = = =1 (49)

da=a da x2 4 50

17

2.1.2 Consumer optimisation model: a numerical example

M ax U = X10:4 X20:6 (50)

Subject to

p1 :X1 + p2 :X2 = 150 (51)

Lagrangian optimisation:

Optimal demand for goods X1

0:4 (150) 60 0:6 (150) 90

X1 = = = 20; X2 = = = 45 (53)

p1 3 p2 2

0:4 0:6

U0 = X10:4 X20:6 = (20) (45) = 32:53 (54)

Equivalent Variation What is the Hicksian Equivalent and compensating variations of price

change? What are the income and substitution e¤ects of this price change?

First …nd out how much money is required at new prices to guarantee the original utility by

solving

0:4 0:6

0:4 (m0 ) 0:6 (m0 )

U0 = = 32:53 (55)

2 2

0:4 0:6

0:4 (m0 ) 0:6 (m0 ) 2 (32:53)

U0 = ; m0 = = 127:49 (56)

2 2 0:40:4 0:60:6

Equivalent variation (money to be taken away when prices fall)

Compensating Variation

For compensating variation …rst compute the demand in new prices and utility

0:4 (150) 60 0:6 (150) 90

X1 = = = 30; X2 = = = 45 (58)

p1 2 p2 2

0:4 0:6

U1 = X10:4 X20:6 = (30) (45) = 38:26 (59)

0 00

10:4

0:4 m 0:6 (m00 )

0:6

U1 = @ A = 38:26 (60)

3 2

18

0 (38:26) 30:4 20:6

m0= = 176:39 (61)

0:40:4 0:60:6

Fall in Price Rise in Price Fall in Price Basis of evaluation

EV + - 22.51 New Price-Old Utility

CV - + -26.39 OLD Price- New Utility

Substitution E¤ect : 2.5 =10-7.6; Income e¤ect:7.6=22.5/3 and total e¤ect: 10.

Measure of elasticity di¤ers by the functional forms used to estimate it. With data on quantiy (Y )

and price (X) ; in brief these can be stated as follows:

Elasticity around the mean values of X and Y in a linear regression model , Yi = 1 + 2 Xi +ei is

@Yi X @Yi

de…ned as e = @X i Y

Then given estimate of the slope @X i

= 2 is it obtained as e = 2 X Y

. In a log

@Yi X

dependent variable linear regression model of the form ln (Yi ) = 1 + 2 Xi +ei e = @X i Y

Y = 2X

@Yi 1

because @Xi Yi = 2 : Similarly elasticity in a log explanatory variable linear regression model:

Y = 2 Y * @Xi = 2 Xi . Then elasticity

@Yi X @Yi

Yi = 1 + 2 ln (Xi ) + ei is given by e = @X i Y

= 2 X1i X 1 1

@Yi X

in a double log linear regression model, ln (Yi ) = 1 + 2 ln (Xi ) + ei is e = @Xi Y = 2 XYi X Y =

2 * @Xi Yi =

@Yi 1 1

2 Xi . Elasticity in a regression model linear in reciprocal of an explanatory

variable, Yi = 1 + 2 X1i + ei is given by e = @X @Yi X

i Y

= 2 X1i Y1i * @X

@Yi

i

= 1

2 X 2 : In a a quadratic

i

@Yi X

regression model, Yi = 1 + 2 Xi + 3 Xi2 + ei the elasticity is e = @X i Y

= ( 2 + 2 3 Xi ) X

Y

* @X

@Yi

i

= 2 + 2 3 Xi

2

: How to decide which one these two choose? First, should depend on the

optimisation functions discussed in this chapter. Secondly choice between linear and log-linear

models should be econometric tests such as MacKinnon, White and Davidson test.

Suppose that you are interested in estimating the demand for beer in a country and consider the

following multiple regression model:

where Yi is the demand for beer, X1;i is the price of beer, X2;i is the price of other liquor products,

X3;i is the price of food and other services, X4;i is consumer income. Coe¢ cients 0 , 1 , 2 , 3 ,and

4 are the set of unknown elasticity coe¢ cients you would like to estimate. Again assume that

errors "i are independently normally distributed, "i N (0; 2 ). Given non-sample information on

the relation between the price and income coe¢ cients as following:

19

1. (a) i. sum of the elasticities equals zero: 1 + 2 + 3 + 4 = 0:

ii. two cross elasticities are equal: 3 = 4 = 0 or 3 - 4 = 0

iii. income elasticity is equal to unity: 5 = 1

0 1

(Rb r) [Rcov (b) R0 ] (Rb r)

F = (64)

J

Here J = 3 is the number of restrictions

2 3 2 3 2 3

1 0 0 b 0

1

6 7

R=4 0 1 0 5 ; b = 4 b2 5 ; r = 4 0 5 (65)

0 0 1 b 0

3

Thus empirical test of consumer behaviour whether purchase of x1 and x2 are proportionate

to the changes in the level of income or prices are measures by income and price elasticities of

demand. These are empirically estimated using the cross section and time series data on quantities

and prices. These data can be obtained from various organisations1

Utility e¤ect of price changes will be higher for the commodity that is heavily weighted in the

consumer’s consumption basket. In real life households vary by their income and have good varieties

in consumption bundles as:

Deciles agri Prod Constr Dist Infcom Finins Rlest Prfspp Ghlthed Othrsrv

H1 435 10520 201 3688 1071 1541 3915 432 1835 1448

H2 671 16224 310 5688 1651 2377 6037 666 2831 2233

H3 854 20663 395 7244 2103 3027 7689 848 3605 2844

H4 1037 25073 479 8790 2552 3673 9330 1029 4375 3451

H5 1223 29583 565 10372 3011 4334 11008 1214 5161 4071

H6 1407 34031 650 11931 3463 4985 12663 1397 5937 4683

H7 1676 40532 775 14210 4125 5938 15083 1663 7072 5578

H8 1977 47829 914 16769 4868 7007 17798 1963 8345 6582

H9 2358 57037 1090 19997 5805 8355 21224 2341 9951 7850

H10 3864 93463 1786 32767 9512 13692 34779 3835 16307 12863

Note: Constructed from the ONS data.

Rich households with more income can consumer more goods and services and enjoy more utility

than poor households. Governments apply commodity taxes (VAT of 20%) and income taxes in

order transfer some income from the richer to poorer households. Such transfer may reduce the

gap between the income of rich and poor but it is very di¢ cult to imagine a society with perfect

equality.

1 Such as Food and Agriculture Organisation: http://faostat.fao.org/ or from the Department for Environment,

https://www.gov.uk/government/statistical-data-sets/commodity-prices. In general consult government depart-

ment web pages to …nd such data at https://www.gov.uk/government/organisations or for many other links in

http://www.hull.ac.uk/php/ecskrb/Confer/research.html.

20

Table 5: Benchmark production tax and prices by sectors

Deciles Leisure Consumption Income share Consshare Income tax rate

H1 2577 38163 0.0281 0.0627 0.0

H2 7451 52401 0.0433 0.0552 0.32

H3 14230 66740 0.0551 0.0624 0.32

H4 21877 80983 0.0669 0.0850 0.32

H5 28269 95550 0.0789 0.0966 0.32

H6 35535 109917 0.0908 0.1067 0.32

H7 41156 130916 0.1081 0.1078 0.32

H8 46294 154484 0.1276 0.1323 0.32

H9 54041 178551 0.1521 0.1409 0.40

H10 73363 292582 0.2493 0.1945 0.50

Note: Constructed from the ONS data.

More detailed estimates of price, income and cross elasticities of demand can be estimated from

the survey data such as food and expenditure survey, travel and tourism survey, multiple household

survey including the understanding society dataset that can be obtained from the data archive or

could be constructed from the ONS.

of Economic Studies, 30, 2, 73-83

McFadden Daniel and Paul A. Ruud (1994) Estimation by Simulation, Review of Economics

and Statistics, 76, 4 , 591-608

Stone R (1954) “Linear Expenditure System and Demand Analysis: An Application to the

Pattern of British Demand”, Economic Journal 64:511-527.

Q1. Consider a utility maximisation problem of a consumer with the CES utility function on goods

x1 and x2 :

1

max u = (x1 + x2 ) (66)

x1; x2;

Derive Marshallian demand functions x1 and x2 for and indirect utility function u x1; x2; .

Prove that the v(p; y) is homegenous of degree zero in p and y.

prove that it is increasing in y and decreasing in p.

21

Q2. Show above properties in the following CES utility maximisation problem:

1

max u = (x1 + x2 ) (68)

x1 ;x2

Subject to

M = p1 x1 + p2 x2 (69)

1

L (x1 ; x2 ; ) = (x1 + x2 ) + [M p1 x1 p2 x2 ] (70)

@L 1 1

1 1

= (x1 + x2 ) x1 p1 = 0 (71)

@x1

@L 1 1

1 1

= (x1 + x2 ) x2 p2 = 0 (72)

@x2

@L

= M p1 x1 p2 x2 = 0 (73)

@

The marginal rate of substitution bewteen x1 and x2

1

x1 p1

= (74)

x2 p2

1

p1 1

x1 = x2 (75)

p2

M = p1 x1 + p2 x2 (76)

" #

p1

1

1

p1

1

1 h i 1

1 1 1

M = p1 x2 + p2 x2 = x2 p1 + p 2 = x2 p 1 + p2 p2 (77)

p2 p2

Properties of the CES demand functions

1

1

M p2

x2 = h i (78)

1 1

p1 + p2

1 1 1

1 1

M p2 p1 1

M p1

x1 = h i =h i (79)

p1 1

+ p2 1 p2 p1 1

+ p2 1

Value function:

20 1 0 1 31

1 1

1 1

6B M p1 C B M p2 C 7

v (x1 ; x2 ) = 4@ h iA + @h iA 5 (80)

1 1 1 1

p1 + p2 p1 + p2

22

If M and p1 and p2 increase by t it does not change the value function: v (x1 (tM; tp1 ; tp2 ) ; x2 (tM; tp1 ; tp2 )) =

v (x1 ; x2 ) :

@v(x1 ;x2 ) @v(x1 ;x2 ) @v(x1 ;x2 )

@M > 0 and @p1 < 0 and @p2 < 0.

Roy’s Identity:

@v (p0 ;M 0 )

@Pi

xi p0 ; M 0 = @v(p0 ;y 0 )

::::i = 1::m (81)

@M

(Marshallian demand for xi equal negative of the ratio derivative of IUF wrt price and income).

Note that the derivative of value function wrt price equals derivative of Lagranging function wrt

price and this equals negative of lagrange multiplier times the demand for the product as:

@V @L

= = x1 (p1 ; p2 ; m): (82)

@pi @pi

Consumer’s primal problem is to maximise utility (U ) subject to budget constraints. When optimal

demands for xi are substituted in the utility function it becomes indirect utility function (V ). By

Roy’s identity Marshallian demand for xi equals the negavite of the ratio of the …rst derivative

of V wrt pi to its …rst derivative wrt income (M ). Consumer’s dual problem is to minimise the

expenditure (E) wrt a target utility U . When optimal values of xi are substituted in E it

becomes an expenditure function. The …rst derivative of the expenditure function wrt pi is equal

to the compensated demand function xi : This means given E(p1 ; p2 ; U ) compesated demand is

1 ;p2 ;U )

xci = @E(p@p i

: While the compensated demand gives the pure substitution e¤ect of price change

and the Marshallian demand minus the compensated demand equals the income e¤ect of price

change. Inverse of indirect utility function is the expenditure function.

min E = p1 x1 + p2 x2 (83)

x1 ;x2

Subject to

1

u = (x1 + x2 ) (84)

h 1

i

L (x1 ; x2 ; ) = p1 x1 + p2 x2 + u (x1 + x2 ) (85)

@L 1 1

1 1

= p1 (x1 + x2 ) x1 =0 (86)

@x1

@L 1 1

1 1

= p2 (x1 + x2 ) x2 =0 (87)

@x2

Expenditure Functions with the CES utility functions

@L 1

=u (x1 + x2 ) = 0 (88)

@

23

1

p1 x1

= (89)

p2 x2

1

p1 1 1

1

1

1

x1 = x2 = x2 p1 p2 (90)

p2

" #1 " #1

1 p1 1

p1 1

u = (x1 + x2 ) = x2 + x2 = x2 +1 (91)

p2 p2

" # 1

p1 1 h i 1

1 1 ( 1 )( 1

)

x2 = u +1 = u p1 + p2 p2

p2

Expenditure Functions with the CES utility functions

1

h i 1

1

u p2 1

1 1 1

x2 = u p 1 + p2 p2 =h i1 (92)

1 1

p1 + p2

Putting x2 in x1

1 1 h i 1

1 1 1

1 1 1 1 1 1 1

x1 = x2 p 1 p2 = u p1 + p2 p2 p1 p2 (93)

1

h i 1

1

u p1 1

1 1 1

x1 = u p 1 + p2 p1 =h i1 (94)

1 1

p1 + p2

fects): Duality on consumer optimisation

h 1 1

i

L = p1 x1 + p1 x2 + U x12 x22 (95)

@L 1 21 1 12

= p1 x x2 = 0 (96)

@x1 2 1

@L 1 21 12 1

= p2 x x =0 (97)

@x2 2 1 2

@L 1 1

= u x12 x22 = 0 (98)

@

p1 x2 p2

= ==> x1 = x2 (99)

p2 x1 p1

1 1

1 1 p2 2 1 p2 2

u = x1 x2 = 2 2

x2 x2 =2

x2 (100)

p1 p1

1

p1 2 1 1

x2 = u = up12 p2 2

(101)

p2

24

Then

1

p2 p1 2

p2 1 1

x1 = x2 = u = up1 2 p22 (102)

p1 p2 p1

Now the expenditure fucntion

1 1 1 1 1 1

E = p1 x1 + p2 x2 = p1 up1 2 p22 + p2 up12 p2 2

= 2up12 p22 (103)

E

u= 1 1 (104)

2p12 p22

Slutskey Equation:

Total e¤ect of price change = (substituion e¤ect + income e¤ect)

= (105)

@p1 @p1 Cmp @p1 @E

Compensated demand

!

1 1 @x1 1 3 1 1 E 3 1 1

x1 = up1 p2 =)

2 2

= up1 2 p22 = p1 2 p22 = Ep 2 (106)

@p1 cmp 2 2 1

2p1 p2

2

1

2 4 1

1 1 @E 1 1

E = 2up12 p22 =) = up1 2 p22 = x1 (107)

@p1

E

Given the Marshalian demand x1 = 2p1

@x1 1

= (108)

@E 2p1

Slutskey decomposition:

= = Ep 2 up1 2 p22

@p1 @p1 Cmp @p1 @E 4 1 2p1

!

1 E 1 1 1 1 1 E

= Ep 2 p1 2 p22 = Ep 2 Ep1 2 = 2 (109)

4 1 1 1

2p12 p22 2p1 4 1 4 2p1

First part is substitution e¤ect and the second part is income e¤ect.

If E = 800; p1 = 4

E 800 800 E 800

substitution e¢ ect is - 4p 2 = 2 42 = 4 4 4 = 12:5 and the income e¤ect is also - 4p 2 = 2 42 =

1 1

800

4 4 4= 12:5 .

Both reinforce each other and total e¤ect is -25.

Blundell R (2014) Income Dynamics and Life-cycle Inequality: Mechanisms and Controversies,

Economic Journal, 124, 576, 289–318

25

Jehle G A and P.J. Reny (2005) Advanced Microeconomic Theory, Pearson Education.

M. Hoy, J Livernois, C McKenna, R Rees and T. Stengos (2001) Mathematics for Economics,

2nd ed., MIT Press.

Consider a consumer maximisation problem given below:

M ax U (X; Y ) (110)

X;Y

Subject to

I = px X + py Y (111)

Form a constrained optimisation problem and characterise the demand function X(px ; py ; I)

and Y (px ; py ; I).

L = U (X; Y ) + [I px X py Y ] (112)

@L

= I px X py Y = 0 (113)

@

@L

= Ux px = 0 (114)

@X

@L

= UY py = 0 (115)

@Y

Following Henderson and Quandt (1980) take the total di¤erentiation of these FOCS. (Consumer

takes prices of commodities as given, x and y are constant values of X and Y):

In matrix notation

2 32 3 2 3

0 px py d xdpx + ydpy dI

4 px Uxx Uxy 5 4 dX 5 = 4 dpx 5 (119)

py Uyx Uyy dY dpY

Evaluating the impact of change in shadow price of income d on demand taking all else constant

dpx = 0 and dpY = 0

2 32 3 2 3

0 px py d =dI 1

4 px Uxx Uxy 5 4 dX=dI 5 = 4 0 5 (120)

py Uyx Uyy dY =dI 0

26

Similarly comparative static when only prices of X change dpx 6= 0 taking everything else is

constant dpy = 0 and d = 0

2 32 3 2 3

0 px py d =dpx x

4 px Uxx Uxy 5 4 dX=dpx 5 = 4 5 (121)

py Uyx Uyy dY =dpx 0

Similarly comparative static when only prices of Y change dpy 6= 0 taking everything else is

constant dpx = 0 and d = 0

2 32 3 2 3

0 px py d =dpy y

4 px Uxx Uxy 5 4 dX=dpy 5 = 4 0 5 (122)

py Uyx Uyy dY =dpy

Each of these could be solved using the Cramer’s rule. For instance

2 3 2 3 1 2 3

d =dI 0 px py 1

4 dX=dI 5 = 4 px Uxx Uxy 5 4 0 5 (123)

dY =dI py Uyx Uyy 0

Apply Cramer’s rule to …nd how much the shadow price and demand change in response to

change in income; solve for d =dI; dX=dI; dY =dI

1 px py 2

Uxx Uyy + Ux;y

1

d =dI = 0 Uxx Uxy = (124)

0 px py 2px py Uxy p2y Uxx p2x Uyy

0 Uyx Uyy

px Uxx Uxy

py Uyx Uyy

0 1 py

1 py Ux;y px Ux;y

dX=dI = px 0 Uxy = (125)

0 px py 2px py Uxy p2y Uxx p2x Uyy

py 0 Uyy

px Uxx Uxy

py Uyx Uyy

0 px 1

1 px Ux;y py Ux;x

dY =dI = px Uxx 0 = (126)

0 px py 2px py Uxy p2y Uxx p2x Uyy

py Uyx 0

px Uxx Uxy

py Uyx Uyy

2 3 2 3 1 2 3

d =dpx 0 px py x

4 dX=dpx 5 = 4 px Uxx Uxy 5 4 5 (127)

dY =dpx py Uyx Uyy 0

27

x px py xUxx Uy;y 2

py Uy;x + px Uy;y: xUx;y

1

d =dpx = Uxx Uxy =

0 px py 2px py Uxy p2y Uxx p2x Uyy

0 Uyx Uyy

px Uxx Uxy

py Uyx Uyy

(128)

Marshalian Demand Function

0 x py

1

dX=dpx = px Uxy (129)

0 px py py 0 Uyy

px Uxx Uxy

py Uyx Uyy

xpy Ux;y p2y + xpx Uy;y:

= (130)

2px py Uxy p2y Uxx p2x Uyy

Analysis of signs: Give that px > 0, py > 0, Ux;x: < 0, Uy;y: < 0; dpx > 0, dpy > 0„ the

denomenator (determinant) is positive. Whether the numerator is positive depends on the sign of

the numerator terms which denotes income and substitution e¤ects of changes in prices of X. Here

dX=dpx < 0 because each term in numerator is negative and xpy Ux;y p2y + xpx Uy;y: < 0.

0 px x

1

dY =dpx = px Uxx (131)

0 px py py Uyx 0

px Uxx Uxy

py Uyx Uyy

py px xpx Uyx + xpy Ux;x:

= (132)

2px py Uxy p2y Uxx p2x Uyy

This is exactly what would be expected, the inverse relation between demand for X and its

own price. However the impact of a change in px on the demand for Y is not predictable o¤hand

because the …rst term in the numerator, py px xpx U + xpy Ux;x , is positive but the last two terms

are negative. Thus dpx would have positive impact only if py px > xpx U + xpy Ux;x .

xpy Ux;y p2 +xpx Uy;y:

Here 2px py Uxy p2yUxx p2 Uyy is the total e¤ect of change in prices. It can be decomposed into

y x

income and substitution e¤ect by deriving the compensated demand

Hicksian demand function

xUxx

(dX=dpx )compensated = <0 (133)

2px py Uxy p2y Uxx p2x Uyy

(dX=dpx )income = (134)

2px py Uxy p2y Uxx p2x Uyy

Question: There is VAT of 20 percent in X, decompose that into income and substitution e¤ects.

Then evaluate impacts of taxes on among households.

28

Henderson J. M. and R. E. Quandt (1980) Microeconomic Theory: A Mathematical Approach,

McGraw-Hill, London.

Consider a utilitymaximisation problem of consumer given below:

M ax u(x1 ; x2 ) (135)

x1 ;x2

Subject to

p1 x1 + p2 x2 = m (136)

Form a constrained optimisation problem and characterise the demand function x1 (p1 ; p2 ; m)

and x2 (p1 ; p2 ; m).

L = u(x1 ; x2 ) + [m p1 x1 p 2 x2 ] (137)

Determine the value function u(x1 (p1 ; p2 ; m); x2 (p1 ; p2 ; m)) = V (p1 ; p2 ; m)

@L

= ux1 (x1 ; x2 ) p1 = 0 (138)

@x1

@L

= ux2 (x1 ; x2 ) p2 = 0 (139)

@x2

@L

= m p1 x1 p2 x2 = 0 (140)

@

Ratio of marginal utilities equal to their prices

ux1 (x1 ; x2 ) p1

= (141)

ux2 (x1 ; x2 ) p2

Substituting these values into the budget constraint one gets demand for x1 and x2 :

x1 (p1 ; p2 ; m) x2 (p1 ; p2 ; m)

L = x1 x2 + [m p 1 x1 p2 x2 ] (143)

@L

= x1 1 x2 p1 = 0 (144)

@x1

@L

= x1 x2 1 p2 = 0 (145)

@x2

@L

= m p1 x1 p2 x2 = 0 (146)

@

m

This leads to x1 (p1 ; p2 ; m) = pm 1

and x2 (p1 ; p2 ; m) = p2 and to the indirect utility function

u(x1 (p1 ; p2 ; m); x2 (p1 ; p2 ; m)) = V (p1 ; p2 ; m)

29

2.4.1 Indirect utility and expenditure functions: Roy’s Identity

Indierct utility function

m m

V (x1 ; x2 ) = =m p1 p2 (147)

p1 p2

Expenditure function

m= p1 p2 u (148)

Theorem: derivative of value function wrt price equals derivative of Lagranging function wrt

price.

@V @L

= = x1 (p1 ; p2 ; m): (149)

@pi @pi

Roy’s Identity

@V 1 m

= m p1 p2 = p1 p2

@p1 p1

m

= = x1 (p1 ; p2 ; m); ) = p1 p1 (150)

p1

1

From above x1 x2 = p 1 :

x1 1 x2 1

= = x1 x2 p 1 1 =

p1

1

m m

p1 1 = p1 p1 (151)

p1 p2

Maximisation of utility is equivalent to the minmimisation of expenditure required to meet a given

level of utility.

M in E = p1 x1 + p2 x2 (152)

x1 ;x2

Subject to

U = u(x1 ; x2 ) (153)

Find the optimal values of x1 and x2 Hint: L = p1 x1 + p2 x2 + U u(x1 ; x2 )

30

2.4.3 Shephard’s Lemma

Compensated demand for a product xi can be obtained by partially di¤erentiating the expenditure

@E @L

function wrt its own price pi . @pi

= @pi

= xi (p1 ; p2 ; m)

Proof: Take a CobbDouglas utility function as u(x1 ; x2 ) = x1 x2 where + = 1: Then the

constrained maximisation problems is:

h i

L = p1 x1 + p2 x2 + u x1 x2 (155)

@L 1

= p1 x1 x2 = 0 (156)

@x1

@L 1

= p2 x1 x2 =0 (157)

@x2

@L

=u x1 x2 = 0 (158)

@

1

p1 x1 x2 x2

= 1

= (159)

p2 x1 x2 x1

p1 x1 = x2 p2 (160)

p2

x1 = x2 (161)

p1

p2

u = x1 x2 = x2 x2 = p1 p2 x2 (162)

p1

x2 = p1 p2 u (163)

p2

x1 = p1 p2 u = p1 p2 u (164)

p1

e = p1 x1 + p2 x2 = p1 p1 p2 u + p2 p1 p2 u (165)

1+

e= 1

p1 p12 u + p1 p12 u (167)

1

e= p1 p12 u +1 (168)

+

e= p1 p12 u (169)

1

e= p1 p12 u (170)

1

e= p1 p12 u= p1 p2 u (171)

31

Proof of Shephard’s Lemma

@E @L

= = xi (p1 ; p2 ; m) (172)

@pi @pi

@e 1 1

e= p1 p2 u =) = p1 p2 u = p1 p2 u (173)

@p1

h i

L = p1 x1 + p2 x2 + u x1 x2 (174)

@L

= x1 (p1 ; p2 ; m) = p1 p2 u (175)

@p1

QED.

Roy’s Identity

@V 1 m

= m p1 p2 = p1 p2

@p1 p1

m

= = x1 (p1 ; p2 ; m) (176)

p1

1

x1 x2 = p 1 ;

x1 1 x2 1

= = x1 x2 p 1 1 =

p1

1

m m

p1 1 = p1 p1 (177)

p1 p2

This is the proof of Roy’s identity.

Rutherford (2007) in www.mpsge.org provides more explanation for this derivation.

1

M ax u(x; y) = [ x + (1 )y ] (178)

x;y

Subject to

x + py y = m (179)

1

Note that the elasticity of substituion and are linked as: =1 ; px = 1:

Formulate a constrained optimisation problem .

1

L (x1 ; x2 ; ) = [ x + (1 ) y ] + [m x1 py y] (180)

@L 1 1

1 1

= [ x + (1 )y ] x =0 (181)

@x1

@L 1 1

1 1

= [ x + (1 )y ] (1 ) y py = 0 (182)

@x1

32

@L

=m x py y = 0 (183)

@

Determine the demand functions of x and y.

1

x 1

= (184)

1 y py

y 1 1 1

= (185)

x py

1

y 1 1 1

1 1

= = (186)

x py py

1 1

y=x (187)

py

" #

1 1 + p1y (1 )

m = x + py y = x + py x =x (188)

py

m

x= (189)

+ p1y (1 )

1 1 m 1 1 (1 ) m p1y

y=x = = (190)

py + p1y (1 ) py + (1 ) p1y

Calibrate the share parameter .

p Y m 1

Let share spent on y be = ym ; select the units so that py = 1 in the benchmark. y =

m + (1 ) 1

= = (191)

y (1 )

m 1

=1+ = (192)

y 1

1

1

= 1 (193)

1

1 1

1 1 1 1

= (1 ) 1 = (1 ) = (1 ) (1 ) (194)

h 1 1

i 1 1

1 + (1 ) = (1 ) (195)

1

(1 )

=h 1 1

i (196)

+ (1 )

Derive the indirect utility function (value function) u [x(px ; py ; m); y(px ; py ; m)] = V (px ; py ; m)

This is obtained by putting the demand functions into utility function;

33

1

u (px ; py ; m) = [ x + (1 )y ] (197)

" ! ! #1

m (1 ) m p1y

= + (1 ) (198)

+ (1 ) p1y + (1 ) p1y

1 1 1

Note that =1 = ; = 1

m h 1 1 i 1

u (px ; py ; m) = ( ) + (1 ) ((1 ) ) p1y (199)

+ (1 ) py1

m

u (px ; py ; m) = + (1 ) p1y 1

(200)

+ (1 ) p1y

m m

u (px ; py ; m) = 1

= 1 (201)

+ (1 ) p1y 1

+ (1 ) p1y 1

m

u (px ; py ; m) = 1 (202)

+ (1 ) p1y 1

1

(1 )

=h 1 1

i (203)

+ (1 )

m

V (py ; m) = " ! ! #11 (204)

1 1

(1 ) (1 )

h 1 1 i + 1 h 1 1 i p1y

+(1 ) +(1 )

m

V (py ; m) = " ! #11 (205)

1 1 1

(1 ) +(1 ) (1 )

h 1 1 i + h 1 1 i p1y

+(1 ) +(1 )

m

V (py ; m) = " #11 (206)

(1 )

h 1 1 i + h 1 1 i p1y

+(1 ) +(1 )

m

V (py ; m) = 1 (207)

h 1

1

1 i

1

(1 ) + p1y 1

+(1 )

m

V (py ; m) = 1 (208)

k (1 ) + p1y 1

1

where k= h 1 1 i

1

:

+(1 )

34

Demand functions in calibrated share form

y pu

y= V (py ; m) (209)

m py

x pu

x= V (py ; m) (210)

m 1

1

where pu = k (1 ) + p1y 1

1

X Ci

U (py ; m) = M (211)

Ci

X

M= P iC i (212)

P iC i

i = (213)

M

M

V (py ; m) = (214)

pu

" #11

X pi

1

pu = i (215)

pi

Demand functions

V (py ; m) pu pi

ci = ci (216)

m pi

GAMS programe CES.gms

Rutherford T. F. (2007) www.mpsge.org.

Consider consumers problems for comparative static analysis

I = Px X + Py Y (218)

(b) By total di¤erentiation of the …rst order conditions determine

the impact of change in shadow prices on demand for X and Y

the impact of change in price of X on demand for X and Y.

the impact of change the price of Y on demand for X and Y.

the impact of change in income on demand for X and Y and the shadow price.

(c) Decompose the total e¤ect of price change in substitution and income e¤ects.

35

2.4.6 Exercise 2: Indirect utility function, Shephard’s Lemma and Roy’s Identity

Problem 2: Indirect Utility Function, Shephard’s Lemma and Roy’s Identity

M ax u(x1 ; x2 ) (219)

x1 ;x2

Subject to

p1 x1 + p2 x2 = m (220)

(a) Form a constrained optimisation problem and characterise the demand function x1 (p1 ; p2 ; m)

and x2 (p1 ; p2 ; m).

(b) Determine the value function u(x1 (p1 ; p2 ; m); x2 (p1 ; p2 ; m)) = V (p1 ; p2 ; m)

@V

(c) What is the meaning of @m = ? Marginal utility of income?

@V @L

(d) Explain the meaning of Roy’s identity @pi = @pi = x1 (p1 ; p2 ; m).

(e) Derive Roy’s identify when preferences are Cobb-Douglas: u(x1 ; x2 ) = x1 x2 where +

= 1:

M in E = p1 x1 + p2 x2 (221)

x1 ;x2

Subject to

U = u(x1 ; x2 ) (222)

@E

(b) What is the meaning of @u = ?

@E @L

(c) Prove Shephard’s lemma @p i

= @pi

= xi (p1 ; p2 ; m) for i = 1; 2

= 1:

36

2.4.7 Duality in consumption and Slutskey decomposition

Expenditure Functions with the CES utility functions

min E = px x + py y (224)

x;y

Subject to

1

u = [ x + (1 )y ] (225)

h 1

i

L = px x + py y + U [ x + (1 )y ] (226)

@L 1 1

1 1

= px [ x + (1 )y ] x =0 (227)

@x

@L 1 1

1 1

= py [ x + (1 )y ] (1 )y =0 (228)

@y

@L 1

=U [ x + (1 )y ] = 0 (229)

@

1 1

1

px x (1 ) 1

px 1

= ==> x = y (230)

py (1 ) y py

" 1 1 ! #1

(1 ) 1

px 1

u = y + (1 )y

py

" #1

1 px 1

= y 1 (1 ) 1

+ (1 )

py

1 h 1

i1

1 1 1

= y py 1 (1 ) 1

px + (1 ) py (231)

u

y= h i1 (232)

1 1

1 1 1

py 1 (1 ) 1

px + (1 ) py

1 1 1 1

(1 ) 1

px 1

u (1 ) 1

px 1

x=y = h i1

py 1

1

1

1 1

py

py 1 (1 ) 1

px + (1 ) py

(233)

Now it is possible to apply the Slutskey equation

@x1 @x1 @E @x1

@p1 = @p1 @p1 @E

Cmp

37

2.4.8 Problem 4: CES Demand

1. Consider a consumer maximisation problem given below:

1

M ax u(x; y) = [ x + (1 )y ] (234)

x;y

Subject to

x + py y = m (235)

1

Note that the elasticity of substitution and are linked as: =1

(b) Determine the demand functions of x and y.

(c) Calibrate the share parameter .

(d) Derive the indirect utility function (value function) u(x(p1 ; py ; m); y(p1 ; py ; m)) = V (p1 ; py ; m)

@V

(e) What is the meaning of @m = ? Marginal utility of income?

@V @L @V @L

(f) Explain the meaning of Roy’s identity @px = @px = x(p1 ; py ; m) and @py = @py =

y(p1 ; py ; m).

(a) u(xi = 0) = 0

N

(b) It continuous in R++ R+

(c) unbounded above for all prices p 0

(d) Homogenous of degree 1 in xi

(e) Strictly increasing in income

(f) Decreasing in prices

(g) Quasiconvex in (p; m)

(h) Ful…lls Roy’s identity

1

max u = (x1 + x2 ) (236)

x1 ;x2

Subject to

M = p1 x1 + p2 x2 (237)

N

(b) It continuos in R++ R+

38

(c) unbounded above in u for all prices p 0

(d) Homogenous of degree 1 in p

(e) Strictly increasing in income

(f) Concave in p

@E @L

(g) ful…ls Shephard’s lemma @pi = @pi = xi (p1 ; p2 ; m) for i = 1; 2

Subject to

min E = p1 x1 + p2 x2 (238)

x1 ;x2

Subject to

1

u = (x1 + x2 ) (239)

1. Utility function for a consumer is given by

u = x1 x2 (240)

here budget constraint is

I = p1 x1 + p2 x2 (241)

2. Determine the indirect utility function for this consumer.

3. Solving corresponding duality problem determine the expenditure function for this consumer.

4. Find the compensated (Hicksian) demand curve for X or Y? [hint Slutskey equation].

@E @L

5. Prove Shephard’s lemma @pi == xi (p1 ; p2 ; m) .

@pi

h i

@V @L

6. Prove Roy’s identity for this case @p i

= @pi :

Answer

Consumer’s Optimisation

L = x1 x2 + [m p 1 x1 p2 x2 ] (242)

@L 1

= x1 x2 p1 = 0 (243)

@x1

@L 1

= x1 x2 p2 = 0 (244)

@x2

@L

=m p1 x1 p 2 x2 = 0 (245)

@

39

Marshallian demand functions

m m

x1 = ; x2 =

p1 p2

m m

V (x1 ; x2 ) = =m p1 p2 (246)

p1 p2

m= p1 p2 u (247)

@V @L

= = x1 (p1 ; p2 ; m): (248)

@pi @pi

2.4.12 Duality

h 1 1

i

L = p1 x1 + p1 x2 + U x12 x22 (249)

@L 1 21 1 12

= p1 x x2 = 0 (250)

@x1 2 1

@L 1 21 12 1

= p2 x x =0 (251)

@x2 2 1 2

@L 1 1

= u x12 x22 = 0 (252)

@

p1 x2 p2

= ==> x1 = x2 (253)

p2 x1 p1

1 1

1 1 p2 2 1 p2 2

u = x12 x22 = x2 x22 = x2 (254)

p1 p1

1

p1 2 1 1

x2 = u = up12 p2 2

(255)

p2

Then

1

p2 p1 2

p2 1 1

x1 = x2 = u = up1 2 p22 (256)

p1 p2 p1

Now the expenditure fucntion

1 1 1 1 1 1

E = p1 x1 + p2 x2 = p1 up1 2 p22 + p2 up12 p2 2

= 2up12 p22 (257)

E

u= 1 1 (258)

2p12 p22

40

Slutskey Equation: Total e¤ect of price change = substituion e¤ect and income e¤ect

= (259)

@p1 @p1 Cmp @p1 @E

Compensated demand

!

1 1 @x1 1 3 1 1 E 3 1 1

x1 = up1 p2 =)

2 2

= up1 2 p22 = p1 2 p22 = Ep 2 (260)

@p1 cmp 2 2 1

2p1 p2

2

1

2 4 1

1 1 @E 1 1

E = 2up12 p22 =) = up1 2 p22 = x1 (261)

@p1

E

Given the Marshalian demand x1 = 2p1

@x1 1

= (262)

@E 2p1

Slutskey decomposition:

= = Ep 2 up1 2 p22

@p1 @p1 Cmp @p1 @E 4 1 2p1

!

1 E 1 1 1 1 1 E

= Ep 2 p1 2 p22 = Ep 2 Ep 2 = 2 (263)

4 1 1 1

2p1 p2

2 2 2p 1 4 1 4 1 2p1

First part is substitution e¤ect and the second part is income e¤ect.

@E @L

@pi = @pi = xi (p1 ; p2 ; m)

u(x1 ; x2 ) = x1 x2 where + = 1:

h i

L = p 1 x1 + p 2 x2 + u x1 x2 (264)

@L

@u =

@L 1

= p1 x1 x2 = 0 (265)

@x1

@L 1

= p2 x1 x2 =0 (266)

@x2

@L

=u x1 x2 = 0 (267)

@

1

p1 x1 x2 x2

= 1

= (268)

p2 x1 x2 x1

41

Shephard’s Lemma

p1 x1 = x2 p2 (269)

p2

x1 = x2 (270)

p1

p2

u = x1 x2 = x2 x2 = p1 p2 x2 (271)

p1

x2 = p1 p2 u (272)

p2

x1 = p1 p2 u = p1 p2 u (273)

p1

e = p1 x1 + p2 x2 = p1 p1 p2 u + p2 p1 p2 u (274)

1+

e= 1

p1 p12 u + p1 p12 u (276)

1

e= p1 p12 u +1 (277)

+

e= p1 p12 u (278)

1

e= p1 p12 u (279)

1

e= p1 p12 u= p1 p2 u (280)

Proof of Shephard’s Lemma

@E @L

= = xi (p1 ; p2 ; m) (281)

@pi @pi

@e 1 1

e= p1 p2 u =) = p1 p2 u = p1 p2 u (282)

@p1

h i

L = p1 x1 + p2 x2 + u x1 x2 (283)

@L

= x1 (p1 ; p2 ; m) = p1 p2 u (284)

@p1

QED

42

2.4.14 Roy’s Identity

@V 1 m

= m p1 p2 = p1 p2

@p1 p1

m

= = x1 (p1 ; p2 ; m) (285)

p1

1

x1 x2 = p 1 :

x1 1 x2 1

= = x1 x2 p 1 1 =

p1

1

m m

p1 1 = p1 p1 (286)

p1 p2

43

2.5 Revealed Preference Theory

Utility function based analysis on derivation of consumer demand is subjective and hence less

precise. Neither the utility function nor the preference parameters are observable. Revealed

prefernce theory focuses on observed income, price and choices to generalise axioms on consumer

behaviour. It makes a number of assumptions: 1) all income is spent (M0 = p0 x0 ) 2) buyers

always have a unique x bundlde for given M and p; that means there is a unique bundle for each

combination of p and M and preferences are consistent.

1 Weak axiom of revealed preference (WARP) : draw a diagram.

0 1 1

p1 x0 > p1 x1 () p0 x0 > p x1 p x1 < p x0

This will give the substitution and income e¤ect as in the indi¤erence curve analysis. But this

does not apply in all circumstances; p1 x0 = M2 = p1 x2 . This leads to p1 p0 x1 x0 < 0

X

and in general p1i p0i x1i x0i = p1j p0j x1j x0j < 0.

2. Strong axiom of revealed preference (SARP)

3. Congruent axiom

4. Generalised axiom

The WARP and GARP axioms were re…need and generalised by Houthakker (1950), Richter

(1966), Afriat (1967) Varian (1982), Bandyopadhyay (1988) and most recently by Echinique (2011).

The Economic Journal 2012 has a special section on the recent developments of the revealed pref-

erence theory (Varian (2012), Vermeulen (2012)).

Following Gravelle and Rees (2004) now derive the Slutskey equation from the Revealed preference

theory as follows:

Divide by pj

= +

pj pj pj

or

= x0j

pj pj M

xj xj xj

jM = jpx x0j jp

pj pj M

Thus the utility maximising theory and the revealed preference theory of consumer behavior are

equivalent.

Revealed preference to Laspeyeres price index:

p1 x1 p 1 x0

p1 x1 > p1 x0 () M I = 0 0

> 0 0 = LP

p x p x

44

Revealed preference to Paasche price index:

1 1 p 1 x1 p1 x1

p0 x0 > p0 x1 () 5 () M I = 5 = PP

p 0 x0 p0 x1 p 0 x0 p0 x1

Afriat (1967 and 2012) proves correspondence between the revealed preference and the utility

function.

Readings:

Afriat, S. N. (2012), Afriat’s Theorem and the Index Number Problem, Economic Journal,

122: 295–304.

Bandyopadhyay TD (1988) Revealed Preference Theory, Ordering and the Axiom of Sequen-

tial Path Independence, Review of Economic Studies, 343-351.

Samuelson, Paul A. (1938). “A note on the pure theory of consumer’s behavior,”Economica,

5(17), 61–71.

— — . (1948). “Consumption theory in terms of revealed preference,” Economica, 15(60),

243–253

Varian, H. R. (2012), Revealed Preference and its Applications, Economic Journal, 122: 332–

338

Vermeulen F. (2012) Foundations ¤ Revealed Preference: Introduction, Economic Journal,

122 (May), 287–294

Kahneman and Tversky (1979): Prospect theory

Bandyopadhyay (1988):Revealed Preference Theory, Ordering and the Axiom of Sequential

Path Independence

Hey and Orme (1994): Experimental approach to consumer choice

Blundell, Pistaferri, and Preston (2008), Blundell, and Preston (2008) Consumption and

income inequality and Partial Insurance

Balasko (1975) equilibrium manifold.

Blundell R and I. Preston (1998) Consumption Inequality and Income Uncertainty, Quarterly

Journal of Economics, 113,2, 603-640.

Blundell R, L.Pistaferri, and I. Preston (2008) Consumption Inequality and Partial Insurance,

American Economic Review, 98:5, 1887–1921

45

Carey K. (2000) Hospital Cost Containment and Length of Stay: An Econometric Analysis

Southern Economic Journal, 67, 2, 363-380

Deolalikar A. B. and R. E. Evenson (1989) Technology Production and Technology Purchase

in Indian Industry: An Econometric Analysis The Review of Economics and Statistics, 71, 4,

687-692

Hey J. D and J. A. Knoll (2011) Strategies in dynamic decision making: An experimental

investigation of the rationality of decision behaviour, Journal of Economic Psychology 32,399–

409

Hey J. D and C. Orme (1994) Investigating Generalizations of Expected Utility Theory Using

Experimental Data Econometrica, 62, 6, 1291-1326

Hey, J. D., Lotito, G., & Ma¢ oletti, A. (2010). The descriptive and predictive adequacy of

theories of decision making under uncertainty/ambiguity. Journal of Risk and Uncertainty,

41(2), 81–111. Experimental lab of John Hey at York http://www.york.ac.uk/economics/our-

people/sta¤-pro…les/john-hey/

Kahneman, D. and Tversky, A. (1979). Prospect theory: an analysis of decision under risk.

Econometrica,67, 263–291.

Lee R-S and N. Singh (1994) Patterns in Residential Gas and Electricity Consumption: An

Econometric Analysis Journal of Business & Economic Statistics, 12, 2, 233-241

McGuinness T. (1980) Econometric Analysis of Total Demand For Alcoholic Beverages in the

U.K., 1956-75 The Journal of Industrial Economics, 29, 1, 85-109

Segal, U. (1987). The Ellsberg Paradox and risk aversion: an anticipated utility approach.

International Economic Review, 28, 175–202.

Schmeidler, D. (1989). Subjective probability and expected utility without additivity. Econo-

metrica, 57,571–587.

Van Soest A and P. Kooreman (1987) A Micro-Econometric Analysis of Vacation Behaviour

Journal of Applied Econometrics, 2, 3 , 215-226.

Explain whether following two estimations are as expected from the microeconomic theory of con-

sumer demand presented in this section.

1) Consider the cross-regional variation of expenditure on food in the UK. For simplicity, it is

assumed that food expenditure (F) depends only on wage and salary income (Y) in each region as:

2

Fi;t = i + 1 yi;t + ei;t ei;t IID 0; e (287)

This model has been estimated using a pooled time series and cross section data set (with the

sample size of T=14 and N=13) available from the web site of the O¢ ce of the National Statistics

(food_exp_UK_regional_panel.csv: hhttp://www.statistics.gov.uk). The estimated coe¢ cients,

by region, are given in the following table.

2) Determinants of houseprices by regions in UK estimated by 3SLS and data in House-

Price_regional.csv.

46

Table 6: Food expenditure on income : Stacking Data for SURE)l

Coe¢ cient t-value t_Prob

Emp_income 0.511 69.4 0.000

Constant -252.126 -2.18 0.031

NW -28.2405 -0.178 0.859

YH -362.599 -2.29 0.023

EM 359.178 2.27 0.025

WM 2034.03 12.8 0.000

EA 1715.26 10.3 0.000

GL 753.455 4.77 0.000

SE -700.345 -4.36 0.000

SE_R -326.693 -2.02 0.045

SW 412.537 2.61 0.010

WL 710.626 4.49 0.000

SCT 580.688 3.65 0.000

NI 2374.79 4.66 0.000

R2 = 0.99; N =182; T = 14; Chi2 =4815. [0.000] **

Production is a process to modify or transform inputs into outputs. Goods and services are produced

by millions of …rms in the economy. Production functions show how much output is obtained for

given combinations of inputs. Production technologies di¤er by production sectors and perhaps by

the sizes of production …rms that can be from being small to midium to large or to multinational

company. For instance consider types of soft drinks: Coke, Pepsi, Fanta, Tango, Sprite, 7 Up, Dr.

Pepper or cars such as BMW, Voxhaul, Poeguet, Chrisler, Ford, GM, Toyota, Nissan, Hyundai, Fiat.

There are varieties of daily use products supplied by many …rms. Many big companies are listed in

stock markets such as FTSE 5000 or Nikkie or Dow Jones but there are many …rms operating in

smaller scales. Most often these productions occur in sectors as recorded in the UNIDO databases.

The agriculture sector,- that includes farms crops, livestock, forestry, and …sheries usually is

operated by small …rms and requires more land. The mining sector is usually more capital intensive

and dominated by larger …rms. Firms in manufacturing sector are mostly very big and require more

physical and human capital. These vary a lot by the types of manufacturing that according to the

Iput Output Table of UK from the ONS these include meat processing, …sh and fruit processing,

oils and fats, dairy products, grain milling and starch and animal feed, bread, biscuits, etc, sugar,

confectionery, other food products, alcoholic beverages, soft drinks and mineral waters, tobacco

products, textile …bres, textile weaving, textile …nishing, made-up textiles, carpets and rugs, other

textiles, knitted goods, wearing apparel and fur products, leather goods, footwear, wood and wood

products, pulp, paper and paperboard, paper and paperboard products, printing and publishing,

coke ovens, re…ned petroleum & nuclear fuel, industrial gases and dyes, inorganic chemicals, organic

chemicals, fertilisers, plastics & synthetic resins etc, pesticides, paints, varnishes, printing ink etc,

pharmaceuticals, soap and toilet preparations, other chemical products, man-made …bres, rubber

products, plastic products, glass and glass products ceramic goods, structural clay products, ce-

ment, lime and plaster, articles of concrete, stone etc , iron and steel, non-ferrous metals, metal

47

Table 7: Determinants of houseprice in UK: SURE (3SLS) estimation

Coe¢ cient t-value t_Prob

Rincome 4.64 45.2 0.000

Pop 1.25 0.55 0.054

MRT_RT -11.51 -0.022 0.982

M/H_Ratio -237240 -19.9 0.000

CRNTDP 1.94 5.85 0.000

SVDEP 1.10 3.72 0.000

NE 22845.3 2.04 0.042

NW 8064.9 2.85 0.005

YH 14615.8 2.37 0.018

SW 9939.4 1.50 0.134

EN -148092 -1.66 0.097

EM 12868.1 1.61 0.108

WM 12404.2 2.20 0.029

EE 16599.7 2.84 0.005

GL 5454.8 2.00 0.046

Constant 101298.1 5.31 0.000

F(90, 373) = 7.09 (0.00); N =480; Chi2 (2)=59.2. [0.000] **

castings, structural metal products, metal boilers and radiators, metal forging, pressing, etc; cutlery,

tools etc, other metal products, mechanical power equipment, general purpose machinery, agricul-

tural machinery, machine tools, special purpose machinery, weapons and ammunition, domestic

appliances, o¢ ce machinery & computers, electric motors and generators etc, insulated wire and

cable, electrical equipment, electronic components, transmitters for TV, radio and phone receivers

for TV and radio, medical and precision instruments, motor vehicles, shipbuilding and repair, other

transport equipment, aircraft and spacecraft, furniture, jewelry and related products Sports goods

and toys, miscellaneous manufacturing & recycling that rely very much on fossil fuels.

The production and distribution of electricity and gas is vital in order to run all these industries.

Firms in construction sector contribute both to the supply of residential and non-residential proper-

ties but also to big infrastructure in the form of transport, communication and service networks and

logistics and supply chain management. The distribution sector consists of motor vehicle distribu-

tion and repair, automotive fuel retail, wholesale distribution, retail distribution, hotels, catering,

pubs etc.

The business service sector represents banking and …nance , insurance and pension funds , auxil-

iary …nancial services, owning and dealing in real estate, letting of dwellings, estate agent activities,

renting of machinery etc, computer services, research and development , legal activities, accoun-

tancy services, market research, management consultancy, architectural activities and technical

consultancy, advertising and other business services.

The other services sector includes public administration and defence, education, health and

veterinary services, social work activities, membership organisations, recreational services, other

service activities, private households with employed persons and sewage and sanitary services.

Datastream provides basic timeseries information on public companies regarding their production,

sales, revenue, costs, pro…ts, price of stocks and their leverages. Megazines such as Forbes regularly

48

Top 10 Firms in the World in May 2014 (Forb's List): http://www.forbes.com/global2000/list/

Rank Company Country Sales Profits Assets Market

Value

ICBC

2 China $1 21 .3 B $34.2 B $2,449.5 B $1 7 4.4 B

China Construction Bank

3 China $1 36.4 B $27 B $2,405.4 B $1 41 .1 B

Agricultural Bank of China

4 United States $1 05.7 B $1 7 .3 B $2,435.3 B $229.7 B

JPMorgan Chase

5 United States $1 7 8.8 B $1 9.5 B $493.4 B $309.1 B

Berkshire Hathaway

6 United States $394 B $32.6 B $346.8 B $422.3 B

Exxon Mobil

7 United States $1 43.3 B $1 4.8 B $656.6 B $259.6 B

General Electric

8 United States $88.7 B $21 .9 B $1 ,543 B $261 .4 B

Wells Fargo

9 China $1 05.1 B $25.5 B $2,291 .8 B $1 24.2 B

Bank of China

10 China $328.5 B $21 .1 B $386.9 B $202 B

PetroChina

update top 100 companies by thier turn over. For instance Industrial & Commercial Bank of

China Ltd. had assets of 3.1 trillion dollars in 2014 with pro…ts over 148 billion dollars. It is also

possible to …lter prominent …rms in each of above sectors operating in the global economy using

such databases.

A production technology in each of above sector shows how inputs are transferred into outputs.

Usually labour, the human toils and trouble in process of production; capital, the man made means

of production, as re‡ected in building, structures including highways, communication networks

and education, health and environmental system; natural resources including clear air, water, and

mineral and energy products represent such inputs. In addition there are intermediate inputs as

presented in the input output table of an economy. There are linear and non-linear production

functions. Returns to scale vary and possibility of substitution vary among them . Intensity of

use of these factors in a speci…c industry or a …rm is re‡ected in these production function. These

are important in process of substitution of more expensive by less expensive inputs. The CES

categories of these functions being the most commonly used ones in the economic literature as they

capture the cross price elasticity more e¢ ciently than any other linear or Cobb-Douglas production

functions [see articles such as (Pigou (1934) , Meade (1934) Lancaster and Chesher (1983), Dolton

and Makepeace (1990), Harmatuck (1991), Basu and Fernald (1997), Barmby , Ercolani and Treble

(2002), Costinot, Vogel and Wang (2013)) discussion about production; Coase (1937) The Nature

of the Firm, Economica, 386-405].

Popular production functions where output ( y) is expressed as functions of inputs (xi ):

Cobb-Douglas: y = x1 x12

1

CES: y = (x1 + x2 )

1

Nested: x4 = (x1 + x2 ) and then y = x4 x13

49

P

n P

n

p

generalised Leontief: Y = aij xi xj ; aij = aji

i=1j=1

P

n P

n P

n

Translog: ln Y = a0 + ai ln xi + aij ln xi ln xj ; aij = aji

i=1 i=1j=1

A tanslog production function adds squares and product terms to the regual production function

as:

n

X n X

X n

ln Y = a0 + ai ln xi + aij ln xi ln xj ; aij = aji

i=1 i=1 j=1

This function is popular as it allows a large number of substitution posibilities among inputs.

Pn P

n

Prove that this function becomes a constant return to scale when ai = 1 and aij = 0:

i=1 j=1

Generalised Leontief function:

n X

X n

p

Y = aij xi xj ; aij = aji

i=1 j=1

Nested production function shows how composite inputs are used with other inputs (very popular

in the CGE and macro modelling):

Let V be the CES composite of labour and capital

1

V = [ L + (1 )K ] (288)

then let E be energy input in production. Then Y is prouced using V and E as:

Y = V E1

This is one level nest. There can be many levels of nests in the production process.

Questions: What are the elasticities of output to input x1 in above production

functions?

1. Let us consider a production function for a fruit …rm operating in the competitive market is

given by p

y=2 l (289)

where y is output and l is labour input. Product price is p and input price is w. What is

the cost function for this …rm? What is its pro…t function? What is its supply function? What is

the demand function for labour? What are the properties of the these production, pro…t and cost

functions?

Since this is a one input production funtion the cost function can derived direcly from the

production technology as:

y2

l= (290)

4

50

Producer pay wage to supply this commodity:

y2

c = wl = w (291)

4

The pro…t is the di¤erence between the revenue and cost of the …rm as given by the pro…t

function:

y2

= py c = py w (292)

4

The supply function for commodity y is derived using the …rst orcer condition of the pro…t

function as:

@ y 2p

=p w = 0 =) y = (293)

@y 2 w

Supply is positively related to prices and negatively to the input cost, in this case the wage rate.

Demand for labour:

2

1 2 1 2p

l= y = (294)

4 4 w

1. Increasing in p

2. decreasing in w

3. homogenous of degree one in p and w

4. concave in y and convex w

This supply function is homegeous of degree zero in price and wage, y = 2p w as there is no

change in level of output when price and wage increase by the same amount. It is increasing in p

and decreasing in w.

2

Pro…t function is concave as its second derivative wrt to output is negative, @@y2 = w2 < 0;

1 2 3

Production function is also concave. @y

@l = l

2 =)

@ y

@l2 =

1

2l

2 < 0:

y 2

@c @ c w

Cost function is convex: @y = w 2 =) @y2 = 2 > 0.

1 2p 2

Demand function for labour is also homegeous of degree zero in price and wage as l = 4 w .

Hotelling’s lemma Derivative of pro…t function wrt price gives the supply function; derivative

pro…t function wrt input prices gives demand function for inputs:

@ (p;y) @ (p;w)

@p = y (p; w) @wi = xi (p; w)

Properties of output supply and input demand functions

2. xi (tp; tw) = xi (p; w) for all t > 0 See substituion matrix

51

3.1.2 Production function and its scale properties

A production function f : Rn+ =) R is continuous, strictly increasing, strictly quasiconcave function

in Rn+ f (0) = 0

Isoquant Q(y) = fx 0 = f (x) = yg is set of inputs giving a …xed output y.

Returns to scale

1. Constant return to scale f (tx) = tf (x) for all t > 0 and all x

2. Increasing returns to scale f (tx) > tf (x) for all t > 0 and all x

3. Decreasing returns to scale f (tx) < tf (x) for all t > 0 and all x

Xn

d ln (f (tx)) f (x) xi

i=1

(x) = lim = (295)

t !1 d ln (t) f (x)

1

y = k(1 + x1 x2 ) (296)

@y x1 1

1 (x) = = (1 + x1 x2 ) x1 x2 (297)

@x1 y

@y x2 1

2 (x) = = (1 + x1 x2 ) x1 x2 (298)

@x2 y

Elasticity of scale is obtained by adding above two:

1

(x) = ( + ) (1 + x1 x2 ) x1 x2 (299)

This varies with x.

Variable returns to scale

1 k

y = k(1 + x1 x2 ) ; =) x1 x2 = 1 (300)

y

y

1 (y) = (1 ) (301)

k

y

2 (y) = (1 ) (302)

k

Elasticity of scale

y

(y) = ( + ) (1

) (303)

k

Returns to each input declines with output here. Increasing return for 0 < y < k; constant

return 0 < y = k and decreasing return when y > k > 0 . k is the upper bound of output. (see

more in Jehle and Reny (2001).

52

3.1.4 Cost function

It is a minimum value function for for all input price w 0 and output levels y 2 Rn+

subject to

f (x) y (305)

Constrained optimisation

@L (x; )

= w1 f 0 (x1 ) = 0 (307)

@x1

:: (308)

@L (x; )

= wn f 0 (xn ) = 0 (309)

@xn

y f (x) = 0 (310)

Marginal Rate of Trasformation

@f (x;)

@xj wj

M RT Sj;i = @f (x;)

= (311)

wi

@xi

Comparison Economic Journal, 112, 480, F315-F331

Basu S and J. G. Fernald (1997) Returns to Scale in U.S. Production: Estimates and Impli-

cations, Journal of Political Economy, 105, 2, 249-283

Benabou R. and Tirole, J. (2010), Individual and Corporate Social Responsibility. Economica,

77: 1–19.

Bloom N., R. Sadun and J. van Reenen (2012) The organization of …rms across countries,

Quarterly Journal of Economics 127 (4), 1663–1705.

Costinot, A. and J. S. Vogel and S. Wang (2013), An Elementary Theory of Global Supply

Chains, Review of Economic Studies 80, 109–144

Dolton P.J. and G. H. Makepeace (1990) The Earnings of Economics Graduates The Economic

Journal, 100, 399, 237-250

53

Harmatuck D.J. (1991) Economies of Scale and Scope in the Motor Carrier Industry: An

Analysis of the Cost Functions for Seventeen Large LTL Common Motor Carriers, Journal of

Transport Economics and Policy, 25, 2 , 135-151

Lancaster T and A. Chesher (1983) An Econometric Analysis of Reservation Wages Econo-

metrica, 51, 6,1661-1676

Meade (1934) The Elasticity of Substitution and the Elasticity of Demand for One Factor of

Production The Review of Economic Studies, 1, 2 ,152-153

Panagariya A (1981) Variable Returns to Scale in Production and Patterns of Specialization,

The American Economic Review, 71, 1, 221-230

Pigou A. C. (1934) The Elasticity of Substitution ,The Economic Journal, 44, 174 , 232-241

Tirole J. (1995) The Theory of Industrial Organisation, MIT Press.

Cobb-Douglas Production Function

Y = AK L1 (312)

CES Production Function

1

Y =A K + (1 )L (313)

Prove that the elasticity of substitution is 1 in Cobb-Douglas production function and = 1+1

in the CES production function. Also prove that the Cobb-Douglas is a special case of the CES

production function.

Proof that = 1 in the Cobb-Douglas production function

K K K K K K

d L = L d L = L d L = L

= w w = = K K

=1 (314)

d r = r d (1 )AK L

= (1 )AK L d L = L

AK 1 L1 AK 1 L1

1+

@Y 1 1

1 1 (1 ) A1+ Y

= A K + (1 )L ( ) (1 )L = (315)

@K A L

1+

@Y 1 1

1 1 A1+ Y

= A K + (1 )L ( ) K = (316)

@K A K

1+

dK YL (1 ) K

= = <0 (317)

dL YK L

1+

YL (1 ) K w

= = (318)

YK L r

54

1

K w 1+

= (319)

L 1 r

The marginal function

@ K 1

1+

1 h w i 1+1 1

L

w = (320)

@ r

1 1+ r

average function

h i 1+1

K w 1

h w i 1+1

1 r 1+ 1

L

w = w = (321)

r r

1 r

1

1

1+

1 w 1+ 1

K K

d L = L 1 1+ r 1

= w w = 1 = (322)

d r = r

1+

w

1

1+ 1 1+

1 r

=0 g=f 1 (323)

0< <1 <1

The CES is not de…ned in case of = 0 Need to apply L’Hopital’s rule lim m(x) = lim

x !a n(n) x !a

m0 (x)

n0 (n) : When a function is not de…ned it is approximated by the marginal functions.

Y [ K + (1 )L ] m( )

ln = ln = (324)

A n( )

As !0

0 1 d ln K (1 ) ln L

m ( )= [ K +(1 )L ]d [ K + (1 )L ]= 1

Taking antilog

Y

= K L1 =) Y = AK L1 (325)

A

Thus Cobb-Douglas production funciton is a special case of the CES production function. QED.

Some papers with CES functions:

Bhattarai and Whalley (1999) Role of labour demand elasticities in tax incidence analysis

with heterogeneity of labour, Empirical Economics, 24:4:.599-620, November.

Chrisman, J. J., Memili, E. and Misra, K. (2014), Nonfamily Managers, Family Firms, and

the Winner’s Curse: The In‡uence of Noneconomic Goals and Bounded Rationality. Entre-

preneurship Theory and Practice, 38: 1103–1127.

Feldstein M.S (1967) Alternative Methods of Estimating a CES Production Function for

Britain, Economica, New Series, 34, 136,. 384-394

55

Fisher F.M, R. M. Solow, J, M. Kearl (1977) Aggregate Production Functions: Some CES

Experiments ,The Review of Economic Studies, 44, 2, 305-320

McFadden Daniel (1963) Constant Elasticity of Substitution Production Functions, Review

of Economic Studies, 30, 2, 73-83

A …rm’s objective is to minimise cost

C = rK + wL (326)

1

Y = [ L + (1 )K ] (327)

(b) Derive the cost function of the …rm.

1

(c) Prove that the elasticity of substituion is = 1:

(d) Discuss propperties of CES cost function.

(e) Prove that Cobb-Douglas production function is a special case of the CES production

function.

Lagrange:

h 1

i

L = rK + wL + Y ( L + (1 )K ) (328)

@L 1h 1

i

1

=w ( L + (1 )K ) L =0 (329)

@L

@L 1h 1

i

1

=r ( L + (1 )K ) (1 ) K =0 (330)

@K

@L 1

= Y ( L + (1 )K ) = 0 (331)

@

From the …rst two …rst order conditioins:

1 1

w L 1 r 1 r 1

1

= ;K = (L) ;K = L (332)

r 1 K w 1 w 1

1

Y = ( L + (1 )K ) (333)

56

( " # )1

1

r 1

1

Y = L + (1 ) L (334)

w 1

8 2 2

39 1

< r 1

1 =

Y = L + (1 )4 L 5 (335)

: w 1 ;

8 2 2

39 1

< r 1

1 =

Y = + (1 )4 5 L (336)

: w 1 ;

8 2 2

39 1

< r 1

1 =

L= + (1 )4 5 Y (337)

: w 1 ;

1

r 1

1

K= L (338)

w 1

8 2 2

39 1

r 1

1

1 < r 1

1 =

K= + (1 )4 5 Y (339)

w 1 : w 1 ;

Putting these optimal demands for labour and capital in the cost function:

C = rK + wL (340)

2 ( " #) 1 3

2

1

6 r r 1

1

+ (1 ) r 1

1

7

6 w 1 w 1 7

6 7

C=6 ( " #) 1 7Y (341)

6 2 7

4 r 1

1 5

+w + (1 ) w 1

C = C (r; w) Y (342)

Elasticity of substitution between capital and labour

As derived above

1 1 1

w L K r 1

= =) = (343)

r 1 K L w 1

K 1 1

@ L 1 r 1 1

r = (344)

@ w

1 w 1

57

Average function

K 1 1

r 1 1

L

r = (345)

w w 1

1

@( K

L)

1

1

1 r 1

@( w

r

) 1 w 1 1

= K = = (346)

L

r

1

1

1 1

w

r 1

w 1

1

= (347)

1

C = rK + wL

Technology:

Y =K L

L = rK + wL + Y K L

@L 1

=r K L =0

@K

@L 1

=w K L =0

@L

@L

=Y K L =0

@

From the …rst two conditions

r L w

= =) K = L

w K r

substitute this in the production function

w w +

Y =K L = L L = L

r r

w w +

Y =K L = L L = L

r r

1 r + 1

L=Y + =Y + r + w + + +

w

58

w w 1 r + 1 r +

K= L= Y + =Y +

r r w w

1

K=Y + r + w + + +

1 1

C = rK + wL = rY + r + w + + + +w Y + r + w + + +

1 1

C = Y + r + w + + + ( + ) = BY + r + w +

where B = + + ( + ):

Cost function is homogenous of degree 1 in input prices, increases in y, r and w and concave in

r and w.

Take a natural log of this function

ln C = ln B + ( + ) ln Y + ln r + ln w

+ +

Thus the cost is linear in output and input prices.

A translog cost function adds squares and product terms to above function to make costs ‡exible

to production as:

2 2

ln C = ln Y + a0 + a1 ln r + a2 ln w + a3 (ln r) + a4 (ln w) + a5 ln r ln w

This is homogenous of degree 1 when a1 + a2 = 1 and a3 = a4 = a5 = 0: Cobb-Douglas is a

special case of this translog function when a3 = a4 = a5 = 0:

Input shares in translog cost functions:

@ ln C

sw =

= a2 + 2a4 (ln w) + a5 ln r

@ ln w

@ ln C

sr = = a1 + 2a3 (ln r) + a5 ln w

@ ln r

input shares are constant when a4 = 0; a5 = 0:

Consider a problem of producer

x1; x2;

subject to

1

(x1 + x2 ) y (349)

Show that solution is

h i 1

1 1

c (w; y) = y w1 + w2 (350)

59

h 1

i

L = w1 :x1 + w2 :x2 + y (x1 + x2 ) (351)

@L 1 1

1 1

= w1 (x1 + x2 ) x1 =0 (352)

@x1

@L 1 1

1 1

= w2 (x1 + x2 ) x2 =0 (353)

@x2

@L 1

=y (x1 + x2 ) = 0 (354)

@

1 1

1 1 1

w1 (x1 + x2 ) x1 x1

= 1 1

= (355)

w2 1

(x1 + x2 ) 1

x2 x2

1

w1 1

x1 = x2 (356)

w2

Substituting this into the production function

" #1

1 w1 1

y = (x1 + x2 ) = x2 + x2 (357)

w2

" #1

w1 1

y = x2 +1 (358)

w2

" # 1

w1 1 1 h i 1

1 1 1

x2 = y +1 = yw2 w1 + w2 (359)

w2

1 h i 1

1 1 1

x1 = yw1 w1 + w2 (360)

1 h i 1

1 h i 1

1 1 1 1 1 1

c = w1 :yw1 w1 + w2 + w2 :yw2 w1 + w2 (362)

h i 1

1 1 1 1

c = y w1 + w2 w1 + w2 (363)

h i 1

1 1

c (w; y) = y w1 + w2 (364)

60

3.3.2 Properties of a cost function

If f is continous and strictly increasing then c(w; y); cost function has following properties

1. zero when y = 0

2. continous on its domain

4. increasing in w

5. Homogenous of degree one in w

6. Concave in w

Shephard’s lemma in production Input demand functions can be obtained by the derivative

of the cost function (c) wrt inpurt prices (wi ):

@c w0 ; y 0

= xi w 0 ; y 0 i = 1; :::n (365)

@wi

Let

@c (w; y)

c(w; y) = Aw1 w2 y =) x1 (w; y) = = Aw1 w2 y (366)

@w1

h i

w Aw w y

Then prove that and represent input share. = 1Aw w1 y2 :

1 2

Duality:

Pro…t function

It is a minimum value function for for all input price w 0 and output levels y 2 Rn+

subject to

f (x) y (369)

Constrained optimisation

@L (x; )

= w1 f 0 (x1 ) = 0 (371)

@x1

:: (372)

61

@L (x; )

= wn f 0 (xn ) = 0 (373)

@xn

@f (x;)

@xj wj

y f (x) = 0; @f (x;)

= (374)

wi

@xi

1

1.For a CES production function y = (x1 + x2 )

Derive supply function

Determine the long run pro…t.

run supply and pro…t functions.

Capital is constant in the short run, only labour is the variable input. Take the derivative of the

pro…t function wrt to labour to determine the optimal demand for labour.

= pL K wL rK (375)

@ (p; w) h i1 1

= pL 1 K w = 0 =) L = pK (376)

@L w

The short run supply function is obtained by substituting L in Y function

h i1

Y = pK K (377)

w

@Y

Short run supply function slops upward wrt it product price as @p > 0; and diminishes when

the wage rate increase, @Y

@w < 0.

Derivative of pro…t function wrt output price gives the supply function; derivative pro…t function

wrt input prices gives demand function for inputs:

@ (p; w)

y (p; w) = (378)

@p

@ (p; w)

xi (w; p) = (379)

@w

62

Pro…t function

= py rK wL (380)

Constrained pro…t optimisation problem:

= (x; ) = py rK wL + K1 L y (381)

@= (x; )

=p =0 (382)

@y

@= (x; )

= K1 L 1

w=0 (383)

@L

@= (x; )

= (1 )K L r=0 (384)

@K

@= (x; )

= K1 L y=0 (385)

@

Solving these Jacobians one will …nd input demands as L(r; w; p) and K(r; w; p) and the level

of output y(r; w; p).

Insert these functions into the pro…t function to get the value function as:

Applying the envelop theorem:

@V @=

= = y(r; w; p) (387)

@p @p

@V @=

= = L(r; w; p) (388)

@w @w

@V @=

= = K(r; w; p) (389)

@r @r

Di¤erentiating the value function with respect to price gives the output supply function and

di¤erentiating wrt input prices gives input demand functions of the …rm. This is Hotelling’s Lemma.

Repeat the same process to technology y = K 0:4 L0:4 as:

Hotelling’s Lemma like the Shephard’s lemma is very useful for solving Duals of consumer and

producer optimisation problems.

63

3.3.6 Exercise 7: Minimising the cost with Cobb-Douglas and CES production func-

tion

1. Consider cost of production of a …rm:

C = wK + rL (391)

and its production technology constraint

y=K L (392)

(b) Write a Langrangian of pro…t subject to technology constraint

(c) Determine the optimal demand for inputs

(d) Derive the pro…t function in terms of optimal inputs , V (p; w; r):

(e) Determine the cost function.

@V @L

(f) Prove Hotelling’s lemma @P = @P = y(p; w; r); @V

@w =

@L

@w = L(p; w; r); @V

@r =

@L

@r =

K(p; w; r):

(g) Derive input demand, output supply and pro…t functions when the technology is y =

K10:4 L0:4

1

2. Derive the short run pro…t function for a …rm under the perfect competion

= PY wL rK (393)

Y =L K (394)

1. Here is pro…t, L labour supply, K capital, w wage rate, P price of good, Y ouput . For

simplicity assume capital is …xed at K. Technology operates under the constant returns to

scale + = 1:

(b) What are the price and output of this …rm in the short run. Prove that …rm earns

positive pro…t in the short run taking = 0:5; w = 4; r = 1; k = 1:

(c) Now assume that the market demand is given by p = 39 0:009q and the pro…t function

is given by = p2 2p 399: Find output, market demand and the number of …rms in

the long run ( = 0)

(d) Why is the number of …rms indeterminate in the perfect competion?

C = rK + wL (395)

64

subject to technology constraint as:

1

Y = [ L + (1 )K ] (396)

(b) Derive the cost function of the …rm.

1

(c) Prove that the elasticity of substituion is = 1:

(d) Discuss propperties of CES cost function.

C = rK + wL (397)

1

Y = [ L + (1 )K ] (398)

(b) Derive the cost function of the …rm.

1

(c) Prove that the elasticity of substitution is = 1:

(d) Discuss properties of CES cost function.

Answer

Comparative static: Derivation of the CES cost function.

Lagrange:

h 1

i

L = rK + wL + Y ( L + (1 )K ) (399)

@L 1h 1

i

1

=w ( L + (1 )K ) L =0 (400)

@L

@L 1h 1

i

1

=r ( L + (1 )K ) (1 ) K =0 (401)

@K

@L 1

= Y ( L + (1 )K ) = 0 (402)

@

From the …rst two …rst order conditions:

1 1

w L 1 r 1 r 1

1

= ;K = (L) ;K = L (403)

r 1 K w 1 w 1

65

1

Y = ( L + (1 )K ) (404)

( " # )1

1

r 1

1

Y = L + (1 ) L (405)

w 1

8 2 2

39 1

< r 1

1 =

Y = L + (1 )4 L 5 (406)

: w 1 ;

8 2 2

39 1

< r 1

1 =

Y = + (1 )4 5 L (407)

: w 1 ;

8 2 2

39 1

< r 1

1 =

L= + (1 )4 5 Y (408)

: w 1 ;

1

r 1

1

K= L (409)

w 1

8 2 2

39 1

r 1

1

1 < r 1

1 =

K= + (1 )4 5 Y (410)

w 1 : w 1 ;

Putting these optimal demands for labour and capital in the cost function:

C = rK + wL (411)

2 ( " #) 1 3

2

1

6 r r 1

1

+ (1 ) r 1

1

7

6 w 1 w 1 7

6 7

C=6 ( " #) 1 7Y (412)

6 2 7

4 r 1

1 5

+w + (1 ) w 1

C = C (r; w) Y (413)

Elasticity of substitution between capital and labour

As derived above

1 1 1

w L K r 1

= =) = (414)

r 1 K L w 1

66

K 1 1

@ L 1 r 1 1

r = (415)

@ w

1 w 1

Average function

K 1 1

r 1 1

L

r = (416)

w w 1

1

L)

@( K 1

1

1 r 1

@( w

r

) 1 w 1 1

= K = = (417)

L

r

1

1

1 1

w

r 1

w 1

1

= (418)

1

Problem of a Producer: Maximising the pro…t

Pro…t function

= py rK wL (419)

Constrained pro…t optimisation problem:

= (x; ) = py rK wL + K1 L y (420)

@= (x; )

=p =0 (421)

@y

@= (x; )

= K1 L 1

w=0 (422)

@L

@= (x; )

= (1 )K L r=0 (423)

@K

@= (x; )

= K1 L y=0 (424)

@

Solving these Jacobians one will …nd input demands as L(r; w; p) and K(r; w; p) and the level

of output y(r; w; p).

Insert these functions into the pro…t function to get the value function as:

Applying the envelop theorem:

@V @=

= = y(r; w; p) (426)

@p @p

67

@V @=

= = L(r; w; p) (427)

@w @w

@V @=

= = K(r; w; p) (428)

@r @r

Di¤erentiating the value function with respect to price gives the output supply function and

input demand function of the …rm.This is Hotelling’s Lemma.

Harold Hotelling (1935) Demand Functions with Limited Budgets, Econometrica, 3, 1 , 66-78

Pro…t function

= py rK wL (429)

Constrained pro…t optimisation problem:

= (x; ) = py rK wL + K1 L y (430)

@= (x; )

=p =0 (431)

@y

@= (x; )

= K1 L 1

w=0 (432)

@L

@= (x; )

= (1 )K L r=0 (433)

@K

@= (x; )

= K1 L y=0 (434)

@

Solving these Jacobians one will …nd input demands as L(r; w; p) and K(r; w; p) and the level

of output y(r; w; p).

Insert these functions into the pro…t function to get the value function as:

Applying the envelop theorem:

@V @=

= = y(r; w; p) (436)

@p @p

@V @=

= = L(r; w; p) (437)

@w @w

@V @=

= = K(r; w; p) (438)

@r @r

68

Di¤erentiating the value function with respect to price gives the output supply function and

di¤erentiating wrt input prices gives input demand functions of the …rm. This is Hotelling’s Lemma.

Repeat the same process to technology y = K 0:4 L0:4

0:4 0:4

Repeat the same proces to technology y = K L

=w (441)

0:6

p 0:4K L0:4 = r (442)

b = ln X

Log-linearise this system: X

2 32 b 3 2 3

0:6 0:4 0 L w b pb ln (0:4)

4 0:4 6 b 7 4

0:6 0 5 4 K 5= rb pb ln (0:4) 5 (444)

0:4 0:4 1 b

Y 0

2 3 2 3 12 3

Lb 0:6 0:4 0 b pb ln (0:4)

w

6 b 7 4

4 K 5= 0:4 0:6 0 5 4 rb pb ln (0:4) 5 (445)

Yb 0:4 0:4 1 0

rb pb ln (0:6) 0:6 0 0:4 rb pb ln (0:4) 0

b= 0 0:4 1 b = 0:4 0 1

L 0:2 ;K 0:2 ;

0:6 0:4 wb pb ln (0:4)

0:4 0:6 rb pb ln (0:4)

0:4 0:4 0

Yb = 0:2

Insert these functions into the pro…t function to get the value function as:

Applying the envelop theorem (Hotelling’s Lemma):

@ @=

= = y(r; w; p) (447)

@p @p

@ @=

= = L(r; w; p) (448)

@w @w

@ @=

= = K(r; w; p) (449)

@r @r

69

3.4 Consumer and producer surplus

P d = 25 Q2 (450)

P s = 1 + 2Q (451)

Demand supply balance

25 Q2 = 1 + 2Q (452)

Q2 + 2Q 24 = 0 (453)

Q2 + 6Q 4Q 24 = Q (Q + 6) 4 (Q + 6) = 0 (454)

Either Q = 6 or Q = 4

P = 25 Q2 = 25 42 = 9

Consumer surplus

Z 4 4

Q3

CS = 25 Q2 dQ PQ = 25Q PQ

0 3 0

64 128

= 100 36 = = 42:7 (455)

3 3

Producer surplus

Z 4

4

PS = PQ (1 + 2Q) dQ = P Q ((1 + 2Q) dQj0

0

4

2Q2 32

= PQ Q = 36 4 = 36 20 = 16 (456)

2 0 2

Marshall Alfred (1893) Consumer’s, Annals of the American Academy of Political and Social

Science, 3, 90-93

3.4.1 Pro…t

Estimating a revenue, cost and pro…t functions of a certain corporation:

Revenue:

R = aQ bQ2 (457)

Cost:

Pro…t:

70

=R C = (a f) Q (b + e) Q2 dQ3 845 (459)

Now get the data on Q, R, C then parameters a; b; c; d; e; f can be estimated using econometric

techniques. Calculate them and put them in a diagram. This model can be applied then to estimate

or predict pro…ts.

Bloom N., R. Sadun and J. van Reenen (2012) The organization of …rms across countries,

Quarterly Journal of Economics 127 (4), 1663–1705.

Linear programming is a process of …nding the optimal solution in a problem where both the ob-

jective function and constraints are linear. A simplex algorithm explains this optimisation process.

Linear programming are used frequently to solve large scale optimisation problems both in the pri-

vate and the public sectors of the economy. Leif Johansen (1960) had solved the general equilibrium

of an economy using this approach. Articles of Chipman (1953), Dorfman (1953) , Dorfman, Samuel-

son and Solow (1958),Williams (1965), Frieze (1982), Samet and Zemel (1984), Hill (1990),Todd

(1991), GAMS (1995), Ryan (2000), Robinson (1975), Harker and Pang (1990), Rutherford (1995),

Dirkse and Ferris (1996), Ferris and Pang (1997) have signi…cantly contributed in advancing the

theory of linear programming. These also explained in popular texts such as Lancaster (1968), Chi-

ang (1984), Hoy, Livernois, McKenna, Rees and Stengos (2001), Sydsaeter, Hammond, Seierstad

and Strom (2008). Simple versions of these also can be solved using solvers in the excel routines.

Larger problems require speci…c software such as GAMS or MATLAB.

Let us consider a revenue maximisation problem of a …rm that is subject to labour and capital

input constraint as:

Subject to

X1 + 4X2 100 (461)

4X1 + 2X2 200 (462)

where X1 0 and X2 0;

R X1 X2 S1 S2 Constant Ratios

Row0 1 -2 -5 0 0 0

Row1 0 1 4 1 0 100 25

Row2 0 2 1 0 1 200 100

Basic feasible solution R X1 X2 S1 S2 = 125 0 25 0 75

Basic feasible solution R X1 X2 S1 S2 = 157.1 42.9 14.3 0 0

71

Table 9: Simplex Table 2

R X1 X2 S1 S2 Constant Ratios

Row0 1 -0.75 0 1.25 0 125

Row1 0 0.25 1 0.25 0 25

Row2 0 7/4 0 -1/4 1 75

R X1 X2 S1 S2 Constant

Row0 1 0 0 1.14 0.21 157.14

Row1 0 0 1 0.22 -0.14 14.3

Row2 0 1 0 -0.14 4/7 42.86

Subject to

X1 + 4X2 100 (464)

3X1 + X2 150 (465)

where X1 0 and X2 0;

Subject to

10X1 + 4X2 20 (467)

5X1 + 5X2 1500 (468)

2X1 + 6X2 12 (469)

where X1 0 and X2 0

What are the optimal values of X1 and X2 ? Can you simplify this model?

Solve this model using routines in Excel.

Q3 Solve the following linear programming problem using a simplex method. What are the

optimal value of R; X1 and X2 ?

Subject to

25X1 + 10X2 1000 (471)

20X1 + 50X2 1500 (472)

where X1 0 and X2 0;

72

Table 11: Simplex Table 1

R X1 X2 S1 S2 Constant Ratios

Row0 1 -10 -5 0 0 0

Row1 0 25 10 1 0 1000 40

Row2 0 20 50 0 1 1500 75

R X1 X2 S1 S2 Constant Ratios

Row0 1 0 -1 2/5 0 400

Row1 0 1 2/5 1/25 0 40 100

Row2 0 0 42 -4/5 1 700 16.7

Write the dual of the above problem. Show that optimal solution of dual is equivalent to optimal

solution of the primal problem.

Show that LP problem given above is a special case of non-linear problem.

Linear Programming: Simplex Algorithm for Maximisation

Basic feasible solution R X1 X2 S1 S2 = 0 0 0 1000 1500

Basic feasible solution R X1 X2 S1 S2 = 400 40 0 0 700

R X1 X2 S1 S2 Constant

Row0 1 0 0 8/21 1/42 17500/42

Row1 0 1 0 1/25 -1/105 700/21

Row2 0 0 1 -2/105 1/42 700/42

R X1 X2 S1 S2 = 416.7 33.3 16.7 0 0

Every maximisation problem has corresponding minimisation problem. The revenue maximisation

problem above has equivalent to the cost minimisation problem.

Primal

max R = 10X1 + 5X2 (473)

Subject to

25 10 X1 1000

; X1 0; X2 0 (474)

20 50 X2 1500

This is equivalent to minimising the cost

M in C = 1000Y1 + 1500Y2 (475)

subject to:

25 20 Y1 10

; Y1 0; Y2 0 (476)

10 50 Y2 5

73

Fundamental Theorems of Duality in Linear Programming: Two fundamental theorems

of duality:

(1) Optimal values of the primal and the dual objective functions are always identical, provided

that optimal feasible solution does exist.

(2) If a certain choice variable in a linear programme is optimally nonzero then the corresponding

dummy variable should be equal to zero. Similarly if a certain choice variable in a linear programme

is optimally zero then the corresponding dummy variable in the linear programme should be non-

zero.

Chiang A.C. (1984) Fundamental Methods of Mathematical Economics, 3rd edition, McGraw

Hill.

Chipman J (1953) Linear Programming , Review of Economics and Statistics, 35, 2, 101-117

Dirkse S.P. and M. C. Ferris (1996) A pathsearch damped Newton method for computing

general equilibria. Annals of Operations Research, pages 211–232, 1996.

Dorfman R (1953) Mathematical, or "Linear," Programming: A Nonmathematical Exposi-

tion,American Economic Review, 43, 5, 797-825

Ferris M. C. and J. S. Pang (1997) Engineering and economic applications of complementarity

problems. SIAM Review,39:669–713.

Frieze A. M. (1982) Algebraic Linear Programmin, Mathematics of Operations Research, 7,

2 , 172-182

Harker P. T. and J. S. Pang (1990) Finite–dimensional variational inequality and nonlinear

complementarity problems: A survey of theory, algorithms and applications. Mathematical

Programming, 48:161–220.

Hill D. R (1990) A Tool for Teaching Linear Programming within MATLABA, College Math-

ematics Journal, 21, 1, 55-56

Morton G (1951) Notes on Linear Programming, Economica, New Series, 18, 72, 397-411

Robinson S.M.(1975), ”A quadratically-convergent algorithm for general nonlinear program-

ming problems”, Mathematical Programming Study 3.

Rutherford T. F. (1995) Extensions of GAMS for complementarity problems arising in applied

economic analysis. Journal of Economic Dynamics and Control, 19:1299–1324.

Ryan M. (2000) Economies of scale and scope, Manchester School. 68, 6, 701-722.

Samet D, E. Zemel (1984) On the Core and Dual Set of Linear Programming Games Mathe-

matics of Operations Research, 9, 2, 309-316

Solow R (1952) On the Structure of Linear Models, Econometrica, 20, 1, 29-46.

Todd M.J. (1991) Probabilistic Models for Linear Programming, Mathematics of Operations

Research, 16, 4, 671-693

74

Williams A. C. (1965) On Stochastic Linear Programming, Journal of the Society for Industrial

and Applied Mathematics, 13, 4 927-940

Texts:

Chiang A.C. (1984) Fundamental Methods of Mathematical Economics, 3rd edition, McGraw

Hill.

Dorfman R., P.A. Samuelson and R. Solow (1958) Linear Programming and Economic Analy-

sis, Macmillan, 1958

Hoy M., J. Livernois, C McKenna, R. Rees and T Stengos (2001) Mathematics for Economics,

MIT Press

Lancaster Kevin (1968) Mathematical Economics, McGraw-Hill.

Sydsaeter Knut, P. Hammond, A. Seierstad and A. Strom (2008) Further mathematics for

economic analysis, Prentice Hall

On the supply side the gross output by sectors, re‡ect the cost of production that is divided into

intermediate inputs, value added, tax and import components. On the demand side, each sector

sells its product for intermediate use by itself and by other sectors and for …nal demand. Consistency

requires equality between supply and demand for each sector. The sum of labour income, capital

income, and production taxes should equal …nal demand of households for consumption, of producers

for investment, of government for public spending and of the Rest of the World Sector (ROW) for

net exports. Stone (1942-43).

A balanced and consistent input-output table provides the basis for assessment of economic

policies taking account of entire structure of an economy. It also provides benchmark data for

a general equilibrium model. This section shows a procedure to construct such an input-output

table based on existing data on per capita GDP, level of employment and output and their sectoral

compositions from the national or regional statistical o¢ ces with some production and demand side

coe¢ cients trusted sources. It is expected that a detailed survey could be conducted to gather nec-

essary information on the cost of production of …rms and the patterns of expenditure of households,

investment structure of …rms, net exports from the Rest of the World sector and the spending of

the government sector. (see exercise below).

Structure of an input-output table (snap-shot of the economy for a given time)

IO F

(477)

VA T rasf ers

here IO stands for input output relations among sectors, V A is primary such as labour and

capital, F is …nal demand and transfer represent such as bene…ts, remittances or invisible other

incomes.

75

Table 14: Leontief Coe¢ cients

Intermediate demand Final Demand Total

X1 X2 F Y

X1 10 20 70 100

X2 30 20 150 200

Labour input 40 50 90

Capital intput 20 110 130

Total 100 200 220

Intermediate demand

X1 X2

X1 0.1 0.1

X2 0.3 0.1

Labour input 0.4 0.25

Capital intput 0.2 0.55

Total 1.0 1.0

Leontief coe¢ cients

Input-Output Model: Structural Equations

a11 = ; a12 = ;a = ; a22 = ; (480)

X1 X2 21 X1 X2

Input-Output Model

(1 a11 ) a12 X1 F1

= (485)

a21 (1 a22 ) X2 F2

76

1

X1 (1 a11 ) a12 F1

= (486)

X2 a21 (1 a22 ) F2

1

X = (I A) F (487)

Solution of the input - output model by Cramer’s Rule

(1 a11 ) a12

jAj = = 1 a1;1 1 a2;2 a21 a12 (488)

a21 (1 a22 )

F1 a12

F2 (1 a22 ) F1 (1 a22 ) + a12 F2

X1 = = (489)

(1 a11 ) a12 1 a1;1 1 a2;2 a21 a12

a21 (1 a22 )

(1 a11 ) F1

a21 F2 F2 (1 a11 ) + a21 F1

X2 = = (490)

(1 a11 ) a12 1 a1;1 1 a2;2 a21 a12

a21 (1 a22 )

1

X1 (1 0:1) 0:1 70

= (491)

X2 0:3 (1 0:1) 150

70 0:1

150 0:9 63 + 15 78

X1 = = = = 100 (492)

0:9 0:1 0:81 0:03 0:78

0:3 0:9

0:9 70

0:3 150 135 + 21 156

X2 = = = = 200 (493)

0:9 0:1 0:81 0:03 0:78

0:3 0:9

Solutions reproduce the benchmark data. Model is calibrated.

Solving the Input-Output Model by Matrix Inverse

1

X = (I A) F (494)

1

1 0:9 0:1 1

(I A) = = adj (I A) (495)

0:3 0:9 jI Aj

adj (I A) = C 0 (496)

For C cofactor matrix. For this cross the row and column corresponding to an element and

multiply by ( 1)i+j

77

j1 a22 j ja21 j 0:9 0:3

C= = (497)

ja12 j j1 a11 j 0:1 0:9

0

C = = (498)

0:1 0:9 0:3 0:9

Inverse of A

Inverse of the Leontief technology matrix is the major elesment of the Input-Output model

1

(I A) =

1 1 a22 a12

=

1 a1;1 1 a2;2 a21 a12 a21 1 a11

1 0:9 0:1

=

0:81 0:03 0:3 0:9

1 0:9 0:1

0:9 0:1 0:78 0:78

= 0:3 0:9

0:78 0:3 0:9 0:78 0:78

1 1 0:9 0:1 70

X = (I A) F = (499)

0:78 0:3 0:9 150

Inverse of A

1 1 0:9 0:1 70

X = (I A) F =

0:78 0:3 0:9 150

1 63 + 15 1 78 100

= = = (500)

0:78 21 + 135 0:78 156 200

Model is calibrated.

1

X1 (1 a11 ) a12 F1

= (501)

X2 a21 (1 a22 ) F2

1

X = (I A) F (502)

If the …nal demand of sector X1 changes by 15 percent

=

X2 0:78 0:3 0:9 150 0

1 0:9 0:1 10:05

=

0:78 0:3 0:9 0

X1 1 9:45 12:11

= = (503)

X2 0:78 3:15 4:03

78

A 15 pecent change in the …nal demand of sector will change gross output of both sector.

change in capital and labour demand could be found out by using the capital and labour

coe¢ cients.

Backward and forward linkages cause this to happen.

Real world input- output model can be easily computed using Matrix routines in Excel.

There is a signi…cant body of literature literature on the input output analysis including those

by Leontief (1949), Stone (1961), Pyatt and Round (1979), Piggott and Whalley (1985) , Deardor¤

and Stern (1995), Bhattarai and Whalley (2000), Thijs ten Raa (2005), Bhattarai (2007), Turner,

Gilmartin, McGregor, and Swales (2012), Economic System Research (Input-Output Association),

Minx, Wiedmann, Wood, Peters, Lenzen, Owen, Scott, Barrett, Hubacek, Baiocchi, Paul, Dawkins,

Briggs, Guan, Suh and Ackerman (2009), Dietzenbacher, Bart Losa, Stehrer,Timmera and De Vries

(2013). For instance see the input output table of the UK for 2009, Constructed from the O¢ ce

of National Statistics, UK.

agri P ro d C onstr D ist In fco m F in n s R le st P rfsp p G h lth e d O thrsrv

P ro d 7256 289576 35007 66800 13040 6002 622 11790 71029 6674

C onstr 426 4722 57324 13139 1639 4300 9765 2075 6725 784

D ist 974 17089 3467 60804 4062 13401 696 9064 14481 1855

In fco m 227 6245 1444 18376 15795 13174 1261 9884 9890 3483

F in in s 863 14741 4369 11293 2729 20750 44549 5918 6781 1233

R le st 139 1558 1980 15065 1157 3938 1139 1723 5356 723

P rfsp p 790 25019 16794 43919 19727 26786 4538 76723 33101 12561

G h lth e d 32 2502 1511 5298 1107 2560 3370 9068 48167 782

Bhattarai K. (2007) Economic Models of Hull and Humber Region, Atlantic Economic Jour-

nal, 35:473-490 December.

Deardor¤ A.V. and R. M. Stern (1995) Input-output technologies and the e¤ects of tari¤

reductions Journal of Policy Modeling, 7, 2, 253-279

Dietzenbacher E, Bart Losa, R Stehrer, M. Timmera And G. De Vries (2013) The Construction

Ofworld Input–Output Tables In The Wiod Project, Economic Systems Research, 25,1, 71–98

Leontief, W. (1949) Structural Matrices of National Economy, Econometrica, 17: 273-282,

Suppl.

79

Table 17: Benchmark production tax rate, prices income and demand by sectors

Wages C a p ita l C ons Inv G ov Exp Im p P rtxsb C aptax L abtax

Piggott, J. and J.Whalley (1985) UK Tax Policy and Applied General Equilibrium Analysis,

Cambridge University Press.

Minx J.C., T. Wiedmann, R. Wood, G.P. Peters, M. Lenzen, A. Owen, K. Scott, J. Barrett,

K. Hubacek, G. Baiocchi, A. Paul, E. Dawkins, J. Briggs, D. Guan, S. Suh And F. Acker-

man (2009) Input–Output Analysis And Carbon Footprinting: An Overview Of Applications

Economic Systems Research, 21(3), 187–216

O¢ ce for National Statistics (ONS (2013)) Input Output: Tables for the United Kingdom,

HMSO, London; Supply and Use Tables.

O¢ ce for National Statistics (ONS (1995)) Input Output: Tables for the United Kingdom,

HMSO, London.

Stone Richard (1942-43) National Income in the United Kingdom and the United States of

America, American Economic Review, 10(1): 1-27.

Thijs ten Raa. (2005)The economics of input-output analysis Cambridge : Cambridge Uni-

versity Press

Turner, K., Gilmartin, M., McGregor, P. G. and Swales, J. K. (2012), An integrated IO and

CGE approach to analysing changes in environmental trade balances. Papers in Regional

Science, 91: 161–180

OECD IO database: http://stats.oecd.org/index.aspx; www.mpsge.org.

Input Output Model

80

X1 = X1;1 + X1;2 + ::::: + X1;n + C1 + I1 + G1 + N X1 (504)

::::::: (506)

Employment, capital and tax:

L = L1 + L2 + ::::: + Ln (508)

K = K1 + K2 + ::::: + Kn (509)

T = T1 + T2 + ::::: + Tn (510)

The …nal demand can be written as Fi = Ci + Ii + Gi + N Xi

1. (a) Develop an input-output model to …nd impacts on output of changes in net exports N Xi

by percent.

(b) What is the impact on employment of an increase in public spending by percent?

(c) What is the impact on capital stock of an increase in consumption spending by percent?

(d) Comment how this model can be employed for manpower planning?

(e) What is the major shortcoming of this model.

2 GDP per capita in an economy is 11850 and population 243589. Employment and output

share were as given below.

Employment share Output share

Agriculture 0.01% 0.10%

Energy 0.60% 1.30%

Manufacturing 20.70% 28.20%

Construction 4.10% 4.30%

Distribution 24.30% 17.00%

Transports 5.40% 9.70%

Banking and Finance 12.60% 12.40%

Public administration 27.40% 23.50%

Other Services 4.90% 3.40%

1.Take the total employment and output and sectoral composition of these employments and

output from the existing data.

81

2. Split the total output in labour and capital income using employment and income per

capita information. Sectoral employment is obtained by multiplying the sectoral share by total

employment. Then sectoral labour income is obtained by multiplying the sectoral employment

by the gross value added per worker. Sectoral output is obtained by multiplying the sectoral

share of output by total output. Capital income is the di¤erence between total output and

the labour income.

Study the input-output coe¢ cients and the …nal demand components included in Excel

spreadsheet as following

Agric Enrwtr Manu Const Distb Trans Busi Edupub OthSect

Agric 0.0865829 0.000604 0.03517731 4.7392E-05 0.003639 0.000487 5.68E-05 0 0.000832

Enrwtr 0.0008262 0.120376 0.01664546 0.00475107 0.000677 0.000173 3.03E-05 0.13229 0.000321

Manu 0.2033625 0.068337 0.20228767 0.1527452 0.102854 0.083622 0.043803 0.040461 0.056192

const 0.0071051 0.00526 0.00063624 0.24981636 0.003891 0.001532 0.022375 0 0.000821

Distb 0.0415152 0.017505 0.03754367 0.01624369 0.026867 0.025066 0.008611 0.008509 0.004443

Trans 0.0101206 0.044796 0.02760104 0.01050923 0.09595 0.158739 0.065376 0.004386 0.017857

Busi 0.0805106 0.049237 0.0737451 0.12420322 0.14469 0.125707 0.249916 0.045159 0.075562

Edupub 0.0115251 0.006898 0.0196062 0.00322267 0.007749 0.008697 0.004566 0.294183 0.003965

OthSect 0.0156147 0.001811 0.01246805 0.00286723 0.006459 0.013893 0.015504 0.004291 0.043622

con inv gov exp Total

0.77223178 0.000115 0.004819 0.222834 1

0.04078441 0.00012 0.005654 0.953441 1

0.21958636 0.097767 0.04372 0.638926 1

0.92186707 5.64E-05 0.074581 0.003495 1

0.06289297 0.858263 0.078844 0 1

0.86389737 0.020094 0.00955 0.106459 1

0.55810333 0.022052 0.07465 0.345195 1

0.72730468 0.078453 0.078222 0.11602 1

0.27582045 6.32E-06 0.695715 0.028458 1

The input-output coe¢ cients of this economy can be approximated by the national input-

output coe¢ cients as above. Decompose this …nal demand into consumption, investment,

government consumption and export components again based on approximations from the

national input-output table.

Derive tax or imports components as residuals in the supply side - gross output minus inter-

mediate, labour and capitals costs altogether.

Check consistency that demand should equal supply for each sector in constructed input

output table.

(b) What is the impact on capital stock of an increase in consumption spending by 20

percent?

82

(c) GAMS programme: Humber.gms

Bhattarai K. (2007) Economic Models of Hull and Humber Region, Atlantic Economic Jour-

nal, 35:473-490 December.

Leontief, W. (1949) Structural Matrices of National Economy, Econometrica, 17: 273-282,

Suppl.

Piggott, J. and J.Whalley (1985) UK Tax Policy and Applied General Equilibrium Analysis,

Cambridge University Press.

O¢ ce for National Statistics (ONS (1995)) Input Output: Tables for the United Kingdom,

HMSO, London.

Thijs ten Raa. (2005)The economics of input-output analysis Cambridge : Cambridge Uni-

versity Press

OECD IO database: http://stats.oecd.org/index.aspx

4.1 De…nition

Markets bring consumers and producers together in determining the relative prices in which com-

modities are bought and sold. Demand functions derived from the utility maximisation by con-

sumers and supply functions derived from the pro…t maximisation by producers interact in de-

termining prices. When all markets clear simultaneously allocations become Pareto e¢ cient and

ful…l the …rst and second theorems of the welfare economics; 1) every competitive equilibrium is

Pareto optimal 2) every Pareto optimal allocation is consistent to competitive equilibrium alloca-

tion. E¢ cient markets are good for the social welfare by the …rst theorem and benevolent dictators

maximise social welfare in the second theorem. Marshall (1890), Pigou (1932), Hicks (1939), Shoven

and Whalley (1984), Dawes and Thaler (1988), Jarrell, Brickley and Netter (1988), Elster (1989),

Simon (1991), North (1991), Katz and Shapiro (1994), Markusen (1995), and Porter and van der

Linde (1995) provide general introduction to markets. This section focuses on partial equilibrium

and general equilibrium will be discussed in the next section.

Let I = (1; 2; ::::::; I) be index set of consumers and market demand is sum of their individual

demand; P is prices of other commodities.

X

q d (p) = q i (p; P; y) (511)

i2J

Let J = (1; 2; ::::::; J) be index set of suppliers and market supply is sum of their supplies

X

q s (p) = q j (p; P; y) (512)

j2J

Partial equilibrium is given by the price of the this commodity that clears this market holding

everything else constant

q d (p ) = q s (p ) (513)

GAMS programme: demand_supply_2.gms

83

Exercise Consider market for two interrelated goods with following demand and supply functions

with price elasticity parameters aij and income elasticity parameter bi :

Linearise the above market system taking log both sides

solve for equilibrium prices p1 and p2 and q1 and q2

(a11 n1 ) a12 p1 m1 b1 y k1

= (520)

a21 (a22 n2 ) p2 m2 b2 y k2

1

p1 (a11 n1 ) a12 m1 b1 y k1

= (521)

p2 a21 (a22 n2 ) m2 b2 y k2

By Cramer’s rule the solution of this system is:

m1 b1 y k1 a12

m2 b2 y k2 (a22 n2 )

p1 =

(a11 n1 ) a12

a21 (a22 n2 )

(m1 b1 y k1 ) (a22 n2 ) a12 (m2 b2 y k2 )

= (522)

(a11 n1 ) (a22 n2 ) a12 a21

(a11 n1 ) m1 b1 y k1

a21 m2 b2 y k2

p2 =

( a11 + n1 ) a12

a21 (a22 n2 )

(m2 b2 y k2 ) (a11 n1 ) a21 (m1 b1 y k1 )

= (523)

(a11 n1 ) (a22 n2 ) a12 a21

Here coe¢ cients a11 and a22 are larger than a12 and a21 therefore the numerator is positive.

Equilibrium quantities can easily be derived substitution equilibrium prices in the supply equa-

tions

84

(m1 b1 y k1 ) (a22 n2 ) a12 (m2 b2 y k2 )

q1 = m1 + n1 p1 = m1 + n1 (524)

( a11 + n1 ) (a22 n2 ) a12 a21

q2 = m2 + n2 p2 = m2 + n2 (525)

( a11 + n1 ) (a22 n2 ) a12 a21

Impact of change in elasticities on prices can easily be computed from this.

What are the impacts of changes in tax on prices

Consider increase in VAT in good 1 which chages price of commodity 1 to P1 (1 + t1 ). Determine

the impact on p1 and p2 and q1 and q2 :

solve for equilibrium prices p1 and p2 and q1 and q2

= (528)

a21 (a22 n2 ) p2 m2 a21 ln (1 + t1 ) b2 y k2

1

p1 ( a11 + n1 ) a12 m1 a11 ln (1 + t1 ) b1 y k1

= (529)

p2 a21 (a22 n2 ) m2 a21 ln (1 + t1 ) b2 y k2

By Cramer’s rule the solution of this system is:

m1 a11 ln (1 + t1 ) b1 y k1 a12

m2 a21 ln (1 + t1 ) b2 y k2 (a22 n2 )

p1 =

( a11 + n1 ) a12

a21 (a22 n2 )

(m1 a11 ln (1 + t1 ) b1 y k1 ) (a22 n2 ) a12 (m2 a21 ln (1 + t1 ) b2 y k2 )

= (530)

( a11 + n1 ) (a22 n2 ) a12 a21

( a11 + n1 ) m1 a11 ln (1 + t1 ) b1 y k1

a21 m2 a21 ln (1 + t1 ) b2 y k2

p2 =

( a11 + n1 ) a12

a21 (a22 n2 )

(m2 a21 ln (1 + t1 ) b2 y k2 ) ( a11 + n1 ) a21 (m1 a11 ln (1 + t1 ) b1 y k1 )

= (531)

( a11 + n1 ) (a22 n2 ) a12 a21

q1 = m1 +n1 p1 = m1 +n1 (1 + t1 )

( a11 + n1 ) (a22 n2 ) a12 a21

(532)

85

(m2 a21 ln (1 + t1 ) b2 y k2 ) ( a11 + n1 ) a21 (m1 a11 ln (1 + t1 ) b1 y k1 )

q2 = m2 +n2 p2 = m2 +n2 (1 + t1 )

( a11 + n1 ) (a22 n2 ) a12 a21

(533)

What values of b1 and b2 imply normal, inferior or superior goods; what signs of aij imply

substitute or complements?

If the producer of good 1 is taxed instead they receive P1 (1 t1 ). This system could be solved

accordingly.

Q1. Derive the short run pro…t function for a …rm under the perfect competition

= PY wL rK (534)

Y =L K (535)

Here is pro…t, L labour supply, K capital, w wage rate, P price of good, Y output . For

simplicity assume capital is …xed at K. Technology operates under the constant returns to

scale + = 1:

(b) What are the price and output of this …rm in the short run. Prove that …rm earns

positive pro…t in the short run taking = 0:5; w = 4; r = 1; k = 1:

(c) Now assume that the market demand is given by p = 39 0:009q and the pro…t function

is given by = p2 2p 399: Find output, market demand and the number of …rms in

the long run ( = 0)

(d) Why is the number of …rms indeterminate in the perfect competition?

D = 150 3P (536)

S = 30 + 2P (537)

Equilibrium D =S implies P=24 and Q = 78.

Now there is tax in commodity so that consumers pay more and suppliers get less.

PD = PS + t (538)

where t is tax imposed per unit. Let t = 2.

86

D = 150 3P D = 150 3 PS + 2 (539)

Burden of Taxes in Partial Equilibrium Analysis (it depends on elasticities)

S = 30 + 2P S (541)

D S

P = 24:8 P = 22:8 Q= 75.6

Deadweight loss of taxes =loss of consumer surplus+loss of producer surplus=

= 0.5(0.8 2:4) + 0:5 (1:2 2:4) = 0:96 + 1:44 = 2:4

Elasticity of demand = -3 24

78 = 0:92 Elasticity of supply = 2 24

78 = 0:61 . Thus more burden

is taken by producers.

General equilibrium impacts are much di¤erent than the partial equilibrium impacts. General

equilibrium tax model is discussed in the next section. Bigger models are solved in GAMS.

Bhattarai K. and J. Whalley (1999) "The role of labour demand elasticities in tax incidence

analysis with heterogenous labour", Empirical Economics, 24:4:.599-620.

Marshall Alfred (1893) Consumer’s,Annals of the American Academy of Political and Social

Science, 3, 90-93

Sonnenschein Hugo (1968) The Dual of Duopoly Is Complementary Monopoly: or, Two of

Cournot’s Theories Are One Journal of Political Economy,76, 2, 316-318

Sonnenschein H. (1982) Price Dynamics Based on the Adjustment of Firms, American Eco-

nomic Review, 72, 5, 1088-1096

Tirole J. (2006) The Theory of Corporate Finance, Oxford: Princeton University Press.

Tirole J. (1995) The Theory of Industrial Organization, MIT Press.

Market demand function where two …rms produce q1 ; q2 levels of output and sell them at the market

price P as:

P = 30 q1 q2 (542)

Cost function

Ci = 6qi (543)

Pro…t:

i = P qi Ci (544)

87

Cournot set up Pro…t of …rm 1

Reaction functions:

@ 1 q2

= 0 ) 2q1 + q2 = 24 =) q1 = 12 (547)

@q1 2

@ 2 q1

= 0 ) q1 + 2q2 = 24 =) q2 = 12 (548)

@q2 2

Cournot solution is symmetric

q1 = q2 = 8 (549)

P = 30 8 8 = 14 (550)

1 = 2 = 64 (551)

1

CS1 = CS2 = 16 8 = 64 (552)

2

Total welfare under duopoly

When the Firm 1 is the leader and …rm 2 is the follower. Leader incorporates follower reaction

function into its pro…t function.

q1 1 2

= 30q1 q12 q1 12 6q1 = 12q1 q (554)

2 2 1

@ 1

= 0 ) q1 = 12 (555)

@q1

q1

q2 = 12 =6 (556)

2

P = 30 q1 q2 = 30 12 6 = 12 (557)

88

1 = P q1 6q1 = 12 12 6 12 = 72 (558)

2 = P q2 6q2 = 12 6 6 6 = 36 (559)

Consumer surpluses from both …rms

1

CS1 = 18 12 = 108 (560)

2

1

CS2 = 18 6 = 54 (561)

2

Total welfare under price leadership

@

= 24 2Q = 0 =) Q = 12 (564)

@Q

P = 30 Q = 30 12 = 18 (565)

Industry pro…t

= PQ C = 18 12 6 12 = 144 (566)

If both …rm are equally strong they will share output and pro…ts in half. q1 = q2 = 6 and

1 = 2 = 72

Welfare under cartel

1

CS1 = 12 6 = 36 (567)

2

1

CS2 = 12 6 = 36 (568)

2

Under the perfect competition P = MC =6; Q=30-6=24 for each …rm. Number of …rms is

indeterminate but assume only there were two …rms. Each will supply 24 and generate consumer

surplus 288. Total welfare would be 576, about 2.25 times higher than in the monopoly. Actual

welfare gain can be a lot more than this if more …rms operate in the market. This is the argument

for regulating monopolies and liberalising the market. Consumers can buy goods at lower prices

and can have a big consumer surplus under the competitive markets compared to those under the

monopolies.

89

Table 19: Cournot, Stackleberg and Cartel: Comparison

Cournot Stakleberg Cartel Perfect Competition

P 14 12 18 6

q1 8 12 6 24

q2 8 6 6 24

1 64 72 72 0

2 64 36 72 0

CS1 64 36 72 288

CS2 64 108 36 288

C1 48 72 36 144

C2 46 36 36 144

TW 256 270 216 576

Two questions are important in monopolistic competion: 1) how much does each …rm produce? 2)

How many …rms exist in the market?

Consumer likes to consume varieties of products qi :

X 1

max u = u q0 ; qi (570)

X

q0 + pi qi I (571)

First order conditions qi

X 1

1

1

u1 pi = u2 qi qi (572)

1

1

qi = k:pi ; k>0 (573)

Demand elasticity:

@qi pi 1

= = (574)

qi @pi 1

Producer’s problem with c as marginal cost and f as …xed cost:

pi

1 c

pi 1 = c; pi = (576)

Less substitutable the product (smaller ) higher the product price (pi ) .

90

c

All …rms produce the same quantity qi = q; c q=f

f

q= (577)

c1

Thus level of output is higher with lower marginal cost. If perfectly substitutable ( = 1) the

level of output is in…nite. If nosubstitutable at all ( 0) no variety is produced.

How many …rms exist in the market?

Put this solution in the consumers’optimality condition.

c X 1

1

1 1

1 u1 c 1

1

u1 = u2 qi qi = u2 (nq ) q ; n= (578)

u2

u1

Now n can be determined by marginal utility ratio u2 and c and . See more in Tirole (1995 ,

ch. 7).

Perfect competitions and monopolies are two extreme possibilties of market conditions. Actual

markets have elements of both of these. Ever sicne Chamberlin (1933) developed this concept in his

book “Theory of Monopolistic Competition”, this type of market has been very popular in economic

analysis. The literature on brand loyalty and product di¤erentiation characterise the main form

of the monopolistic competition. There are plenty of examples in the market; for instance: ipod,

CD, DVD, diskettes PCs in information technology induestry. There varieties of product in the soft

drinks market such as Coke, Pepsi, Fanta, Tango, Sprite, 7 Up, Dr. Pepper or think of brands of

cars such as BMW, Voxhaul, Poeguet, Chrisler, Ford, GM, Toyota, Nissan, Hyundai, Fiat or the

Cosmetics, Shoes ,Watches, Camera, Fast food,Yoghurt, Aspirins,Pens, or books in microeconomics

or macroeconomics. After Chamberlin (1933) authors like Sweezy (1939), Hall and Hitch (1939),

Stigler (1947, 1948), Peck (1961), Osborne (1974), Reid (1981), Maskin and Tirole (1988), Bhaskar

(1988) have contributed signi…cantly in developing the theory of monopolistic competition.

Similar to …rm under the monopoly a …rm in the monopolistic compition has its own downward

sloping demand and so has some monopolistic power in pricing. It faces competition from …rms

producing close substitutes. If it charges higher prices it loses markets to other producers. Free

entry implies zero pro…t for the incumbent …rms. Firms do not produce at the most e¢ cient

point. Therefore ther producce at less e¢ cient point than …rms in perfectly competitive markets.

A number of authors including Sweezy (1939) have developed the concepts of kink in demand to

explain such behaviour. It is called a model of price and quantity rigidity. If a …rm reduces its own

price rival …rms will reduce it, when it raises its own price none of the others will raise their prices.

A …rm reduces its own price when another …rm reduces it but does not raise its own price when

another raise their prices. In general a …rm is reluctant to change its own price as it does not want

to stir and disturb the other …rms in the market by sending wrong signals. Both price and quantity

are …xed. This kind of behaviour also occurs in the factor markets particularly in labour markets.

Prices (P ) and quantities (X) are …xed, …rms do not follow M R = M C principle.

Price and revenue:

P = a X; R = P X = aX X 2 (579)

Average cost:

91

AC = 20 2X + 0:1X 2 (580)

Total cost:

Marginal revenue (MR):

@R

=a 2X (582)

@X

Marginal cost (MC)

@T C

= 20 4X + 0:3X 2 (583)

@X

Two conditions required in the monopolistic competition 1) MR = MC and 2) AR =AC

MR = MC implies

AR =AC implies

From both of these equations

Now price can be determined

There are two …rms in a market, I and II. The marked demand and cost functions faced by each is

as following

P2 = 35 q1 q2 ; C2 = q22 (590)

When …rm I raises price …rm II does not raise its price and gets more pro…t by supplying more

but charging the same price. When …rm I reduces price …rm II also reduces price and produces

same as before but gets less pro…t.

The base line Cournot duopoly equilibrium:

92

2 = P2 q 2 C2 = (35 q1 q2 ) q2 q22 = 35q2 q1 q2 2q22 (592)

Reaction functions

@ 1

= 0 ) 105 q2 14q1 = 0 =) 14q1 + q2 = 105 (593)

@q1

@ 2

= 0 ) 35 q1 4q2 = 0 =) q1 + 4q2 = 35 (594)

@q2

Solving two reaction functions

q1 + 4q2 = 35 (596)

385

55q1 = 385 =) q1 = = 7; q2 = 7 (597)

55

P2 = 35 q1 q2 = 35 7 7 = 21 (599)

C2 = q22 = 72 = 49 (601)

2 = P2 q2 C2 = 21 7 72 = 147 49 = 98 (603)

Now consider that …rm I raises its price by 2 but the …rm II does not react.

P1 = 84 + 2 = 86 but P2 = 21

First get the reaction function of …rm II that does not change its price, i.e. or

P2 = 35 q1 q2 = 21 =) q2 = 14 q1

Use this reaction function of II into the price function of I to get output of …rm I.

P1 = 105 2q1 q2 = 105 2q1 (14 q1 ) =) 86 = 91 q1 =) q1 = 5

Using II’s reaction function

q2 = 14 q1 = 14 5=9 (604)

93

C1 = 5q12 = 5 52 = 125 (607)

C2 = q22 = 92 = 81 (608)

If the duopolist I reduces price by 2 the …rm II will also follow the suit.

P1 = 84 2 = 82 but P2 = 21 2 = 19

Given above demand functions

Firm I reduces its price by 2 i.e.

Get …rm II’s reaction function from and use this reaction function of II into the price function

of I to get output of …rm I.

P2 = 35 q1 q2 ; =) 19 = 35 9 q2 =) q2 = 7 C2 = q22 (610)

Note …rm II wants to maintain the old level of output by reducing its price

2 = P2 q2 C2 = 19 7 72 = 133 49 = 84 (612)

C2 = q22 = 72 = 49 (614)

Summary of the Monopolistic Competition Model

Baseline Cournot When I raises P1 by 2 When I reduces P1 by 2

P1 84 86 82

P2 21 21 19

q1 7 5 9

q2 7 9 7

1 343 305 333

2 98 108 84

R1 588 430 738

R2 147 189 133

C1 245 125 405

C2 49 81 49

Journal of Industrial Organization Vol. 6, pp. 373-384.

94

Hall, R. and Hitch, C. 1939. "Price Theory and Business Behaviour" Oxford Economic Papers

Vol. 2, pp. 12-45.

Maskin, E. and Tirole, J. 1988. "A Theory of Dynamic Oligopoly, II: Price Competition,

Kinked Demand Curves, and Edgeworth Cycles" Econometrica Vol. 56, pp. 571-599.

Osborne, D. 1974. "A Duopoly Price Game" Economica Vol. 41, pp. 157-175.

Peck, M. 1961. Competition in the Aluminium Industry: 1945-58. Harvard University Press,

Cambridge.

Reid, G. 1981. The Kinked Demand Curve Analysis of Oligopoly: Theory and Evidence.

Edinburgh University Press, Edinburgh.

Stigler, G. 1947. "The Kinky Oligopoly Demand and Rigid Prices" The Journal of Political

Economy Vol. 55, pp. 432-449.

Stigler, G. 1978. "The literature of economics: the case of the kinked oligopoly demand curve"

Economic Inquiry Vol. 16, pp. 185–204.

Sweezy, P. 1939. "Demand Under Conditions of Oligopoly" The Journal of Political Economy

Vol. 47, pp. 568-573.

MR = MC rule leads to negative pro…t under the natural monopoly

Price

P = 100 X; R = P X = 100X X 2 (615)

Average cost

AC = 50 0:125X (616)

Total cost

Marginal revenue (MR)

@R

= 100 2X (618)

@X

Marginal cost (MC)

@T C

= 50 0:25X (619)

@X

MR = MC does not produce e¢ cient quantity

50

100 2X = 50 0:25X =) 1:75X = 50 =) X = = 28:57 (620)

1:75

95

AC = 50 0:125X = 50 0:125 (28:57) = 46:43 (622)

If P = MC natural monopolist will make negative pro…t

50

P = 100 X = 50 0:25X =)=) 0:75X = 50 =) X = = 66:7 (624)

0:75

Two part tari¤ in natural monopoly Let the natural monopolist set price equal to the average

cost but let them allow any loss to be made by second tari¤ to each consumer. P = AC

50

P = 100 X = 50 0:125X =) X = = 58:14 (627)

0:857

(629)

If there are 1000 customers each will pay tari¤ to make up the loss equal to 50.76/1000= 0.05

increase price to them by that margin.

Berg, Sanford; John Tschirhart (1988). Natural Monopoly Regulation: Principles and Prac-

tices. Cambridge University Press.

Baumol, William J.; Panzar, J. C.; Willig, R. D. (1982). Contestable Markets and the Theory

of Industry Structure. New York: Harcourt Brace Jovanovich.

Filippini, Massimo (1998). "Are Municipal Electricity Distribution Utilities Natural Monop-

olies?". Annals of Public and Cooperative Economics 69 (2): 157.

Sharkey, W. (1982). The Theory of Natural Monopoly. Cambridge University Press

96

4.3.1 Bertrand Game of price competition

There are two …rms and the market price is

Firm I is considering three pricing strategies. First P = 10:02 or P = 10:01 or P = 10:

"cut-throat" price competition implies that if …rm I charges 10.02 then …rm II can also set

P = 10:02 or charge less P = 10:01 to get all customers or set P = 10 to drive …rm I out from the

market. If both agree to charge P = 10:02 then

10:02 = 130 (q1 + q2 ) =) (q1 + q2 ) = 130 10:02 = 119:98. Then total pro…t is 0.02 119:98 =

2:3996 and each makes 1.1998.

Similarly if they agree to charge P = 10:01 then 10:01 = 130 (q1 + q2 ) =) (q1 + q2 ) =

130 10:01 = 119:99.Then total pro…t is 0.01 119:98 = 1:1999 and each makes 0.5995.

Instead if both charge P = 10 Then 10:0 = 130 (q1 + q2 ) =) (q1 + q2 ) = 130 10 = 120.

There will zero pro…t; none will make any pro…t. Price war has resulted in perfect competition

outcome. Draw these points in a diagram.

Exercise

If the inverse demand function for a …rm is

P =a qA qB (631)

and the cost of production is

Ci = cqi (632)

Prove that Cournot reaction functions are given by

a c qB

qA = (633)

2

a c qA

qB = (634)

2

a c

qA = (635)

3

a c

qB = (636)

3

a c qA

If …rm A is stackelberg quantity leader and considers …rm B’s reaction function qB = 2 while

making its price and output decisions, prove that

a c

qA = (637)

2

a c

qB = (638)

4

97

Bertrand competition Demand for product of …rm A depends on price it charge and price

charged by the rival …rm B

qA = a PA + bPB (639)

qB = a PB + bPA (640)

Reaction functions

@ A a + bPB + c

= 0 ) (a 2PA + bPB ) + c = 0 =) PA = (643)

@PA 2

@ B a + bPA + c

= 0 ) (a 2PB + bPA ) + c = 0 =) PB = (644)

@PB 2

Salop S and Stiglitz J (1977) Bargains and Ripo¤s: A Model of Monopolistically Competitive

Price Dispersion, Review of Economic Studies, 44, 3, 493–510

Dixon H (1984) The existence of mixed-strtaegy equilibria in a price-setting oligopoly with

convex costs,Economics Letters, 16, 205–212.

Solutions of system of linear di¤erence equations:

a) Distinct and real roots case

yt = C1 r1t + C2 r2t + y (645)

r1 a11 r2 a11

xt = C1 r1t + C2 r2t + x (646)

a12 a12

b) real and equal roots case

yt = (C1 + C2 t) rt + y (647)

r1 a11 C2 t

xt = (C1 + C2 t) er1 t + r +x (648)

a12 a12

p

where r1; r2 = tr(A)

2

1

2 tr(A)2 4 jAj; tr(A) = (a11 + a22 ) ; jAj = (a11 a22 a12 a21 )

c) Complex roots

yt = Rt [C1 cos( t) + C2 sin( t)] + y (649)

xt = Rt cos ( t)

a12

C2 R cos( ) + C1 R sin( ) a11 C2

+Rt sin ( t) +x (650)

a12

98

p q

2

tr(A)

where R = jAj; cos( ) = ) = 4 jAj tr(A)

2R ; sin( 2R

Two rival …rms are competing for a market by engaging in a price war; for 0 < < 1 and

0< <1

Price set by the …rst …rm against price of the rival xt

Price set by the …rst …rm against price of the rival yt

Example based on Hoy et al. (2001) Mathematics for Economics, MIT Press.

yt+1 (1 ) yt

= (653)

xt+1 (1 ) xt

Homegeneous solution is requires roots this system as:

tr(A) 1p

r2 tr(A)r + jAj = 0 and r1; r2 = tr(A)2 4 jAj (654)

2 2

tr(A) = 2 and jAj = (1 ) (1 ) =1 + =1

de…ne c = +

tr(A) 1p

r1; r2 = tr(A)2 4 jAj

2 2

2 1p

= (2 )2 4 (1 )

2 2

2 1p

= (4 4c + c2 4 (1 c)

2 2

2 1p 2

= c

2 2

2 1

= ( + ) (655)

2 2

2 1 1

r1 = + ( + ) = (2 + + )=1 (656)

2 2 2

2 1 1

r2 = ( + ) = (2 ) = (1 ) (657)

2 2 2

This is distinct and real roots case, therefore the homegenous system is

r1 a11 r2 a11

xt = C1 r1t + C2 r2t (659)

a12 a12

Putting values of roots

t t

yt = C1 (1) + C2 (1 ) (660)

99

1 (1 ) t (1 ) (1 ) t

xt = C1 (1) + C2 (1 ) (661)

t t

yt = C1 (1) + C2 (1 ) (662)

1 (1 ) t (1 ) (1 ) t

xt = C1 (1) + C2 (1 ) (663)

t

yt = C1 + C2 (1 ) (664)

t

xt = C1 C2 (1 ) (665)

Initial conditions

for t = 0 ; y0 x0

y0 = C1 + C2 =) C1 = y0 C2 (666)

x0 = C1 C2 =) C2 = (C1 x0 ) =)

+

y0 + x0

C1 = y0 C2 = y0 (y0 x0 ) = (668)

+ +

Time path of price levels of …rm 1 and 2

y0 + x0 t

yt = + (y0 x0 ) (1 ) (669)

+ +

y0 + x0 t

xt = (y0 x0 ) (1 ) (670)

+ +

Whether yt , xt converge depends on whether + is greater, equal or less than zero. If +

< 1 then the second term disappears in above equations

y0 + x0

yt = (671)

+

y0 + x0

xt = (672)

+

d) Entry adjustment model

p = qD qS (673)

p = (a + bp mN ) >0 (674)

N = (p c) >0 (675)

100

r1 a11 r2 a11

y2 (t) = C1 er1 t + C2 er2 t + y 2 (677)

a12 a12

Solution to this problem is:

!

p b m p a

= + (678)

N 0 N c

r1

b r2 b

N (t) = C1 er1 t + C 2 e r2 t + N (680)

m m

Now draw the phase diagram for stability analysis.

Steady state N = 0 implies

p=c (681)

p = 0 implies

m a

p= N (682)

b b

Transitional dynamics

p depends on roots

tr(A) 1

r1; r2 = 2 2 tr(A)2 4 jAj ; tr(A) = b and jAj = m

b 1p 2 b2

r1; r2 = 4 m (683)

2 2

2 2

Complex root if b 4 m < 0 then

b 1p

p(t) = eht (A1 cos vt + A2 sin vt) + c; h = ; v= 4 m 2 b2 (684)

2 2

@p

This system converges if b < 0. Consider @N = m:

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growth Economic Modelling, 25, 5, 868–875

Elzinga K.G and D. E. Mills (1999) Price wars triggered by entry, International Journal of

Industrial Organization, 17, 2, 179–198

Levenstein, M. C. (1997), Price Wars and the Stability of Collusion: A Study of the Pre-World

War I Bromine Industry . The Journal of Industrial Economics, 45: 117–137

Klemperer P (1989) Price Wars Caused by Switching Costs, Review of Economic Studies 56

(3): 405-420

101

Oliver P Heila O P and K Helsen (2001) Toward an understanding of price wars: Their nature

and how they erupt, International Journal of Research in Marketing,18, 1–2, 83–98

Zhang Y and D. K. Round (2011) Price wars and price collusion in China’s airline markets,

International Journal of Industrial Organization, 29, 4, 361–372

1. Consider a …rm in monopolistically competitive industry ( refer to chapter 6 of Krugman and

Obstfeld (2000))

Q=A B P (685)

Q

MR = P (686)

B

(a) If the cost function is C = F + cQ then prove that the average cost declines because of

the economy of scale.

(b) Further assume that givens the total sales of the industry (S), the output sold by a …rm

(Q), number of …rms, its own price and average prices of …rms are given by

1

Q=S b P P (687)

N

show that the average cost rises to number of …rms in the industry when all …rms charge

same price .

AC = n:F

s +c

S

[hint: Q = N] More …rms in the industry less each will sell and hence higher the AC.

1. (a) Prove that price charged by a particular …rm declines with the number of …rms

1

P =c+ (688)

b n

(b) Determine the number of …rms and price in equilibrium. Explain entry exit behavior

prices when number of …rms are below or above this equilibrium point. [draw price and

average cost curve against number of …rms in the industry.]

(c) Collusive and strategic behaviors may limit above conclusions. Discuss.

(d) Apply above model to explain international trade and its impact on prices and number

of …rms in a particular industry.

(e) Use this model to explain interindustry and intra-industry trade.

(f) Use monopolistic competition model to analyse consequences of dumping practices in

international trade.

Eckel C and P Neary (2010) Multi-Product Firms and Flexible Manufacturing in the Global

EconomyReview of Economic Studies 77 (1): 188-217.

102

Epifani P and G. Gancia (2011) Trade, markup heterogeneity and misallocations, Journal of

International Economics 83, 1, 1–13

Krugman PR (1979) Increasing returns, monopolistic competition, and international trade,

Journal of international Economics, 9, 4, , 469–479

Zhelobodko E , S Kokovin, M Parenti, JF Thisse (2012) Monopolistic competition: Beyond

the constant elasticity of substitution Econometrica, 80: 2765–2784.

Prove that optimal tax rate is independent of market structure.

First study the revenue maximising tax rate of a monopolist.

Pro…t function of a monopolist with taxes

= PQ TC T (689)

P =a bQ (690)

total cost with marginal cost c and …xed cost f

T C = cQ + f (691)

Tax revenue

T = tQ (692)

Substituting price, cost and revenue in pro…t function

Pro…t maximisation conditions:

@

=a 2bQ (c + t) = 0 (694)

@Q

@2

= 2b < 0 (695)

@Q2

Pro…t function is thus concave and is maximised at

a (c + t)

Q= (696)

2b

Price charged my monopolist at this level is

a (c + t) a+c+t

P =a bQ = a b = (697)

2b 2

Pro…t of the monopolist then:

2

a+c+t a (c + t) fa (c + t)g

= (P c t) Q f= c t f= f (698)

2 2b 4b

103

Impact of taxes on pro…t, output, prices:

@ fa (c + t)g

= <0 (699)

@t 2b

@Q t

= <0 (700)

@t 2b

@P 1

= >0 (701)

@t 2

Higher tax rate will raise the price, lower the output and pro…ts for the monopolist.

What is optimal rate of tax for the government that maximises revenue from the monopolist?

a (c + t) at ct + t2

T = tQ = t = (702)

2b 2b

@T a c 2t a c

= = 0; t= (703)

@t 2b 2

@2T 1

= <0 (704)

@te b

Now, extend this tax model to the oligopoly market.

There are i = 1,..., N …rms in the market

Market supply

n

X

Q= qi (705)

i=1

n

X

P =a bQ = a b qi (706)

i=1

T Ci = (c + t) qi (707)

Tax revenue

T = tQ (708)

Pro…t of a particular …rm

n

!

X

1 = P q1 (c + t) q1 = a b qi q1 (c + t) q1

i=1

n

!

X

= a b qi q1 bq12 (c + t) q1 (709)

i=2

Pro…t of …rm i depends on costs of production, tax rates and on its own level of output and the

output of all other …rms.

104

Optimal condition for pro…t maximisation is:

n

X

@ 1

=a b qi 2bq1 (c + t) = 0 (710)

@q1 i=2

n

a c t 1X

q1 = qi (711)

2b 2 i=2

Pro…t function is concave

@2 1

= 2b < 0 (712)

@q12

Complication: there are N …rms in the market; …nding solution to q1 requires solution to output

of all N-1 …rms. For demand functions are symmetric, therefore marginal costs are same across all

…rms. Then each …rm will produce the same level of output, q. Putting this in the …rst order

condition

n

X

a b qi 2bq1 (c + t) = 0 (713)

i=2

a b (N 1) q 2bq1 (c + t) = 0 (714)

a bq (N + 1) c t=0 (715)

a c t

q= (716)

b (N + 1)

Now supply of all N …rms

n

X N a c t

Q= qi = N q = (717)

i=1

(N + 1) b

Market price:

n

X N a N

P =a b qi = a (a c t) = + (c + t) (718)

i=1

(N + 1) (N + 1) (N + 1)

Impact of number of …rms on output of a particular …rm

@q a c t

= 2 <0 (719)

@N b (N + 1)

Larger the N lower the q.

Impact of number of …rms on market supply

105

!

@Q (N + 1) 1 N a c t 1 a c t

= 2 = 2 >0 (720)

@N (N + 1) b (N + 1) b

Bigger the N larger the Q. Market supply increases when there are more …rms in the market.

Impact of number of …rms on market price:

@P a 1 a c t

= 2 + 2 (c + t) = 2 <0 (721)

@N (N + 1) (N + 1) (N + 1)

Bigger the N smaller the P. Price decreases with larger number of …rms in the market.

Impact of number of …rms on tax revenue:

N a c t

T = tQ = t (722)

(N + 1) b

For revenue maximising tax rate

@T N a c 2t

= =0 (723)

@N (N + 1) b

a c

t= (724)

2

@2T N 2

2

= <0 (725)

@t (N + 1) b

Thus the revenue maximising tax rate is t = a 2 c in both monopoly and oligopoly. Therefore

the market structure does not matter for revenue maximising tax rate.

Exercise:

Inverse demand and cost functions for a monopolist are

p=a bq (726)

C = cq 2 (727)

Government imposes a tax t per unit of output. How does it a¤ect output (q) and prices. Prove

that tax reduces the level of output.

4.6 Tripoly

Market conditions where only three …rms supply to the market. Conjectural variation one …rm

against another matter for pricing and output decisions and have impact on pro…ts.

P =a bQ = a b (q1 + q2 + q3 ) (728)

C i = ci q i (729)

1 = [a b (q1 + q2 + q3 )] q1 C1 (730)

106

2 = [a b (q1 + q2 + q3 )] q2 C2 (731)

3 = [a b (q1 + q2 + q3 )] q3 C3 (732)

@q2 @q3 @q1 @q3 @q1 @q2

Conjectural variations give how certain …rm react to output decision of other …rms: @q1 ; @q1 ; @q2 ; @q2 ; @q3 ; @q3

@ 1 @q2 @q3

= [a b (q1 + q2 + q3 )] bq1 1 + + c1 = 0 (733)

@q1 @q1 @q1

@ 2 @q1 @q3

= [a b (q1 + q2 + q3 )] bq2 +1+ c2 = 0 (734)

@q2 @q2 @q2

@ 3 @q1 @q2

= [a b (q1 + q2 + q3 )] bq3 + +1 c3 = 0 (735)

@q3 @q3 @q3

2 @q2 @q3

32 3 2 a c1 3

2+ @q1 + @q1 1 1 q1

6 74 b

5 q2 5 = 4 b 2 5

@q1 @q3 a c

4 1 @q2 +2+ @q2 1 (736)

@q1 a c3

1 1 @q3 + @q

@q3 + 2

2 q3 b

Optimal output for each …rm could be solved using matrix inverse or the Cramer’s rule:

Let R1 = 2 + @q @q3 @q1 @q3 @q1 @q2

@q1 + @q1 ; R2 = 2 + @q2 + @q2 ; R3 = 2 + @q3 + @q3

2

2 3 2 3 1 2 a c1

3

q1 R1 1 1 b

4 q2 5 = 4 1 R2 1 5 4 a c2 5 (737)

b

a c3

q3 1 1 R3 b

Determinant

jRj = R1 R2 R3 R1 R2 R3 + 2 (738)

Cofactor matrix

2 3

R2 1 1

1 1 R2

6 1 R3 1

R3 1 1 7 2 3

6 7 R2 R3 1 (R3 1) 1 R2

6 1 1 R1 1 R1 1 7

C=6

6

7 = 4 (R3 1)

7 R1 R3 1 (R1 1) 5

6 1 R3 1 R3 1 1 7

4 5 1 R2 (R1 1) R1 R2 1

1 1 R1 1 R1 1

R2 1 1 1 1 R2

(739)

0

This is

2 a symmetric matrix and C = C 3

R2 R3 1 (R3 1) 1 R2

C 0 = 4 (R3 1) R1 R3 1 (R1 1) 5

1 R2 (R1 1) R1 R2 1

2 3 2 32 a c1

3

q1 R2 R3 1 (R3 1) 1 R2

4 q2 5 = 1 4 (R3 1)

b

R1 R3 1 (R1 1) 5 4 a c2

b

5

R1 R2 R3 R1 R2 R3 + 2 a c3

q3 1 R2 (R1 1) R1 R2 1 b

(740)

107

(R2 R3 1) a bc1 (R3 1) a bc2 + (1 R2 ) a bc3

q1 = (741)

R1 R2 R3 R1 R2 R3 + 2

(R3 1) a bc1 + (R1 R3 1) a bc2 (R1 1) a bc3

q2 = (742)

R1 R2 R3 R1 R2 R3 + 2

R2 ) a bc1 (R1 1) a bc2 + (R1 R2 1) a bc3

(1

q3 = (743)

R1 R2 R3 R1 R2 R3 + 2

Equilibrium price now obtained by substituting these quantities in the demand function

P = a b (q1 + q2 + q3 ) (744)

2 3

(R2 R3 1) a bc1 (R3 1) a bc2 + (1 R2 ) a bc3

6 + (R3 1) a bc1 + (R1 R3 1) a bc2 (R1 1) a bc3 7

6 7

6 + (1 R2 ) a bc1 (R1 1) a bc2 + (R1 R2 1) a bc3 7

= a b66

7

7 (745)

6 R1 R2 R3 R1 R2 R3 + 2 7

4 5

Pro…t of …rm 1

2 3

(R2 R3 1) a bc1 (R3 1) a bc2 + (1 R2 ) a bc3

6 + (R3 1) a bc1 + (R1 R3 1) a bc2 (R1 1) a bc3 7

6 7

6 + (1 R2 ) a bc1 (R1 1) a bc2 + (R1 R2 1) a bc3 7

1 = a b6

6

7

7 (746)

6 R1 R2 R3 R1 R2 R3 + 2 7

4 5

C1 (747)

R1 R2 R3 R1 R2 R3 + 2

Exercise on tripoly:

Three …rms exist in a market each with the same cost function and conjectural variation for is

@qi

one to one, @q j

=1

P =a bQ = a b (q1 + q2 + q3 ) (748)

Ci = cqi (749)

a c

Now prove that each …rm produces q1 = 6b which is one third of the market size and market

price is P = a+c

2 .

@ 1 @q2 @q3

= [a b (q1 + q2 + q3 )] bq1 1 + + c=0 (750)

@q1 @q1 @q1

@ 2 @q1 @q3

= [a b (q1 + q2 + q3 )] bq2 +1+ c=0 (751)

@q2 @q2 @q2

108

@ 3 @q1 @q2

= [a b (q1 + q2 + q3 )] bq3 + +1 c=0 (752)

@q3 @q3 @q3

because of conjectural assumptions:

@ 1

= [a b (q1 + q2 + q3 )] bq1 (1 + 1 + 1) c=0 (753)

@q1

@ 2

= [a b (q1 + q2 + q3 )] bq2 (1 + 1 + 1) c=0 (754)

@q2

@ 3

= [a b (q1 + q2 + q3 )] bq3 (1 + 1 + 1) c=0 (755)

@q3

2 32 3 2 a c 3

4 1 1 q1 b

4 1 4 1 5 4 q2 5 = 4 a c 5 (756)

b

a c

1 1 4 q3 b

2 3 2 3 12 a c 3

q1 4 1 1 b

4 q2 5 = 4 1 4 1 5 4 ab c 5 (757)

a c

q3 1 1 4 b

By Cramer’s rule

a c

1 1

1 b

a c 1 a c a c a c

q1 = b 4 1 = 18 9 = (758)

54 a c 54 b b 6b

b 1 4

a c

4 1

1 b

a c 1 a c a c a c

q2 = 1 b 1 = 18 9 = (759)

54 a c 54 b b 6b

1 b 4

a c

4 1

1 b

a c 1 a c a c a c

q3 = 1 4 b = 18 9 = (760)

54 a c 54 b b 6b

1 1 b

Equilibrium price

a c a c a c a c a+c

P =a b (q1 + q2 + q3 ) = a b + + =a = (761)

6b 6b 6b 2 2

2

a+c a c a c (a c)

1 = [a b (q1 + q2 + q3 )] q1 C1 = c = (762)

2 6b 6b 12b

2

(a c)

2 = [a b (q1 + q2 + q3 )] q2 C2 = (763)

12b

2

(a c)

3 = [a b (q1 + q2 + q3 )] q3 C3 = (764)

12b

QED.

109

Baldani J, J. Brad…eld and R. Turner (2004) Mathematical Economics, the Drydon Press,

London.

Murakami H And R Asahi (2011) An Empirical Analysis Of The E¤ect Of Multimarket

Contacts On Us Air Carriers’Pricing Behaviors, Singapore Economic Review 56:04, 593-600

The amount of FDI (F ) in equation (2) above results from the pro…t maximising decision of …rms.

Multinationals engage in FDI and interact strategically with the underlying downward sloping de-

mand functions and …rm speci…c cost functions that are di¤erentiated across countries. Licensing

of copyrights or blueprints versus subsidiary based productions are based on microeconomic princi-

ples. These motives determine the nature of in‡ows and out‡ows or joint ventures between MNCs

and …rms serving in domestic markets. MNCs move to a foreign country for a number of reasons

including the cost advantages in producing there rather than exporting commodities. Particularly:

location (L) based advantages of production;

internalisation (I) of bene…ts of technical know- how by …rms doing R & D.

These OLI factors indicate why MNCs have cost advantages in going abroad because of own-

ership of …rm speci…c factors such as R&D, scienti…c and technical workers, product novelty and

complexity, and marketing expenditures. Also when they have more intangible assets such as

management, engineering, marketing, …nancial services, patents and trademarks. Similarly, tari¤s,

quota, transportation cost, cheap production and customer base are also key location factors for

FDI by a MNC. Internalisation refers to full exploitation of product and processes within the …rm

rather than by licensing or franchising to …rms in other countries. The degree of economies of scale

and the structure of market determine the amount of in‡ows and out‡ows and which one of its FDI

activities are strategically stable in the long run.

Reason for FDI %

Reduction of labour costs 45

Access to new markets 36.5

Strategic decisions taken by the group head 35.7

Reduction of other costs than labour costs 30.7

Other motivation 24.6

Focus on core business 24.1

Improved quality or introduction of new products 19.8

Access to specialised knowledge/ technologies 17.7

Following the behaviour/example of competitors/clients 14.2

Tax or other …nancial incentives 9.2

Source: Eurostat (SBS), 2005.

110

A simple way to analyse the underlying microeconomic theory of FDI activity is to think of

a MNC as a monopolist facing two di¤erent demand functions at home and abroad. It has …rm

speci…c capital, but the two markets di¤er on the structure of demand and cost conditions. In order

for an MNC to open a subsidiary in a foreign market the cost of exporting goods (transportation,

tari¤ and other costs) must be higher than the …xed cost of setting up business in that foreign

country. Bargaining on the share of pro…t for host and MNC has to be further considered in order

to determine net bene…ts to each. In a survey of …rms in the Czech Republic, Denmark, Germany,

Ireland, Italy, the Netherlands, Portugal, Slovenia, Finland, Sweden, the United Kingdom and

Norway the proportion of enterprises carrying out international sourcing state labour cost to be the

main motivation of FDI as stated in Table 1.

Markusen (1995) nicely illustrated the strategic interaction issues of licensing versus subsidiary

production. Taking a two period model of production with given rental fees of license or cost of

subsidiary operation and possibility of defect in the second period. Committing host …rms to the

licence agreements is di¢ cult. Pro…ts earned by an MNC that sells licence of running the business

to a host …rm that defects on the agreement in the second period are less than when the MNC

runs subsidiary operation in the country. Pro…ts from the subsidiary operation would be less if the

licence agreement is implemented without defecting in the second period. This can be summarised

as (R + D F C < 2M F C < 2R F C) where R is the rental income from licensing of a partner

foreign …rm, D is the payments made in case the licensee defects in the second period (this deters

the licensee from supplying the market itself after gaining the know-how from the MNC in the …rst

period), F C is the …xed cost of FDI to the MNC, and M is the pro…t from subsidiary when FDI takes

the form of subsidiary operation. Higher probability of cheating on license agreements motivates

an MNC to run a subsidiary but it would have preferred licensing than opening a subsidiary if it

was guaranteed of full commitment to a license agreement. He concludes that direct investment

is more likely in cases where technology has the joint input characteristic of knowledge capital.

Thus reduction in the production cost is the main microeconomic evidence for the operation of the

multinational corporations of the OECD countries. Here the reduction in the labour costs is the

main incentive of the multinational followed by access to markets for strategic decisions, reduction

of other costs as can be seen from Table above (see Appendix C for a micro model with uncertainty).

How does the market structure in‡uence on price and output decision of a …rm?

Assume that the MNC has home and foreign markets, faces distinct demand curves across

two countries and faces di¤erent cost curves. Home market is more lucrative than the foreign

market both in terms of prices and cost e¤ectiveness. Despite that the MNC has a global ambition,

therefore it aims to extend its business in overseas markets. The main objective of the MNC is to

control the market and to maximise pro…t.

Demand in home country

P1 = 130 Q1 (765)

and associated cost function is

C1 = 10Q1 (766)

Demand in the foreign (host) country

P2 = 90 Q2 (767)

and associated cost function is

111

C2 = 20Q2 (768)

Under the perfect competitions free entry among potential …rms drive the prices to the average

costs.

Q P R C Pro…t

Home 120 10 1200 1200 0

Host 70 20 1400 1400 0

If this …rm possessed absolute monopoly power in the home and foreign markets it will earn

abnormal economic pro…t both at home and abroad by charging very high prices and by reducing

amount supplied.

This reduces consumer surplus from 7800 to 2100, a reduction of 73 percent.

Q P R C Pro…t

Home 60 70 4200 600 3600

Host 35 55 1925 700 1225

Markets are distinct and separate, it is not possible for others to buy in one and sell in another

country. It is possible for MNC to engage itself in a discriminatory practice.

Marginal revenue and marginal cost principle for country 1 implies

Marginal revenue and marginal cost principle (M R = M C) for country 2 implies

90 2Q2 = 20 (770)

The solution of these two markets

Q P R C Pro…t

Home 60 70 4200 600 3600

Host 35 55 1925 700 1225

The transportation cost should be greater than the cost di¤erences (t > C1 C2 )to justify

foreign operation. If (t C1 C2 ) the MNC can safely export by producing at home country.

If the MNC plays a Nash non-cooperative game:

112

Demand in host country is given by

P = 90 (q1 + q2 ) (771)

with associated cost function

C1 = 20Q1 (772)

Foreign …rms are less competitive

C2 = 30Q2 (773)

Now the pro…t functions

foreign form tries to maximise

Reaction functions implied by these functions

2q1 + q2 = 70 (776)

q1 + 2q2 = 60 (777)

80 50

q1 = 3 = 26:6 and q2 = 3 = 16:7 Market price

Q P R C Pro…t

MNC 26.6 46.7 1242.2 532 710.2

Rival 16.7 46.7 779.9 501 278.9

Q P R C Pro…t

MNC 17.5 55 962.5 175.5 789

Rival 17.5 55 962.5 354 608.5

113

MNC can do better by playing a price leadership or predatory pricing strategy.

For price leadership, it takes account of reaction function of its rival host form while deciding

price

1 1 2

1 = 90q1 q12 q1 q2 = 30 q 20q1 = 40q1 q (781)

2 1 2 1

q1 = 40 and q2 = 10

Price in the host country

Q P R C Pro…t

MNC 40 40 1600 800 800

Rival 10 40 400 300 100

MNC has cost advantage over the host rival …rm. By adopting a limit pricing strategy it can set

price at 29 slightly below the average cost of the host …rm, which is 30.

Q P R C Pro…t

MNC 61 29 1769 1220 549

Rival 0 29 0 0 0

Price leadership guarantees a larger share to the MNC and gives reasons for participation by the

rival host country as well.

A Microeconomic Model of FDI: More recent analysis FDI focuses on investment under uncer-

tainty approach discussed in Dixit and Pidyck (1994) and applied in Arijit and Hek (2011). Faced

with a demand shock that moves according to a Brownian motion, foreign …rm decides to invest

amount F in the host country if the expected pro…ts are positive.

Z 1

rs

E =E F Ys e ds F (783)

t

Where Y is demand shock, r is constant interest rate, 0 < < 1 is share of FDI in total

investment, F is the amount of FDI. Shock to demand is given by a Winner process z with drift

term aF and the standard deviation of F .

dY = aF dt + FY dz (784)

114

Whether it is pro…table to invest depends on the critical level of demand shock Y that depends

on a host of technology and preference side parameters. Optimisation problem of the …rm is given

by:

h i

1

V (Y ) = max E ; (1 + rdt) V (Y + dY ) (785)

According to Dixit and Pindyk (1994) the Ito’s Lemma implies partial di¤erential equation

1 2 2 00

Y V (Y ) + aF V 0 (Y ) rF V 0 (Y ) = 0 (786)

2 F

and F V 0 (Y ) must satisfy following boundary conditions:

V (Y ) = E F Y (787)

E F Y

V 0 (Y ) = (788)

@Y

E F = l ( )Y F (789)

The function that satis…es all above equations is:

V (Y ) = mY (790)

mY = l ( )Y F (791)

1 1

mY = l ( )Y (792)

Solving these we get

2 3

1 F

Y =4 5 (793)

l ( )

1

( 1) + aF r=0 (794)

2

s

1 aF aF 1 2r

= 2 + 2 + 2 (795)

2 F F 2 F

Flow of FDI thus occurs only when the critical conditions are met and rely mainly on the future

expectations of pro…ts by the investors in a world that is inherently uncertain as shown by the

Brownian motion in this model. Micro motivations of FDI in this model …ts well to characterise

the analytical aspects of microeconomic justi…cation for the foreign capital (F) from MNCs that

was driving growth in our macro model.

115

4.9 General equilibrium model of a multinational …rm:Batra and Ra-

machandran(1980)

Two country two …rm model with perfect competition, linearly homogeneous and concave

production functions, full employment, and inelastic factor supplies.

Let X be the output of a multinational …rm and Y be the output of local …rms in the source

country.

Multinational …rm’s product requires labour and capital input and …rm speci…c input S.

X = X(Lx ; Kx ; S) (796)

Local …rm produces output using capital and labour.

Y = Y (LY ; Ky ) (797)

Host country MNC and Local …rms: A star denotes the variables in the host country:

X = X (Lx ; Kx ; S ) (798)

Y = Y (LY ; LY )

Marginal conditions

2

Xj > 0; Xjj < 0; Xjk > 0 (j; k = K; L; S; j#k); XLL XKK XKL >0 (799)

and in Y

2

Yj > 0; Yjj < 0; YKL > 0 (j = L; K); YLL YKK YKL =0 (800)

Tax base in host country with p as the relative price of X in terms of Y:

B = (p X w Lx ) (801)

p = p(l + ) where > 0 is the host country’s tari¤ rate on its import of good X

Tax base in source country

C = (p X w Lx )t (803)

Global pro…t after taxes:

= (pX wLx F )(1 t) + (p X w Lx )(1 t ) rKx r Kx

116

F be the expenses incurred by the …rm for research and managerial development necessary to

maintain its global leadership.

capital stock owned by the international …rms is mobile across countries

r=r (805)

Factor prices and optimal conditions: pro…t maximization by the multinational …rm:

pXL = wx ; p XL = wX (806)

pXk (l t) = rx ; p XK (l t ) = rx (807)

pro…t maximization by local …rms:

YL = wY ; YL = w (808)

YK = ry YK = ry (809)

The wage rate is the same in both sectors:

w = wx = wy ; w = wx = wy (810)

Equilibrium conditions between MNC and Local …rms; factor-market equilibrium conditions

which determine the allocation of labor between the two sectors in each country and of the multi-

national capital between the two countries.

Lx + Ly = L (814)

Lx + Ly = L (815)

Kx + Kx = K x (816)

Equilibrium between MNC and Local …rms; resource allocation within each country and the

process of capital movements between the two countries can be determined with the help of six

equations given above, containing six variables (Lx ; Ly ; Lx ; Ly ; Kx and Kx )and eleven parameters

(S; S ; KY ; ; Ky ; L; L ; K x ; p; t; t ; and ; p = p(l + ))

Reduced form:

p XL (Lx ; Kx ; S ) = YL (L Lx ; Ky ) (817)

117

pXL (Lx ; Kx ; S) = YL (L Lx ; Ky ) (818)

Implicit solutions for employment, capital of MNC

The equations can be solved for three unknowns Lx ; Kx ; Lx as:

2 32 3 2 3

p XLL + YLL p XLK 0 dLx 0

4 0 pXLK pXLL + YLL 54 dKx 5 = 4 0 5 (820)

p 1 t XLK p 1 t XKK + p (1 t) XKK p (1 t) XKL dLx p Xk dt pXk dt

2 3 2 3 12 3

dLx p XLL + YLL p XLK 0 0

4 dKx 5 = 4 0 pXLK pXLL + YLL 5 4 0 5 (821)

dLx p 1 t XLK p 1 t XKK + p (1 t) XKK p (1 t) XKL p Xk dt pXk dt

D e te rm in a nt

2

D = p XLL + YLL p XLK (1 t) XKL

2

+p XLK pXLL + YLL 1 t XLK

p 1 t XKK

pXLL + YLL p XLL + YLL > 0 (822)

+p (1 t) XKK

0 p XLK 0

0 pXLK pXLL + YLL

p Xk dt pXk dt p 1 t XKK + p (1 t) XKK p (1 t) XKL

dLx = (823)

D

h i

p XLK pXLL + YLL p Xk dt pXk dt

=

D

0 pXLK 0

p 1 t XLK p 1 t XKK + p (1 t) XKK p Xk dt pXk dt

dLx =

D

h i

p XLL + YLL pXLK p Xk dt pXk dt

= (824)

D

p XLL + YLL 0 0

0 0 pXLL + YLL

p (1 t ) XLK p Xk dt pXk dt p (1 t) XKL

dKx = (825)

D

(pXLL + YLL ) [p Xk dt pXk dt] (p XLL + YLL )

=

D

Impacts of taxes and tari¤s on the employment, income and pro…ts

A number of impact assessment could be carried out with this model:

1. Impact of taxes on international investment on employment, wages and capital stock in the

host country

2. impact of tari¤s imposed by the host country

3. Implications on the terms of trade

118

4.9.1 Empirical evidence on growth e¤ects of FDI

Consider a panel data regression model aimed to measure the impacts of FDI on economic growth:

ei;t IID 0; 2e (826)

where yi;t is the growth rate, Fi;t , Ti;t and Ii;t 1 are the ratios of FDI, tax revenue and dometic

investment to GDP. Use data in panel_growth_in‡ow_out‡ow.csv to estimate this model using

panel package in PcGive. Interpret your results.

Table 29: Determinants of growth in OECD countries: Panel Model (pooled estimation)

Coe¢ cient t-value t-prob

Intercept 0.03319 2.400 0.017

growth-1 0.30686 2.360 0.019

FDI ratio 0.00049 4.680 0.000

tax rate -0.00042 -2.010 0.045

invratio 0.86255 4.270 0.000

invratio-1 -0.85115 -4.670 0.000

R2 = 0.42; N =31; T = 14; Chi2 =399.2 [0.000]

Bhattarai (2012)

Firstly, the ratio of investment to GDP is a signi…cant determinant of growth rates across

OECD countries as shown in Table 1. This is exactly what is expected from the theory of

economic growth. Net investment adds to capital accumulation and more capital associated

with given labour generates more output.

The negative term in the second term shows cyclical pattern of investment ratio.

There is evidence of persistency of growth rate as shown by the signi…cant coe¢ cient on its

own lagged term. FDI contributes positively to growth.

Higher tax rates cause lower growth rates which is very intuitive. Overall …t of the model is

good as R2 -is 42 percent and 2 -value shows normality of errors.

Country and time spe…cit e¤ects could be shown using dummy variables.

Evaluate the consumer and producer surpluses when demand and supply are as following

1.

P D = 25 Q2 (827)

P S = 2Q + 1 (828)

119

2. Consider a multiproduct …rm with revenue and total cost as following

TC = 2Q21 + 2Q1 Q2 + 3Q22 (830)

Using Hessian determinant prove that those output indeed maximise the pro…ts.

3. Write an essay on importance of own price, income and cross elasticities in measuring con-

sumer and producer surpluses in an industry.

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121

4.9.3 General equilibrium with production

1. Consider problems of households and …rms in a market economy.

Households problem

max U = C:L (831)

P C + wL = wL (832)

L = L + LS (833)

Firm’s problem

Subject to

Y = LS K (835)

price of good, Y output and L total labour endowment. For simplicity assume capital is …xed

at K. Technology operates under the constant returns to scale + = 1:

(a) Derive the household’s optimal demand functions for C and L. Explain how the real

wage rate, K and L in‡uence in these demands.

(b) Derive the demand for labour,LS and explain how it relates to the real wage rate.

(c) Find the real wage rate that solves both household and …rm problems.

(d) What are the optimal consumption, leisure demand, labour supply and utility?

(e) Represent this result in a diagram.

2. Simplify the production technology further to Y = aLS: What would be optimal consumption,

leisure and labour supply now.

3. What will be allocations if the utility is additive on consumption and leisure U = C + L and

the the production is linear in labour supply Y = aLS:

5.1 What is a general equilibrium?

This is a system of relative prices that clear all goods and factor markets. It is often stated in terms

of vectors of prices, demand and supply and excess demand functions for inputs and outputs.

A general equilibrium model is a complete speci…cation of the price system in which quantities

and prices are determined by the interaction of both demand and supply sides of goods and factor

markets. It can be applied to measure consequences of economic policy on growth, accumulation

122

and pollution over time and also to determine how a government can in‡uence market outcomes

by distorting the equilibrium prices by means of taxes and transfers. It can show how the labour

leisure choice of households and employment level of …rms, growth rate of output, employment and

capital and the investments occurs through the optimization process of the households, …rms and

traders and how one set of policies can be more e¢ cient than others in generating the optimal levels

of utility for all households leading to just and best social welfare result for the economy.

Equilibrium is a point of rest, where the opposing forces remain in balance. Theoretically there

has been much work, since the time of Adam Smith and Walras to Arrow-Debreau-Hahn-McKinzie

for …nding whether it exists, or is unique or is stable along with analysis of Pareto e¢ ciency for a

centralised or decentralised economy. In abstract level, existence of equilibrium or Walras’ law is

proved using a unit simplex and Brouwer’s …xed point theorem in which the uniqueness is guaranteed

by the choice of preferences and technology and trade functions that ful…l continuity, concavity

or convexity or twice di¤erentiability properties. In applied policy work, numerical methods are

adopted to …nd the solutions of these models as the explicit analytical solutions are possible only for

very small scale models that hardly represent highly complicated mechanism in a modern economy.

A general equilibrium is obatained when the excess demand (demand -supply) is eliminated by

the adustment in the relative prices.

Given the vector of prices, p = (p1; p1; ; :::; pj; :::pn ) demand for commodities are expressed in

terms of the price vector Xjd = Xjd (p) = Xjd (p1; p1; ; :::; pj; :::pn ) and

supply functions de…ned similarly Xjs = Xjs (p) = Xjs (p1; p1; ; :::; pj; :::pn ) and

the excess demand functions E (p) = Xjd (p) Xjs (p) re‡ect the gap between demand and

supply for each commodity for j = 1; 2; : : : : : : :n: Economy has n excess demand functions.

The general equilibrium is a price vector, p , such that p > 0, when E (p ) 0 ;if E (p ) < 0

then p = 0

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123

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669.

2. bounded from below E (p) b for all p and

3. it is homogenous of degree zero in all prices E ( p) = p for all ;

P

n

4. only relative price matter and satis…es the Walras’law; p:E (p) = pi :Ei (p) = 0 for

i=1

all p 0

If the excess demand functions satisfy above properties then, the existence of the general

equilibrium is guaranteed by …xed point theorems.

The …xed equilibrium point is found by continuous transformation of the nonempty convex

set onto itself p ! E (p ) ! p : . Given the properties of demand and supply functions

equilibrium exists and is stable and unique.

Fixed point and contraction mapping

A set S in Rn and B be the set of all bounded functions from S into Rm .Contraction mapping

is T : B ! B There exist a unique function ' in B such that ' = T (' )

Brouwer’s …xed point theorems

For K an non-empty compact (closed and bounded) convex set in Rn , let f is continous mapping

of K into itself. The f has a …xed point f (x ) = x :

A continuous function from a compact convex set into itself has a …xed point.

Prices can be normalised to make their sum equal to one using the homogeneity assumption as

( n )

X

S = p= pi = 1; p 0 (836)

i=1

Consider a set of the excess demand functions evaluated at p. Update or adjust this price

according to following rules for each of j commodities:

8 9

< pj = pj if E (pj ) = 0 =

pj = pj + if E (pj ) > 0 for j = 1; 2; :::; N (837)

: ;

pj = pj if E (pj ) < 0

124

Here represents a very small positive constant. Following above rule in each iteration …nd

new prices as

p ! E (pj ) =) p (838)

p remains unchanged if excess demand is zero, E (p) = 0 ; p rises if, E (p) > 0 and p falls if

E (p) < 0and if E (p) < 0 then p = 0.

The …xed equilibrium point is found by continuous transformation of the nonempty convex set

onto itself

p ! E (p ) =) p (839)

Graphical Illustration of Brouwer …xed point theorem

x* = f ( x* )

f (x)

450

a

a x* b

Triangulation of a unit simplex with grid size of 5.

125

Steps:

1. select an initial simplex and grid size D (5 in above simplex).

2. calculate the labels of vertices of the initial simplex by applying the labelling rule.

3. If the simplex is completely labelled go to step 5 else to step 4.

4. generate a new vertex applying the replacement rule. Determine the label of new vertex.

5. Since the vertex is completely labelled an approximation to competitive equilibrium has

been found where the excess demand is less than a selected small number.

Merrill’s algorithm, Van der Laan and Talman algorithm, Newton methods, Miles, Path are

other algorithm to compute general equilibrium.

Exercise (i) …nd the co-ordinates for any …ve sub-simplices (ii) show division of this unit simplex

for grid size of 10.

Shoven J. B. and J. Whalley (1992) Applying General Equilibrium, Chapters 2 and 3, Cam-

bridge University Press.

More explicit proof of the Brouwer’t theorem requires use of Sperner’s Lemma and Kanster-

Kuatowski-Mazzurkeiwiecz (KKM) theorem which can be found at Ross Starr (1997) on …xed point

algorithm and convex hull.

Kakutani …xed point theorems

For K an non-empty compact (closed and bounded) convex set in Rn , let F a correspondence

K K and suppose that

a. . F (x)is a nonempty convex set in K for each x in K

b. F is upper hemicontinous

Then F has a a …xed point x in K i.e a point x such that x 2 F (x ) :

First and second theorems of welfare

Second welfare theorem: Suppose that x is Pareto e¢ ceint allocation for ui ; ei i2I

and the endowments are redistributed so that new endowmen vector is x Then x

is a Walrasian equilibrium allocation of the resulting exchange economy ui ; xi i2I

.

based on evaluation of Jacobian matrix of excess demand functions. Taking nth commodity as a

numeraire and di¤erentiability of the excess demand functions Jacobian matrix is normalised as

following (Hicksian method):

2 @E1 @E1

3

@p1 @p2 : @p@E 1

N 1

6 @E2 @E2

: @p@E 2 7

6 7

J = 6 @p1 @p2 N 1

7 (840)

4 : 5

@En 1 @En 1

@p1 @p2 : @E n 1

@pN 1

The equilibrium is unique if the principal minors of J alternate in sign, its values is positive

for even number of rows and columns; and negative for uneven number of rows and columns.

126

Stability of equilibrium Intriligator (1971) suggests decentralised iterative computation of equi-

librium, leading to time paths for quantities and prices. If these time paths eventually converge to

equilibrium values then the process is table.

x = (x1; x1; ; :::; xj; :::xn )

p = (p1; p1; ; :::; pj; :::pn )

Equilibrium is locally stable if

t !1

where p (t0 ) denotes the initial starting point and the Euclidean norm in the price space.

Equilibrium is globally stable if it is reached regardless of any starting point lim p (t) = p

t !1

for any p (t0 ) :

The classical approach to Walrasian tatonement process is to raise the price if the total market

demand is greater than supply and lower the prices if the demand is less than supply and keep price

unchanged in the total market demand equals total market supply. This in terms of excess demand

function stability in the Walrasian system requires

8 9 8 9

@pj < > = < > =

=p < = if E (pj ) < 0 for j = 1; 2; :::; N (842)

dt : ; : ;

= =

Economic system is described by a system of relative prices that clear all goods and factor

markets. It is often stated in terms of vectors of prices, demand and supply and excess demand

functions for inputs and outputs.

De…nition: An allocation-price pair (p; x) is a Walrasian equilibrium if (1) allocation is feasible (2)

eachXagent isXmaking an optimal choice permited by the budget set.

xi = ! i and if x0i is preferred by agent to xi then px0i > p! i :

i i

First theorem of welfare reconomics: If (x, p) is a Walrasian equilibiurm, then x is Pareto

e¢ cient.

Proof by contradiction: If x0i is feasible and preferred by the economic agents then px0i > p! i .

Then summing over all individuals

N

X N

X N

X

p !i = p x0i > p! i (843)

i i i

Second theorem of welfare reconomics (revealed preference proof ): If xi is pareto

e¢ cient allocation the (p; x ) is competitive Walrasian equilibrium.

Proof: Since xi is in consumers budget set, it must be true that x0i i xi . As xi is pareto

e¢ cient xi i x0i Thus x0i is as optimal as xi Hence (p0 ; x) is a Walrasian equilibrium.

Pure exchange

Consumption set: x 2 X (point below the budget line with m = 2).

127

m

X m

X

Feasibility condition: xi = ei

i i

Equilibrium can be represented using a budget constraint for consumer i and Edgeworth box

diagram in case of two consumers and Euclidian space for m consumers.

Prove existence using the Fixed point theorem such that equilibrium price vector p and the

allocation x each of dimension 1 m and equilibrium allocation (p; x) are feasible and maximise

consumer’s preferences over commodities.

Equilibrium with production

A possible allocation (x; y) = (x1; ::::; xm; y1::::; yn ) for consumers and producers satisfying fol-

lowing:

Consumption set: x 2 X

Production possibility set: y 2 Y

m

X Xm X m

Resource balance condition: xi = ei + yi

i i P i

Wealth of the consumer: w1 (p) = p:e1 + i;j j (p)

j

Supply correspondence: sj (p) = fy 2 Yj : y 0 2 Yj =) p:y p:y 0 g

Xm

P

Excess demand correspondence: z (p) = (di (p) ei ) si (p)

i i

A competitive equilibrium is a pair of prices, demand and supply (p; (x; y)) with p a vector in

Rn and xi 2 di (p) for consumer i to m, and y j 2 Sj (p) for …rms j to n and where the excess

demand z (p) is zero in equilibrium.

Now consider a Robinson Crusoe economy

Commodity space: R2 (leisure and food)

Consumer characteristic: Xi = R2+

Endowment: ei = (24; 0)

Preference relation: i U (L; F n= LF

p o

Producer characteristics: ; Yj ( L; F ) : L 0; F L

p

where F = L is the production function.

2

PF PF PF PF2 PF2 2

1 PF

Pro…t : = PF F PL F 2 and F = 2PL and = PF 2PL PL 2PL = 2PL 4PL = 4 PL

2

1 PF PF

Supply of Food : s (PL ; PF ) = 4 PL ; 2P L

P 1 PF

2

Value of endowment: w1 (p) = p:e1 + i;j j (p) = 24PL + 4 PL

j

n o n o

P2 P2 2

1 PF PL 1 PF

1

Demand: d (PL ; PF ) = 2PL 24PL + 14 PFL ; 2P1F 24PL + 14 PFL = 12 + 2 ; 12 P

8 PL F

+ 8 PL

North-Holland.

1 PF2 1 PF2

12 + = 24 (844)

8 PL2 4 PL

128

Food demand and supply

PL 1 PF PF

12 + = (845)

PF 8 PL 2PL

Both of above markets give the same solution; by the Walras’ law when labour market clears

food market

p clears as well. This model determines the only relative price. From labour market

PF

PL = 4 2:

Normalise PL = 1:

Equilibrium solution: p

price vector: (PL ; PF ) = h1; 4 2

2

1 PF

p p i

demand vector: (L; F ) = 12 + 2

8 PL = 12 + 1 16 2

8 1 = 16; 12 PPFL + 1 PF

8 PL

1

= 12 4p 2

+ 14 2

8 1 = p3

2

+ p1

2

=2 2 =

p

16; 2 2

p

output vector: (LS; F ) = 8; 2 2

Propositions

1. excess demand function is homogenous of degree zero; for every constant 0 the

m

X

z ( p) = z (p). Prove it. (numeraire commodity, normalisation of absolute prices jpi j =

i

m

X

1;. p2i = 1.

i

2. If consumer’s preferences are non-satiated then the Walras’law holds. Use the neighbour-

hood theorem with " > 0

p1 z1 (p) + p2 z2 (p) + ::: + pm 1 zm 1 (p) + pm zm (p) = 0

Represent equilibrium allocations of production, endowment and consumption in a single dia-

gram.

Two Good Pure Exchange General Equilibrium Model

Households, h = A B.

Two goods X1 and X2

Endowments of two goods ! A A B B

1 !2 !1 !2

Objective of each is to maximise life time utility subject to budget constraints w r t X1 and

X2

Equilibrium relative price determines the optimal allocation; It is Pareto Optimal.

Three conditions

2. Income = expenditure

129

3. Firms maximise pro…t: zero economic pro…t in competitive markets

Relative Prices

2. equilibrium.

3. Relative prices are determined by forces of demand and supply.

4. Numeraire or anchor price; normalised to 1.

2. Income of a household is determined by her endowment and price of that

endowment.

Each consumer/ producer optimises in equilibrium.

For household A

1

U (X1A ; X2A ) = X1A X2A

A A

M ax (846)

Subject to the budget constraint:

P1 X1A + P2 X2A = P1 ! A A

1 + P2 ! 2 = I

A

(847)

For household B

1

U (X1B ; X2B ) = X1B X2B

B B

M ax (848)

Subject to the budget constraint:

P1 X1B + P2 X2B = P1 ! B B

1 + P2 ! 2 = I

B

(849)

Intertemporal budget constraint

Lagrangian for constrained optimisation for Household A :

1

LA = X1A X2A P1 ! A A

P1 X1A P2 X2A

A A

+ 1 + P2 ! 2 (850)

Lagrangian for constrained optimisation for Household V :

1

LB = X1B X2B P1 ! B B

P1 X1B P2 X2B

B B

+ 1 + P2 ! 2 (851)

First order conditions for optimisation

For household A and B

130

@LA 1 1

X1A X2A

A A

= A P1 = 0 (852)

@X1A

@LA

X1A X2A

A A

= (1 A) P2 = 0 (853)

@X2A

@LA

= P1 ! A A

1 + P2 ! 2 P1 X1A P2 X2A = 0 (854)

@

@LB 1 1

X1B X2B

B B

= B P1 = 0 (855)

@X1B

@LB

X1B X2B

B B

= (1 B) P2 = 0 (856)

@X2B

@LB

= P1 ! B B

1 + P2 ! 2 P1 X1B P2 X2B = 0 (857)

@

Demand and market clearing conditions

For household A

A A

AI (1 A) I

X1A = ; X2A = (858)

P1 P2

For household B

B B

BI (1 B) I

X1B = ; X2B = (859)

P1 P2

Market clears each period

X1A + X1B = ! A B

1 + !1 (860)

X2A + X2B = ! A B

2 + !2 (861)

Market clearing Prices

Obtained from the market clearing conditions

A B

AI BI

+ = !A B

1 + !1 (862)

P1 P1

A B

(1 A) I (1 B) I

+ = !A B

2 + !2 (863)

P2 P2

Walrasian numeraire: P1 = 1: with this speci…cation

I A = !A

1 I B = P2 ! B

2 (864)

Equilibrium Relative Price and Proof of Walras’Law

131

Table 30: Parameters in Pure Exchange Model

Household A Household B

A A

Endowments ! 1 ; ! 2 = f100; 0g B

!1 ; !B

2 = f0; 200g

Preference for X1 ( ) 0:4 0:6

Preference for X2 (1 ) 0.6 0.4

A B

AI BI A B

+ = AI + BI

P1 P1

A B

= A !1 + B P2 ! 2 = !A

1

0:4 (100) + 0:6 (200) P2 = 100; P2 = 0:5

I A = !A

1 = 100 I B = P2 ! B

2 = 0:5 (200) = 100 (865)

Household A Household B

Endowments !A

1 ; ! A

2 = f100; 0g ! B B

1 ; !2 = f0; 200g

Prices 1 0.5

Demand for X1 ( ) 40 60

Demand for for X2 (1 ) 120 80

Utility 77.3 67.3

Income 100 100

Theoretical observations

Relative prices of goods, income and consumption change when preferences ( alpha, beta)

change.

Change in the relative income a¤ects the level of utility and welfare of households

Household A can make household B worse o¤ by increasing the demand of good 1 that he

owns ( or supplying less to the market).

Household B can increase his relative income and reduce the relative price of good 1 by

increasing the demand for good 2 (reducing its supply).

Relative prices and allocations depend on preferences and endowments.

Homework

Do sensitivity analysis (solve model for various parametric speci…cations

1) by changing endowments ! A A

1 ; !2 = f100; 50g and ! B B

1 ; !2 = f200; 150g

2) by changing preferences f A , B g = f0:50; 0:50g ; f A , B g = f0:750; 0:30g

3) introduce VAT of 20 percent in commodity 1. Assume that revenue collected is spent entirely

by the government and does not add to any utility for the household.

GAMS programme: pexchange.gms; proto.gms; tax2sector.gms; tax_3sectr_utils.gms

132

5.3.1 Exercise 11: Ricardian trade model

1. Develop the above model for two countries and …nd the global equilibrium in two country

world.

2. Show that relative output of country 1 not only in domestic costs but also the output and

cost in the foreign country.

3. Represent the global economy by three representative countries with the following problem

subject to

Solve for prices and allocations at equilibrium. Apply this model to a realistic situation for

countries producing food, oil and manufacturing commodities.

Households and …rm optimise subject to their constraints

System of prices when all markets clear simultaneously (all goods and factor markets)

Imports equals exports in an open economy model

Saving equals investment in a dynamic economy model

Public spending accounts are balanced in model with public sector

In general equilibrium is obtained by the price system when economy is in perfect harmony.

Consider one of the easiest possible example of a general equilibrium model with production

Exercise

Prove that a …rm need to pay higher wage rate to its workers and lower the price of commodity

while expanding output if it operates under an increasing returns to scale technology such as

Y = L2 .

133

5.5 General equilibrium with production

Bhattarai K. (2006) Macroeconomic Impacts of Taxes: A General Equilibrium Analysis, In-

dian Economic Journal, 54:2:95-116.

maximises utility by consuming goods and services supplied by producers and paying for them by

income that it receives in return of supply of labour and capital inputs to the producers. Firms

optimise pro…t combining inputs with the existing technology in production and rewarding inputs

according to its marginal productivity. Tax policies of government in‡uence both production and

consumption sides of the economy by a¤ecting prices of inputs and outputs. By distorting the mar-

ginal conditions of optimisation, these taxes in‡uence choices of goods and services by households

and use of inputs by producers. The incidence and impact of taxes on consumption may di¤er from

taxes on labour income depending on the key parameters for share or elasticities of substitution in

consumption or in the production sides of the economy.

A general equilibrium implies a set of prices that eliminate excess supply or excess demand and

where these prices and wage rates are consistent with the preferences and endowments of households

and technology of …rms. The perfect match between demand and supply for both goods and services

and inputs of production follow from the properties of utility and production functions as given by

explicit analytical solutions in the next section.

Consider an economy consisting of a representative household and a representative …rm. A rep-

resentative household tries to maximise utility by consuming goods and services and from enjoying

leisure subject to his budget constraints.

max U = C l(1 )

(869)

Subject to time and budget constraints:

l + hs = 1 (870)

pc = whs + (871)

c > 0; h > 0;and l > 0;

s

where c is consumption,l is leisure and hs is labour supply, p is the price of the commodity, w

is the wage rate is the pro…t from owning the …rm.

General equilibrium question: problem of the …rm

The producer wants to maximise pro…t by selling goods produced using the labour supplied by

the household.

Problem of the …rm

= py whd (872)

subject to technology constraint as:

y = (hs ) (873)

y > 0; hd > 0;

where y is the output supplied by the …rm and hd is its demand for labour.

134

Lagrangians for constrained optimisation

For the houshold:

(1 )

L (C; L; ) = C (1 hs ) + [whs + pC] (874)

First order conditions here given demand for consumption and leisuer C; L , supply of labour

(1 l) and shadow price

For the …rm:

First order condition from this will give the demand for labour as a function of real wage rate.

First order conditions for the household:

@L (C; L; ) 1 (1 )

= C (1 hs ) p=0 (876)

@C

@L (C; L; )

= (1 ) C (1 hs ) ( 1) w=0 (877)

@hs

@L (C; L; )

= whs + pC = 0 (878)

@

From above two

(1 ) C (1 hs ) ( 1) w

(1 )

= (879)

C 1 (1 hs ) p

First order conditions for households:

w

C= (1 hs ) (880)

(1 ) p

from the budgent constraint and this FOC

w s w

h + =C= (1 hs ) (881)

p p (1 ) p

Supply labour

w

p (1 ) p

hs = w (882)

p

w

p (1 ) p

L=1 w (883)

p

Demand for consumption

135

w

!

ws p (1 ) p w

C= (1 h ) = 1 w (884)

(1 ) p (1 ) p p

Demand for consumption and leisure and supply of labour are thus functions of

w

Real wage rate p

@ 1

= p hd w=0 (885)

hd

1

d 1w 1

h = (886)

p

s w d 1w 1

w 1w 1

= (h ) h =

p p p p p

" 1 #

w 1

1 1

1 1

= (887)

p

the equilibrium in the labour market is determines the real wage rate

1

d 1w 1

p (1 ) wp

h = = hs = w (888)

p p

1

1

1 ( wp ) 1 (1) 1 (1) 1 (1 )w

p

1 w

p = w

p

1

w

=h i 1 (889)

p 1 1 1

1

1

(1 )

the equilibrium in the labour supply is the function of the real wage rate

0 1 1

1

1

B1 C

hd = @ h 1 i 1A (890)

1 1 1 1

(1 )

136

0 1 1

1

1

B1 C

l=1 h=1 @ h 1 i 1A (891)

1 1 1 1

(1 )

Optimal labour output and consumption

the equilibrium in the labour supply is the function of the real wage rate

0 1 1

1

sB1 C

y = (h ) = @ h 1 i 1A (892)

1 1 1 1

(1 )

and optimal consumption

w

C = (1 hs ) =

(1 ) p

0 0 1 1 1

1

B B1

1

C C

B1 @ h C

(1 )@ 1 i 1A A

1 1 1 1

(1 )

1

h 1 i 1 (893)

1 1 1 1

(1 )

A simple numerical example is provided here for the above general equilibrium tax model and used

it to measure the relative impacts of consumption and income taxes in the economy. These impacts

vary according to the preferences of households in relation to technology of production available to

…rms. If households strongly prefer leisure rather than consumption, the costs of income taxes are

likely to be higher than those of the consumption taxes. On the other hand if the households have

stronger preferences for consumption than for leisure then consumption taxes might be costlier.

As stated above these preference and technology factors jointly determine the prices and prices

in‡uence allocation of resources in the economy. Numerical values of model parameters are as

follows:

Time endowments of 68 ours per week is used here as is customary in the literature. Two types

of simulations are conducted using this model. The …rst one is the base case scenario constructed

using a reasonable set of preference and technology parameters as givenabove . Then there is a

no tax scenario where all taxes are eliminated, followed by scenarios with taxes either only on

consumption or only on labour income. The impacts of tax policy experiments are determined by

comparing the utility and changes in output and employment before and after the change in taxes.

In addition sensitivity analyses are conducted to see how the welfare and macroeconomic impacts

change in response to a distribution of households by preference and that of …rms by the production

technology. The grids of parameters for sensitivity analyses to study the impacts of taxes are

measured in terms of levels and changes in utility, output, leisure, labour supply and consumption

as:

137

Table 32: Parameters of the model in the base scenario

Parameter of the model Numerical value in the base model

Utility weight on consumption ( ) 0.6

Utility weight on leisure (1 ) 0.4

Elasticity of output to labour input ( ) 0.6

Value of Endowment L 68 hours

Base consumption tax rate (tc ) 0.17

Income tax rate in the base case (tl ) 0.35

Time endowments of 68 ours per week is used here as is customary in the literature.

Normalisation of price , w + p = 1

Use of both consumption and income taxes and lump sum transfers (base case)

Elimination of all taxes and no transfer

Only labour income tax and lump sum transfers

Only consumption tax and lump sum transfers

The benchmark economy includes consumption tax rate of 17 percent and income tax rate of 35

percent, similar to the one that actually exists in many of the OECD countries including the UK.

In all experiments the government returns tax revenue to the household in the form of a lump sum

transfer. The model is then used to evaluate the impacts of four di¤erent tax reform experiments:

(1) the distortionary cost of both income and consumption taxes; (2) impact of a complete switch

to the labour income tax holding the revenue …xed; (3) impact of a complete switch towards the

consumption tax; and (4) the test of reliability and robustness of the model by examining the

sensitivity to the key parameters of the model.

The Hicksian equivalent variations (EV) are presented in terms of the money metric utility

in the counter factual scenario in comparison to the benchmark scenario by asking how much

the household bene…ts from the tax changes equivalent in terms of the original equilibrium. The

corresponding compensating variation is also in terms of the money metric utility measuring the

amount of compensation a consumer needs to bring back her to the original level of utility after the

changes in tax rates.

The overall welfare costs of taxes, as presented in Table 3 above, show that the costs of using

both consumption and income taxes are higher than of using only either the consumption or only the

labour income tax. The overall distortionary impacts of both consumption and labour income taxes

are up to 3.2 percent of the benchmark utility. This compares to results as contained in Bhattarai

and Whalley (1999, 2003). If the revenue is returned as a lump sum form to the households, the

model results con…rm that the labour income tax has highly distortionary impact in the economy. It

may cost up to 6.2 percent of the benchmark utility. Higher rate of labour income tax …rst reduces

labour supply and output and consumption consequently. In comparison, sole reliance on only

consumption taxes signi…cantly lowers distortions than labour income taxes. Model calculations

suggest that the cost of moving towards only consumption taxes is 0.05 percent of the benchmark

utility. Thus the overall costs are lower when tax is only on consumption than when taxes are both

on consumption and labour income simultaneously.

For this hypothetical economy taxes a¤ect the aggregate output, employment, leisure, labour

138

Table 34: Parameters of the model in the base scenario

Parameter of the model Numerical value in the base model

Utility weight on consumption ( ) 0.25 to 0.6 with steps size of 0.05

Utility weight on leisure (1 ) 0.75 to 0.4 with steps size of 0.05

Elasticity of output to labour input ( ) 0.3 to .65 with steps size of 0.05

Value of Endowment L 68 to 108 hours with steps size of 5

Base consumption tax rate (tc ) 0.17 to 0.67 with steps size of 0.05

Income tax rate in the base case (tl ) 0.40 to 0.85 with steps size of 0.05

Time endowments of 68 ours per week is used here as is customary in the literature.

Normalisation of price , w + p = 1

Table 35: Overall Welfare Impacts of Tax Changes in the General Equilibrium Model of Taxes

Equivalent variation Compensating variation

Elimination of all taxes 3.2% -3.1%

Labour tax only -6.2% 6.7%

Consumption tax only -0.05% 0.05%

supply as well as consumption of the household as shown in Table 4 to Table 7. It is obvious that

the adverse macroeconomic impacts of only labour income taxes are a lot higher than those of only

consumption taxes.

When both labour income and consumption taxes are removed, households lose the amount

of transfer income from the government but still it has a very good positive impact on output,

consumption and utility level of the representative household. In contrast the labour income tax

discourages labour supply relative to both the no tax and consumption tax only cases leading to

highly distortionary e¤ects on the economy.

This model generates predictable results when subject to sensitivity tests along the various

rates of consumption and labour income tax rates. It con…rms that the welfare costs of taxes rise

proportionately to the squares of tax rates as suggested by the famous Harberger triangle, a measure

of the dead weight loss of taxes.

The model also behaves well when subject to changes in the endowments. Households receive

higher utility as their endowments rise but at a decreasing rate given the law of diminishing marginal

utility. Since the consumer values both consumption and leisure, the increase in utility of increasing

only consumption show a diminishing utility as does the increase in the share of labour in production

which raises the marginal productivity of labour and reduces the amount of leisure in the utility

function.

The …rst scenario considers the e¢ ciency impacts of removing all the taxes and transfers in

the UK. When a representative household does not pay tax it also does not receive any transfer

from the government. This is an extreme scenario in which all public services are provided by the

private sector. The second scenario considers switching completely to the labour income tax and

eliminating all indirect taxes. The third scenario, on the other hand is switching completely to

consumption taxes and removing all taxes on the labour income. The results of the model are very

intuitive.

139

Table 36: Macroeconomic Impacts of Alternative Taxes

Variables Both taxes No taxes Labour income tax Consumption tax

Utility 14.142 14.601 13.689 14.526

Output 6.505 8.032 5.849 7.431

Leisure 45.333 35.789 49.012 39.703

Labour Supply 22.667 32.211 18.988 28.297

Consumption 6.505 8.032 5.849 7.431

Revenue 2.109 1.687 1.687

Wage 0.147 0.13 0.156 0.136

Price 0.853 0.87 0.844 0.864

Pro…t 14.142 14.601 13.689 14.526

Consumption tax 0.17 0.263

Labour income tax 0.35 0.57

Table 37: Impact of Alternative Taxes: Percentage changes compared to the base case

Variables Both taxes Labour income tax Consumption tax

Utility 3.246 -6.246 -0.511

Output 23.471 -27.174 -7.478

Leisure -21.053 36.946 10.936

Labour Supply 42.105 -41.051 -12.151

Consumption 23.471 -27.174 -7.478

Revenue -100

Wage -11.406 19.868 4.595

Price 1.964 -2.972 -0.687

Pro…t 25.896 -29.339 -8.114

Consumption tax 0.17 0.263

Labour income tax 0.35 0.57

Equivalent Variation = 3.715

Compensating Variation = -3.582

E¢ ciency Gains from Switching to Labour income Taxes

Equivalent Variation = -6.9

Compensating Variation = 7.0

E¢ ciency Gains from Switching to Consumption Taxes

Equivalent Variation = 2.967

Compensating Variation = -2.882

Summary of results The key results of this exercise in the general equilibrium impacts of tax

reforms are the following:

1. The e¢ ciency gains from switching to only consumption taxes are about 80 percent of the gains

of eliminating all the taxes. Optimal consumption tax rate given the revenue constraint set

140

equal to 80 percent of the benchmark revenue level is 2.9 percent. This seems a very sensible

result considering the fact that consumers ultimately bear the burden of all taxes. Similarly

consumers make a choice whether to consume a certain product or not depending upon its

price. If the prices are high because of taxes they can increase utility by not consuming the

heavily taxed good and by taking more leisure instead of work.

2. Labour income tax is highly distortionary in this model for various reasons. As before 47

percent tax rate of labour income is optimal to meet the required revenue target. It reduces

the labour supply. Both output and consumption becomes smaller after such a tax is imposed.

The e¢ ciency losses from switching to this sort of taxes can be up to 6.9 percent of the original

utility.

3. The …rst result shows that the net deadweight loss of the current tax and transfer system is

about 4 percent of GDP.

Household gets utility from consuming goods and leisure

M ax U = C L(1 )

(894)

c;l

Subject to

p:C + w:Lh = wL (895)

Lh + Lf = L (896)

C > 0; L > 0;and Lf > 0;

M ax = PY w Lf (897)

Lf

Y = Lf (898)

Y > 0; Lf > 0;

Household Problem: Maximise Utility

M ax U = C L(1 )

(899)

c;l

Subject to

p:C + w:Lh = wL (900)

Lagrangian optimisation:

L (C; Lh ; ) = C L(1 )

+ wL p:C w:Lh (901)

141

Optimal demand for goods C:solving the …rst order conditions

wL L

C= = p (902)

p w

Buy more when goods are cheaper and when they have more income

Optimal demand for leisure Lh

(1 ) wL

Lh = = (1 )L (903)

w

if L = 1600 and = 0:4 then :Lh = 0:6 1600 = 960:

= PY w Lf (904)

Y = Lf (905)

1

P 1

Lf = (906)

w

P 1

Y = (907)

w

Let = 0:5

Clearing Goods and Labour Markets: Real Wage Rate

Y =C (908)

P 1

Y = = 6400:5 = 25:29 (910)

w

L 0:4 1600

C= p = p = y = 25:29 (911)

w w

p 0:4 1600

= = 25:29 (912)

w 25:29

if w = 1 set as numeraire labour market clears as

142

Table 38: Parameters of the General Equilibrium Model

Parameters Value

0.4

0.5

L 1600

w (normalised) 1

C 0:4 25:29

= = = 0:12 (914)

p 25:29

Shadow price in tax scenario

Lh 0:6 480 0:6

C 0:4 21:90

T = = = 0:116 (915)

p 21:90

This is the change in utility associated to unit change in income.

Allocations and Prices in Equilibrium

Variable Base No Tax Solution Tax Solution

output (Y ) 25.29 21.90

Consumption(C) 25.29 21.90

Leisure(Lh ) 960 720

Labour demand(Lf ) 640 480

Utility(U ) 224.19 178.09

Relative price wp 25.29 21.90

Shadow Price 0.12 0.116

Welfare loss to households from the government = (224:19 178:09) =224:19 = 0:2056 = 20:56%:

E¤ective labour tax = 400/1600=0.25= 25%. True if households do not get utility of from

public spending. How far this is true depends on the e¢ ciency of the public sector.

Exercise

Prove that a …rm need to pay higher wage rate to its workers and lower the price of commodity

while expanding output if it operates under an increasing returns to scale technology such as

Y = L2 .

Q5. An economy is inhabited by type 1 and type 2 people. The type 1 is more productive than the

type 2. Policy makers encourage productive people by assigning a greater weight to the utility of

3 1

more productive people. They aim to maximise the social welfare function: W = U14 U24 where W

is the index of the social welfare, U1 represents the utility of type 1 people and U2 is the utility of

type 2 people. For simplicity assume that resources of this economy produce a given level of output

Y. It is consumed either by 1 or by 2 type people. Market clearing condition implies: Y = Y1 + Y2

143

p p

. Preferences for type 1 are given by U1 = Y1 and for type 2 by U2 = Y2 . In a given year total

output, Y, was 1000 billion pounds.

1. What is the distribution of output between type 1 and type 2 that maximises the social welfare

index? What is the maximum value of the social welfare index of this economy?

2. What would have been the allocation if policy makers had given equal weight to the utility

1 1

of both types of people in the economy such as W = U12 U22 . By how much does the welfare

index change in this case than compared to the social welfare in (1) above?

3. How would the social welfare index change in (1) if a tax rate of 20 percent is imposed in

consumption and the tax receipts are not given back to any of these consumers? How much

would the value of social welfare index be in this case?

3 1

4. Assume that the policy makers still hold the welfare function to be W = U14 U24 . How would

the social welfare index change in (3 ) if all tax receipts are transferred to type 2 people?

Answer

Here

Y = Y1 + Y2 = 1000

3 1 p 3

4

p 1

4

L = U14 U24 + [1000 Y1 Y2 ] = Y1 Y2 [1000 Y1 Y2 ] (916)

3 1

L = Y18 Y28 [1000 Y1 Y2 ] (917)

@L 3 5 1

= Y1 8

Y28 =0 (918)

@Y1 8

@L 1 3 7

= Y18 Y2 8

=0 (919)

@Y2 8

@L

= 1000 Y1 Y2 = 0 (920)

@

3 5 1 1 38 7

Y 8

Y28 = Y Y 8

(921)

8 1 8 1 2

3Y2 = Y1 (922)

1000

1000 = Y1 + Y2 = 3Y2 + Y2 =) Y2 = = 250 (923)

4

Index of social welfare in this economy is

3 1 p 3

4 p 1

4 3 1

W = U14 U24 = 750 250 = (750) 8 (250) 8 = 23:9 (925)

144

Answer (2) For both of them to get same level of utility:

1 1 p 1

1

p 1

2

L = U12 U22 + [1000 Y1 Y2 ] = Y1 Y2 [1000 Y1 Y2 ] (926)

1 1

L = Y14 Y24 [1000 Y1 Y2 ] (927)

@L 1 3 1

= Y1 4

Y24 =0 (928)

@Y1 4

@L 1 1 3

= Y14 Y2 4

=0 (929)

@Y2 4

@L

= 1000 Y1 Y2 = 0 (930)

@

1 3 1 1 14 3

Y 4

Y24 = Y Y 4

(931)

4 1 4 1 2

Y2 = Y1 (932)

1000

1000 = Y1 + Y2 =) Y2 = = 500 (933)

2

Y1 = Y2 = 500 (934)

Index of social welfare in this economy is

1 1 p 1

1 p 1

2 1 1

W = U12 U22 = 500 500 = 500 4 500 4 = 22:4 (935)

Answer (3)

3 1 p 3

4

p 1

4

L = U14 U24 + [1000 Y1 Y2 ] = 0:8Y1 0:8Y2 [1000 Y1 Y2 ] (936)

3 1

L = 0:8 Y18 Y28 [1000 Y1 Y2 ] (937)

@L 3 5 1

= 0:8 Y 8

Y28 =0 (938)

@Y1 8 1

@L 1 38 7

= 0:8 Y Y 8

=0 (939)

@Y2 8 1 2

@L

= 1000 Y1 Y2 = 0 (940)

@

3 5 1 1 38 7

0:8 Y 8

Y28 = 0:8 Y Y 8

(941)

8 1 8 1 2

145

3Y2 = Y1 (942)

1000

1000 = Y1 + Y2 = 3Y2 + Y2 =) Y2 = = 250 (943)

4

Index of social welfare in this economy is

3 1 3 1 3 1

W = U14 U24 = (0:8 750) 4 (0:8 250) 4 = (600) 4 (200) 4 = 455:9 (945)

Answer (3)

If all tax is given to person 2.

3 1 p 3

4 p 1

4 3 1

W = U14 U24 = 600 400 = 600 8 400 8 = 23:3 (947)

Problem 7: General Equilibrium and Welfare Analysis

1. There are two people living in an economy. For simplicity assume that a …xed amount of

output of 200 is produced each year. Entire

p output is consumed

p in the same year. Utility of

individual 1 and 2 is represented by U1 = Y1 and U2 = 12 Y1 .

(a) What is the utility received by each individual if the output is divided equally between

these two people? What is the output received by each if it is distributed so that each

of them gets the same amount of the utility?

(b) What is the distribution of output that maximises the total utility for the whole economy?

(c) If person 2 needs utility 5 in order to survive how should the output be distributed?

1 1

(d) Suppose that the authorities like to maximise the social welfare function W = U12 U22 ,

how should the output be distributed between them?

2. (a) An economy is inhabited by type 1 and type 2 people. The type 1 is more productive than

the type 2. Policy makers encourage productive people by assigning a greater weight to

the utility of more productive people. They aim to maximise the social welfare function:

3 1

W = U14 U24 where W is the index of the social welfare, U1 represents the utility of type

1 people and U2 is the utility of type 2 people. For simplicity assume that resources of

this economy produce a given level of output Y. It is consumed either by 1 or by 2 type

people. Marketpclearing condition implies: p Y = Y1 + Y2 . Preferences for type 1 are

given by U1 = Y1 and for type 2 by U2 = Y2 . In a given year total output, Y, was

1000 billion pounds.

(b) What is the distribution of output between type 1 and type 2 that maximises the social

welfare index? What is the maximum value of the social welfare index of this economy?

146

(c) What would have been the allocation if policy makers had given equal weight to the

1 1

utility of both types of people in the economy such as W = U12 U22 . By how much does

the welfare index change in this case than compared to the social welfare in (a) above?

(d) How would the social welfare index change in (a) if a tax rate of 20 percent is imposed

in consumption and the tax receipts are not given back to any of these consumers? How

much would the value of social welfare index be in this case?

3 1

e. Assume that the policy makers still hold the welfare function to be W = U14 U24 . How

would the social welfare index change in (c ) if all tax receipts are transferred to type 2

people?

representative household tries to maximise utility by consuming goods and services and from

enjoying leisure subject to his budget constraints. The producer wants to maximise pro…t by

selling goods produced using the labour supplied by the household.

max U = C l(1 )

(948)

Subject to time and budget constraints:

l + hs = 1 (949)

pc = whs + (950)

c > 0; h > 0;and l > 0;

s

where c is consumption,l is leisure and hs is labour supply, p is the price of the commodity, w

is the wage rate is the pro…t from owning the …rm.

Maximisation problem for the representative …rm can be states as:

= py whd (951)

subject to technology constraint as:

y = (hs ) (952)

y > 0; h > 0;

d

where y is the output supplied by the …rm and hd is its demand for labour.

(b) Derive its demand for consumption goods and derive its demand for leisure.

(c) Write the Lagrangian function for the …rm’s optimisation problem.

(d) Derive …rm’s demand for labour.

(e) De…ne a competitive equilibrium for this economy.

(f) Compute the real wage that brings goods and labour market in equilibrium.

147

(g) What is the equilibrium quantity of c or y?

(h) What is the equilibrium quantity of l and h?

(i) Formulate the problem with sales and income tax. Discuss qualitatively the macroeco-

nomic impacts of (a) switching completely to the sales taxes or (b) to labour income

taxes or to (c) capital income tax.

148

5.8 Two sector model of nessecity and luxury goods (income distribtu-

ion)

Workers and capitalists dwell in an economy. Workers consume only necessities and capitalists

consume necessities and luxury goods. Workers supply all labour and capitalists save 20 percent of

their income, spend 20 percent in necessities and 60 percent in luxury goods. Total labour supply

is 50.

LS = 50; w1 = w2 = w (953)

Production function of sector i is

Qi = Ai Ki i Li1 i

(954)

K A

Necessity sector 0.5 100 1

Luxury sector 0.5 144 1

1 2 3

Workers 1 0 0

Capitalist 0.2 0.6 0.2

wL1 rK1 (955)

@

= (1 1 ) A1 K1 L1

1 1

= P1 0:5 1000:5 L 0:5

w=0 (956)

@L1

Thus labour demand in necessity goods sector

2

5P1 P1

L0:5

1 = ; L1 = 25 (957)

w w

Supply of necessity goods

( )0:5

2

P1 P1

Q1 = A1 K1 1 L11 1

= 10L0:5

1 = 10 25 ; Q1 = 50 (958)

w w

Demand for labour and supply function of luxuries

wL2 rK2 (959)

@

= (1 2 ) A2 K2

2

L2 2

= P2 0:5 1440:5 L 0:5

w=0 (960)

@L2

149

Thus labour demand in luxury goods sector

2 2

6P2 6P2 P2

L0:5

2 = ; L2 = = 36 (961)

w w w

Supply of luxury goods

( )0:5

2

P2 P2

Q2 = A2 K2 L22

2 2

= 12L0:5

2 = 12 36 ; Q2 = 72 (962)

w w

Income of labour and capitalists

Income of workers

YL = wL1 + wL2 = 50w (963)

Income of capitalists (from the production function capitalist get the same as the labour)

YK = YL = 50w (964)

w

Qd1 = 60 (966)

P1

Demand for luxury goods

w

Qd2 = 40 (968)

P2

Market clearing conditions in goods and labour markets

P1 w

Q1 = 50 = Qd1 = 60 (969)

w P1

P2 w

Q2 = 72 = Qd2 = 40 (970)

w P2

2 2

P1 P2

L1 + L2 = LS = 25 + 36 = LS = 50 (971)

w w

I=S (972)

Walras’Law: sum of excess demand is zero; when two markets clear third market automatically

clears.

Market clearing prices

Set numeraire P1 = 1:

From necessity goods market:

150

P1 w 1 w 5

50 = 60 =) 5 = 6 =) w2 = =) w = 0:913 (973)

w P1 w 1 6

From luxury goods market:

P2 w 5 5 5 25

72 = 40 =) P22 = w2 = = = 0:463 =) P2 = 0:680 (974)

w P2 9 9 6 54

Allocations:

1 w 0:913

Q1 = 50 = 54:8 = Qd1 = 60 = 60 = 54:8 (975)

0:913 P1 1

P2 0:680 w 0:913

Q2 = 72 = 72 = 53:63 = Qd2 = 40 = 40 = 53:7 (976)

w 0:913 P2 0:680

2 2

P1 1

L1 = 25 = 25 = 29:97 (977)

w 0:913

2 2

P2 0:680

L2 = 36 = 36 = 19:97 (978)

w 0:913

Consumption:

workers’demand for necessity good

Capitalist’s demand for necessity good

Total demand for necessity good

workers do not consumer luxury good C2;;L = 0;

Capitalist’s demand for luxury good

0:6YK 27:39

C2;;K = = = 40:23 (983)

P2 0:681

Investment demand by capitalist for luxury good

= = = 13:43 (984)

P2 P2 0:680

151

Small Open Economy Trade Model: Expansionary Devaluation Open above model by

including exports and imports and for simplicity …rst assume …xed output and inputs

X = f K; L = C + E (986)

Exports depends on exchange rate (e), domestic price (P) and foreign price for domestic goods

( ) and the elasticity of exports ( )

E = E0 e (987)

P

Imports depends on exchange rate (e), domestic price (P) and price of imported goods (Pm )

and the elasticity of exports ( )

C P

= K0 e m (988)

M P

Resource Balance with foreign borrowing B

P X + eB = P C + ePm M (989)

Small Open Economy Trade Model: Expansionary Devaluation

Devaluation lowers the foreign price of domestic goods ( ) , it raises supply of exports (E), it

reduces the amount of imports (M ) raises the production of import substitute goods. Thus both

domestic and foreign demand for home products rise. Thus devaluation is expansionary.

Excess of imports over exports need to be …nanced by foreign borrowing.

eB = ePm M PE (990)

If borrowing rise, imports rise or exports fall, domestic consumption rise. Borrowing may be

necessary when import prices rise or domestic prices fall. This is an over-determined system. Many

things may happen

Parameters of the model

E0 ; K0 ; ; ; K; L; X; ; B; Pm (991)

Gains from Devaluation

Variables of the model

C; E; M; P; e (992)

Draw a diagram of import export trade-o¤ and export supply and demand functions.

Whether workers or capitalist gain depends on what kind of goods are exported and imported

by external borrowing.

Imported goods may contain necessary goods such as food, medicine, agricultural inputs used

by workers or luxury goods such as cars, perfumes, entertainment goods for capitalists. Exports

may contain necessity goods or luxury goods. Redistribution impacts of devaluation thus depend

on the composition exports and imports.

152

5.9 General equilibrium model of Trade: Ricardian Comparative Ad-

vantage Theory

Theory of international trade has developed over time in works of Ricardo (1817), Ohlin (1933),

Stopler-Samuelson (1947), Bhagawati Helpman (1976), Dixit and Stiglitz (1977), Meade(1978),

Krugman (1980), Whalley (1985), Neary (1988),Krugman and Venables (1995), Hine and Wright

(1998), Edwards(1993), Eaton and Kortum (2002), Markusen (1995), Taylor (1995), Raut and Ranis

(1999), Roe and Mohladi (2001), Greenaway, Morgan and Wright (2002),Melitz (2003), Beaulieu,

Benarroch and Gaisford (2004). These theories are applicable in explaining real world problems

( eg.Bhattarai and Whalley (2006), Bhattarai and Mallick (2003)). As the growth rate of global

trade is greater than the growth of the global GDP there the space of globalization is rapid and it

is a¤ecting lives of millions of people. Trade models, essentially involve application of the general

models to answer who gains and who loses from exchange of goods and services across borders.

Essentially it is application of basic microeconomic theories at international scale.

There are two countries indexed by j, producing two goods, manufacturing and services.

Each of them have an option to be self reliant or to trade on the basis of comparative advan-

tage.

Under the import substituting industrialisation (ISI) regimes countries favoured to be self

reliant and infant industries were protected by tari¤s and non-tari¤ barriers. After numerous

rounds of trade negotiations under GATT/WTO over the years, all countries now have realised

that the autarky solutions like this are economically ine¢ cient. In contrast globalisation is a

norm.

trade is mutually bene…cial for trading nations and raises welfare in both countries. Aim of

this model is to illustrate on these statements analytically and numerically with a small and

transparent example.

For this it is assumed that each country j specialises in commodities in which it is more

e¢ cient and engages in trade.

The exchange rate is determined by the relative prices of two commodities in the global

market.

Preferences in country 1 are expressed by its utility function in consumption of good 1 and 2

, C1;1 and C1;2 respectively:

1 1 1

max U1 = (C1;1 ) (C1;2 ) (993)

Income of country 1 is obtained from the wage income in sector 1 and sector 2 plus the transfers

to country 1

153

where L1;1 and L1;2 are labour employed in sector 1 and sector 2 w1;1 and w1;2 are corresponding

wages respectively and T R1 is the transfer income.

Technology constraints in sector 1 in country 1

where a1;1 is the productivity of labour in sector 1 in country 1.

Technology constraints in sector 2 in country 1

where a1;2 is the productivity of labour in sector 2 in country 1.

Resource constraint in country 1 de…ned by the labour endowment as:

Production possibility frontier of country 1 now can be de…ned as

1 1

L1 = :X1;1 + :X1;2 (998)

a1;1 a1;2

Given above preferences the demand for good 1 in country 1 is

1 :I1

C1;1 = (1000)

P1

the demand for good 2 therefore is:

(1 1 ) :I1

C1;2 = (1001)

P2

Theoretically two trade arrangements are possible in this model. First one is an autarky

equilibrium in which each country is separate and isolated from another. It produces just for

its own consumption and no trade take place between these two countries.

Such autarky solution is close to the production arrangement when countries were adopting

ISI trade strategy.

Proposition 1 Autarky solution is Pareto dominated by trade equilibrium for reasonable pa-

rameters of preferences and technology.

154

A Lagrangian function is used to express how each country maximises welfare subject to its

production possibility frontier constraint under the autarky equilibrium as:

(1 1)

1 1

$1 = X1;11 X2;1 + L1 X1;1 X2;1 (1002)

a11 a12

First order conditions with respect to X11 and X21 and as:

@$1 1 (1 1)

= 1 X1;1

1

X2;1 =0 (1003)

@X1;1 a11

Analytical solutions in autarky

@$1 ( 1)

= (1 1 ) X1;1 X2;1

1

=0 (1004)

@X2;1 a12

@$1 1 1

= L1 X1;1 X2;1 = 0 (1005)

@ a11 a12

Analytical solutions of in autarky

1 1 (1 1)

1 X1;1 X2;1 X2;1 a12

From the …rst two …rst order conditions 1 ( 1)

= (1

1

1) X1;1 = a11

(1 1 )X1;1 X2;1

(1 1) a12

X2;1 = X1;1 (1006)

1 a11

optimal value of X1;1 is found now putting this condition in the production possibility frontier

constraint.

1 1 1 1 (1 1) a12 1 (1 1)

X1;1 + 1 X2;1 = 1 X1;1 + 1 X1;1 = 1 X1;1 1 + = L1 (1007)

a11 a2 a1 a2 1 a11 a1 1

1

X1;1 = 1 a1 L1 (1008)

Similarly the optimal value of X2;1 is found by

(1 1) a12 (1 1) a12 1 1

X2;1 = X1;1 = 1 a1 L1 = (1 1 ) a2 L1 (1009)

1 a11 1 a11

For each of 1 country amount produced depends on productivity and preferences parameters

and the endowment of its labour input. The autarky welfare level is:

1 1 (1

1 1)

U 1 = (X1;1 ) 1 1

1

(X2;1 ) = 1 a1 L1 (1 1 ) a2 L1 (1010)

Two Country Ricardian Trade Model

Preferences in country 2 are expressed by its utility function in consumption of good 1 and 2

, C2;1 and C2;2 respectively:

155

2 1 2

max U2 = (C2;1 ) (C2;2 ) (1011)

Income of country 2 is obtained from the wage income in sector 1 and sector 2 plus the transfers

to country 2

where L2;1 and L2;2 are labour employed in sector 1 and sector 2 w2;1 and w2;2 are corresponding

wages respectively and T R2 is the transfer income.

Technology constraints in sector 1 in country 2

where a2;1 is the productivity of labour in sector 1 in country 2.

Technology constraints in sector 2 in country 2

where a2;2 is the productivity of labour in sector 2 in country 2.

Resource constraint in country 2 de…ned by the labour endowment as:

Production possibility frontier of country 2 now can be de…ned as

1 1

L2 = :X2;1 + :X2;2 (1016)

a2;1 a2;2

Given above preferences the demand for good 1 in country 2 is

2 :I2

C2;1 = (1017)

P1

the demand for good 2 therefore is:

(1 2 ) :I2

C2;2 = (1018)

P2

Autarky or Trade

Theoretically two trade arrangements are possible in this model. First one is an autarky

equilibrium in which each country is separate and isolated from another. It produces just for

its own consumption and no trade take place between these two countries.

Such autarky solution is close to the production arrangement when countries were adopting

ISI trade strategy.

Proposition 2 Autarky solution is Pareto dominated by trade equilibrium for reasonable pa-

rameters of preferences and technology.

156

Analytical solutions in autarky

A Lagrangian function is used to express how each country 2 maximises welfare subject to its

production possibility frontier constraint under the autarky equilibrium as:

(1 2)

1 1

$2 = X1;22 X2;2 + L2 X1;2 X2;2 (1019)

a2;1 a2;2

First order conditions with respect to X12 and X22 and as:

@$2 1 (1 2)

= 2 X1;2

2

X2;2 =0 (1020)

@X1;2 a2;1

@$2 ( 2)

= (1 2 ) X1;2 X2;2

2

=0 (1021)

@X2;2 a2;2

Analytical solutions in autarky

@$2 1 1

= L2 X1;2 X2;2 = 0 (1022)

@ a2;1 a2;2

2 1 (1 2)

2 X1;2 X2;2 X2;2 a2;2

From the …rst two …rst order conditions 2 ( 2)

= (1

2

2) X1;2 = a2;1

(1 2 )X1;2 X2;2

(1 2) a2;2

X2;2 = X1;2 (1023)

2 a2;1

optimal value of X1;2 is found now putting this condition in the production possibility frontier

constraint.

1 1 1 1 (1 2) a2;2 1 (1 2)

X1;2 + X2;2 = X1;2 + X1;2 = X1;2 1 + = L2 (1024)

a2;1 a2;2 a2;1 a2;2 2 a2;1 a2;1 2

Similarly the optimal value of X2;2 is found by

(1 2) a2;2 (1 2) a2;2

X2;2 = X1;2 = 2 a2;1 L2 = (1 2 ) a2;2 L2 (1026)

2 a2;1 2 a2;1

For each of 2 country amount produced depends on productivity and preferences parameters

and the endowment of its labour input. The autarky welfare level is:

2 2

1 (1 2)

U 2 = (X1;2 ) (X2;2 ) =( 2 a2;1 L2 )

2

((1 2 ) a2;2 L2 ) (1027)

Summary of two country trade model in Autarky

Thus the level of welfare in country 1 is determined in terms of its preferences for consumption

of good 1 and 2 as re‡ected by 1 and its own production technology as re‡ected in a11 and

a12 .

157

Numerical version of this model is applied to country 1 and country 2 taking the population

as rough indicator of its resource in production. country 1 has 200 million population and

country 2 has 400 million population. country 1 is more productive in producing services goods

X1 whereas country 2 has more advantage in producing manufacturing goods X2 . Preferences

are similar but technologies are di¤erent. These parameters are set out in Table 1.

a1 a2 L

country 1 0.4 5 2 200

country 2 0.6 2 5 400

Under the autarky equilibrium these two economies are completely isolated and produce only

for domestic consumption. The optimal production and consumption and employment of

labour for both sectors, prices of commodities and labour, and utility for the representative

hocountry 1ehold are as given in Table 2. In per capita terms citizens of the country 1 and

country 2 have welfare of 1.46 and 1.76 respectively.

X1 X2 L1 L2 U p2

country 1 400 240 80 120 294.4 0.6

country 2 480 800 240 160 588.8 1.67

Each country produces both goods in no trade equilibrium which as explained here is very

ine¢ cient. Welfare can be improved by making these countries trade.

Analytical solutions for trade equilibrium under specialisation

A representative hocountry 1ehold in each country maximises its welfare subject to its budget

constraint.

Demand for goods are derived by standard constrained optimisation on supply side for each

country j . Under trade equilibrium it is optimal for each country to specialise in goods in which it

has comparative advantage. The optimisation problem and the …rst order conditions for constrained

optimisation are given as follows:

(1 j)

$j = X1;jj X2;j + [Ij P1 X1;j P2 X2;j ] (1028)

First order conditions:

@$j j 1 (1 j)

= j X1;j X2;j P1 = 0 (1029)

@X1;j

@$j j ( j)

= (1 j ) X1;j X2;j P2 = 0 (1030)

@X2;j

Analytical solutions for trade equilibrium under specialisation

158

@$j

= Ij P1 X1;j P2 X2;j = 0 (1031)

@

j 1 (1 j)

j X1;j X2;j j X2;j P1

(

= = (1032)

j) (1

(1 j ) X1;j X2;j

j

j ) X1;j P2

(1 j) P1

X2;j = X1;j (1033)

j P2

(1 j) P1

P1 X1;j + P2 X2;j = P1 X1;j + P2 j P2 X1;j = Ij

j Ij (1 j ) Ij

X1;j = ; X2;j = (1034)

P1 P2

Analytical solutions for trade equilibrium under specialisation

Global market clearing conditions for goods 1 and 2 are

N

X

X1;j = X1 (1035)

j

N

X

X2;j = X2 (1036)

j

Under complete specialisation, country 1 country 1 specialises in services X2 and produces 1825

units of it. country 2 specialises in manufacturing X1 goods and produced 6000 units of it. It is

easy to determine country 2’s income if we choose good 1 as numeraire setting P1 = 1.

Analytical solutions for trade equilibrium under specialisation

Relative price of good 2, P2 need to be determined to …nd the level of income in the country 1.

This can be done using the global market clearing condition

1

:I 1 2 2

:I

+ = 0:4 (1000 1) + 0:6 (2000 P2 ) = 1000 (1038)

P1 P1

1000 400 600

P2 = = = 0:5 (1039)

1200 1200

Now it is easy to determine the income of the country 1 as:

Analytical solutions for trade equilibrium under specialisation

Since income level for both country 2 and the country 1 are determined, it is now easy to

determine the level of demand in both countries:

159

1 I1 2 I2

X1;1 = = 0:4 (1000) = 400; X1;2 = = 0:6 (1000) = 600 (1041)

P1 P1

(1 1 ) I1 0:6 (1000) (1 2 ) I2

X2;1 = = = 1200; X2;2 = (1042)

P2 0:5 P2

0:4 (1000)

= = 800 (1043)

0:5

Solutions of both autarky and trade equilibria are given in Table 3 and 4. Given the prefer-

ences and technology speci…cations, with complete specialisation both countries gain from trade.

Comparative static analysis of trade can be done changing the preference or technology parameters.

Analytical solutions for trade equilibrium under specialisation

Production Consumption

Autarky Trade Autarky Trade

X1 X2 X1 X2 C1 C2 C1 C2 P

country 1 400 240 1000 0 400 240 400 1200 1

country 2 480 800 0 2000 480 800 600 800 0.5

Table 45: Comparing Employment and Welfere under Specialisation and Autarky

Employment Uitlity

Autarky Trade Autarky Trade

L1 L2 L1 L2 U U

80 120 200 0 294.4 773.3

240 160 0 400 588.8 673.2

Gains from trade may be distributed di¤erently across countries (Bhattarai and Whalley (2006)).

Further there are opportunities for bargaining on the share of those gains particularly from dynamic

strategic considerations and the basic elements required for such dynamic model is provided in the

next section.

GAMS programme: trade.gms; trade_2.gms

Beaulieu E, M. Benarroch and J. Gaisford (2004) Trade barriers and wage inequality in

a North-South model with technology-driven intra-industry, trade, Journal of development

Economics, 75:113-136

Bhattarai K. and S. Mallick (2013) Impact of China’s currency valuation and labour cost

on the US in a trade and exchange rate model. North American Journal of Economics and

Finance, 25, 40-59.

Bhattarai K and J Whalley (2006), Division and Size of Gains from Liberalization of Trade

in Services, Review of International Economics, 14:3:348-361, August.

160

Dixit A K and J E. Stiglitz (1977) Monopolistic Competition and Optimum Product Diversity,

American Economic Review, 67:3:297-308.

Eaton J and S. Kortum (2002) Technology, Geography, and Trade, Econometrica, 70: 5:Sep:1741-

1779

Journal of Economic Literature, 31: 3 :1358-1393, September.

Greenaway D. W. Morgan and P. Wright (2002) Trade Liberalisation and Growth in Devel-

oping Countries, Journal of Development Economics, vol. 67 229-244.

Helpman E (1976) Macroeconomic Policy in a Model of International Trade with a Wage

Restriction, International Economic Review, 17:2:262-277.

Hine R.C. and P.W. Wright (1998) Trade with Low Wage Economies, Employment and Pro-

ductivity in UK Manufacturing, Economic Journal, 108:450:1500-1510.

Krugman P. (1980) Scale Economies, Product Di¤erentiation and the Pattern of Trade, Amer-

ican Economic Review, 70:5:950-959.

Markusen. J, R. (1995) The boundaries of multinational enterprises and the theory of inter-

national trade, Journal of Economic Perspective, 9:2:169-189.

Meade, James (1978) The Meaning of Internal Balance, Economic Journal, 88 (351): Sep

423-435.

Industry Productivity, Econometrica, 71:6:1695-1725.

Neary P.J. (1988) Determinants of the Equilibrium Real Exchange Rate, American Economic

Review, 78:1:Mar.: 210-215.

Ohlin B (1933) Interregional and international trade, Harvard economic studies ; no.39

Raut L and G Ranis (eds.) Trade, Growth and Development: Essays in Honour of Professor

T N Srinivasan, Contribution to Economic Analysis 242, Elsevier, NorthHolland, Amsterdam,

1999

Roe T and H. Mohladi (2001) International Trade and Growth: An Overview Using the New

Growth Theory, Review of Agricultural Economics, 23:2:423-440

Taylor M. P. (1995) The Economics of Exchange Rates, Journal of Economic Literature,

March, vol 33, No. 1, pp. 13-47.

Whalley, J. (1985) Trade Liberalization Among Major World Trading Areas, MIT Press

161

5.10 Exercise 12’: migration and factor mobility

Problem 8: Migration or Factor Movement Across Countries

1. Consider trade between two countries. One is abundant in capital and another in labour. For

simplicity assume that the production functions of these economies are given by

Y1 = K1 1 L1 1 (1044)

Y2 = K2 2 L2 2 (1045)

K L Output

Country 1 500 1000 0.4 0.6 ?

Country 2 1000 500 0.6 0.4 ?

1. (a) What will be the rental rate of capital and wage rate in each country if both goods

and factors are immobile across countries?

(b) What will be the rental rate and output if there is a global market for capital and

labour? Explain the pattern of migration across countries.

(c) Is free trade equivalent to free mobility of factor of production according to Heckscher-

Ohlin-Stopler-Samuelson theorem?

(d) Trade is not bene…cial to every one. Discuss how labour in labour abundant and

capitalists in capital abundant countries gain from trade on the basis of this model.

(e) Show that in a static world like this aggregate global income remains the same but

there is a change in the distribution of income.

Beaulieu E, M. Benarroch and J. Gaisford (2004) Trade barriers and wage inequality in

a North-South model with technology-driven intra-industry, trade, Journal of development

Economics, 75:113-136

Bhattarai K and J Whalley (2006), Division and Size of Gains from Liberalization of Trade

in Services, Review of International Economics, 14:3:348-361, August.

Dixit A K and J E. Stiglitz (1977) Monopolistic Competition and Optimum Product Diversity,

American Economic Review, 67:3:297-308.

Greenaway D. W. Morgan and P. Wright (2002) Trade Liberalisation and Growth in Devel-

oping Countries, Journal of Development Economics, 67 229-244.

Helpman E (1976) Macroeconomic Policy in a Model of International Trade with a Wage

Restriction, International Economic Review, 17:2:262-277.

Hine R.C. and P.W. Wright (1998) Trade with Low Wage Economies, Employment and Pro-

ductivity in UK Manufacturing, Economic Journal, 108:450:1500-1510.

162

Krugman P. (1980) Scale Economies, Product Di¤erentiation and the Pattern of Trade, Amer-

ican Economic Review, 70:5:950-959.

Melitz M. T. (2003) The Impact of Trade on Intra-Industry Reallocations and Aggregate

Industry Productivity, Econometrica, 71:6:1695-1725.

Roe T and H. Mohladi (2001) International Trade and Growth: An Overview Using the New

Growth Theory, Review of Agricultural Economics, 23:2:423-440

Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature,

March, vol 33, No. 1, pp. 13-47.

Optimal Tax and Public Goods

max U h = (1 ) ln Y h Th + ln G (1046)

subject to

P Yh Th + G = I (1047)

h h

where V is the utility of households, Y T is the net of tax income, G the public good and

the weight in utility from consumption of public goods. The production side of the economy is

represented here by income for simplicity.

L Y h ; G; = (1 ) ln Y h Th + ln G + I P Yh Th G (1048)

Optimal Tax and Public Goods

L Y h ; G; (1 )

= P =0 (1049)

@Y h (Y h T h)

L Y h ; G;

= =0 (1050)

@G G

This implies optimal public good and optimal tax correspond to preference for public goods

(1 ) G

=P (1051)

(Y h T h)

G = PTh = PT (1052)

G = PY (1053)

Samuelson’s Theory on Optimal Public Spending

Sum of the marginal rate of substitution of all citizens should equal marginal cost of providing

public goods

(see two citizen public good model)

Consumers consume private (x) and public goods (G)

163

max u1 = u1 (x1 ; G) (1054)

subject to a given level of utility for the second consumer

and the resource contraint

x1 + x2 + c (G) = w1 + w2 (1056)

Constrained optimisation for this is

Samuelson’s Theory on Optimal Public Spending

@u1 (x1 ;G)

@L

@x1 = @x1 = 0 =) = @u1@x (x1 ;G)

1

@L

; ; @x 1

= @u2 (x2 ;G)

@x2 = 0 =) @u2@x2(x2 ;G)

=

@u1 (x1 ;G) @u2 (x2 ;G) @c(G) 1 @u1 (x1 ;G) @u2 (x2 ;G)

@L

@G = @G @G @G = 0; =) @G @G = @c(G)

@G

@G @G @c (G)

@u1 (x1 ;G)

+ @u2 (x2 ;G)

= ; M RS1 + M RS2 = M C(G):::Q:E:D: (1058)

@G

@x1 @x2

Households problem

max U = C L (1059)

Subject to

p (1 + t) C + wL = wL (1060)

Lagrangian for houshold optimisation

L (C; L; ) = C L + p (1 + t) C + wL wL (1061)

Household Optimisation

L (C; L; )

= L + p (1 + t) = 0 (1062)

@C

L (C; L; )

=C+ w=0 (1063)

@L

L (C; L; )

= p (1 + t) C + wL wL = 0 (1064)

@

Above three FOC equations (1403) - (1064) can be solved for three variables :

L(C;L; )

@C L p (1 + t)

M RSCL = L(C;L; )

=) = (1065)

C w

@L

164

Household Optimisation

p (1 + t)

L= C (1066)

w

Putting (1410) into (1064)

p (1 + t)

p (1 + t) c + wL wL = p (1 + t) C + w C wL = 0 (1067)

w

1 wL

C= (1068)

2 p (1 + t)

p (1 + t) p (1 + t) 1 wL 1

L= C= = L (1069)

w w 2 p (1 + t) 2

Demand for goods is low with higher taxes and prices, high with higher wage rate and labour

endowment; high with the higher share of spending on goods and services.Given these pref-

erences the demand for leisure is half of the labour endowment.

Firms’pro…t maximisatin problem

Subject to

r

p 1

Y = LS =

L (1071)

2

Consumers pay tax not the producers. In no tax case, given this production technology and

demand side derivations, labour demand equals labour supply

Labour market clearing

L + LS = L (1072)

Goods market clearing

C=Y (1073)

Let total labour endowment L be 200. Then labour supply is

1 1

LS = L L=L L = L = 100 (1074)

2 2

Given this labour supply the level of output will be

r

p 1 p

Y = LS = L = 100 = 10 (1075)

2

From the zero pro…t condition required equilibrium = p:Y w:LS = 0 and setting the

numeraire p = 1

165

p:Y = w:LS (1076)

Y 10 1

w= = = (1077)

LS 100 10

Numerical Example of the General Equilibrium Model

1

Given the equilibrium relative wage rate of w = 10 both goods and labour market clear

when t = 0, demand for good eqauls supply as:

1 wL 1 1

C= = (200) = 10 (1078)

2 p (1 + t) 2 10

Similarly the demand for labour and leisure equal total endowment of labour

Labour market clears. Therefore this is a general equilibrium; at these prices both goods and

labour market clear, household maximise utility and …rms maximise pro…t.

When t = 0:2 then

1 wL 1 1 (200)

C= = = 8:33 (1080)

2 p (1 + t) 2 10 1:2

Government revenue and spending:

U = C L = 8:33 100 = 833 (1084)

Thus 20 percent tax has reduced the household welfare by 16.7 percent. Can utility from public

spending of compensate for this lost welfare?

Household Problem: Maximise Utility

M ax U = C L(1 )

(1085)

c;l

Subject to

p:C + w:Lh = wL (1086)

Lagrangian optimisation:

L (C; Lh ; ) = C L(1 )

+ wL p:C w:Lh (1087)

166

Optimal demand for goods C:solving the …rst order conditions

wL L

C= = p (1088)

p w

Households buy more when goods are cheaper and when they have more income

Optimal demand for leisure Lh

(1 ) wL

:Lh = = (1 )L (1089)

w

if L = 1600 and = 0:4 then :Lh = 0:6 1600 = 960:

= PY w Lf (1090)

Y = Lf (1091)

1

P 1

Lf = (1092)

w

P 1

Y = (1093)

w

Let = 0:5

Clearing Goods and Labour Markets: Real Wage Rate

Y =C (1094)

P 1

Y = = 6400:5 = 25:29 (1096)

w

L 0:4 1600

C= p = p = y = 25:29 (1097)

w w

p 0:4 1600

= = 25:29 (1098)

w 25:29

if w = 1 set as numeraire labour market clears as

167

Table 47: Parameters of the General Equilibrium Model

Parameters Value

0.4

0.5

L 1600

w (normalised) 1

C 0:4 25:29

= = = 0:12 (1100)

p 25:29

Shadow price in tax scenario

Lh 0:6 480 0:6

C 0:4 21:90

T = = = 0:116 (1101)

p 21:90

This is the change in utility associated to unit change in income.

Allocations and Prices in Equilibrium

Variable Base No Tax Solution Tax Solution

output (Y ) 25.29 21.90

Consumption(C) 25.29 21.90

Leisure(Lh ) 960 720

Labour demand(Lf ) 640 480

Utility(U ) 224.19 178.09

Relative price wp 25.29 21.90

Shadow Price 0.12 0.116

Welfare loss to households from the government = (224:19 178:09) =224:19 = 0:2056 = 20:56%:

E¤ective labour tax = 400/1600=0.25= 25%. True if households do not get utility of from

public spending. How far this is true depends on the e¢ ciency of the public sector.

Problem 9: Monopolistic Competition

1. Using geometric method prove the Heckscher-Ohlin theorem that a country will export the

commodity that uses its relatively abundant factor with unique relation between prices of

factors and products making the commodity trade complete substitutes for trade in factors.

(hint: constant return to scale, free trade in goods but complete immobility of factors of

production; use PPP and Edgeworth boxes for Xand Y and K and L,px =py and w and r).

2. Consider a …rm in monopolistically competitive industry

Q=A B P (1102)

168

Prove that its marginal revenue is given by

Q

MR = P (1103)

B

(a) If the cost function is C = F + cQ then prove that the average cost declines because of

the economy of scale.

(b) Further assume that the output sold by a …rm, number of …rms, its own price and average

prices of …rms are given by

1

Q=S b P P (1104)

N

show that the average cost rises to number of …rms in the industry when all …rms charge

same price.

AC = n:F

s +c

(c) Prove that price charged by a particular …rm declines with the number of …rms

P = c + b1n

(d) Determine the number of …rms and price in equilibrium. Explain entry exit behavior

and prices when number of …rms are below or above this equilibrium point.

(e) Collusive and strategic behaviors may limit above conclusions. Discuss.

(f) Apply above model to explain international trade and its impact on prices and number

of …rms in a particular industry.

(g) Use this model to explain interindustry and intra-industry trade.

(h) Use monopolistic competition model to analyse consequences of dumping practices in

international trade.

1. Assume that the MNC has home and foreign markets, faces distinct demand curves across

two countries and faces di¤erent cost curves. Home market is more lucrative than the foreign

market both in terms of prices and cost e¤ectiveness. Despite that the MNC has a global

ambition, therefore it aims to extend its business in overseas markets. The main objective of

the MNC is to control the market and to maximise pro…t.

P1 = 130 Q1 (1105)

and associated cost function is

C1 = 10Q1 (1106)

Demand in the foreign (host) country

P2 = 90 Q2 (1107)

169

and associated cost function is

C2 = 20Q2 (1108)

1. (a) what will be output price and welfare under perfect competition?

(b) What will be price, output and welfare in the host country if the monopolist forms a

cartel with the …rm in the host country?

(c) What will be price, output and welfare if the MNC plays Cournot game with the …rm in

the host country?

(d) How will above result change if the monopolists acts as a price leader in Stackelberg

equilibrium?

(e) How will above result change if both …rms play under a Bertrand equilibrium adopting

a predatory pricing strategy?

Atkinson A. B.and N. H. Stern (1974) Pigou, Taxation and Public Goods The Review of

Economic Studies, 41:1:119-128.

Bhattarai K (2010) Taxes, public spending and growth in OECD countries, Journal of Per-

spective and Management, 1/2010.

Bhattarai K and J. Whalley (2009) Redistribution E¤ects of Transfers, Economica 76:3:413-

431 July.

Blundell R (2010) Empirical Evidence and Tax Policy Design: Lessons from the Mirrlee’s

Review, Institute of Fiscal Studies.

Darling A. Chancellor of Exchequer, HM Treasury (2009), Securing the Recovery: Growth

and Opportunity, Pre-Budget Report, December , 2009.

Feldstein M (1974) Incidence of Capital Income Tax in a Growth Economy with Varying

Saving Rates, Review of Economic Studies, 41:4:505-513

Fullerton, D., J. Shoven and J. Whalley (1983) Dynamic General Equilibrium Impacts of Re-

placing the US Income tax with a Progressive Consumption Tax, Journal of Public Economics

38, 265-96.

Mirlees, J.A. (1971) An exploration in the theory of optimum income taxation,Review of

Economic Studies, 38:175-208.

Perroni, C. (1995), Assessing the Dynamic E¢ ciency Gains of Tax Reform When Human

Capital is Endogenous, International Economic Review 36, 907-925.

170

6 L6: Game theory: Bargaining in Goods and Factors mar-

kets

In many circumstances optimal decisions of an economic agent depends on decisions taken by

others. Dominants …rms competing for a market shares, political parties contesting for power and

research and scienti…c discoveries aimed for path-breaking innovations are in‡uenced by decision

taken by others. In all these circumstances there are situations where collective e¤orts rather

than individual ones generate the best outcome for the group as a whole and for each individual

members of the group. Concepts of bargaining, coalition and repeated games developed over years

by economists such as Cournot (1838), Bertrand (1883), Edgeworth (1925) von Neumann and

Morgenstern (1944) and Nash (1950, 1953) is developing very fast in recent years following works

of Kuhn (1953), Shapley (1953),Shelten ( 1965) Aumman (1966) Scarf (1967), Shapley and Shubik

(1969), Harsanyi(1967), Spence (1974), Hurwicz (1973), Myerson (1986), Maskin and Tirole (1989),

Kreps (1990), Fundenberg and Tirole (1991) and Binmore (1992), Rubinstein (1982) Sutton (1986)

Cho and Kreps (1987) Sobel (1985) Machina (1987) Riley (1979) McCormick (1990), Ghosal and

Morelli (2004) and others. These have generated models that can be applied to analyse the relative

gains from coalitions rather than without these coalitions.

Outcome of a noncooperative games can be more easily explained by Nash bargaining game that

is popularly known as a game of splitting a pie between two parties, right or left. Rule of this game

is that the sum of the shares of the pie claimed by players cannot exceed more than 1, otherwise

each will get zero. Standard technique to solve this problem is by maximising the Nash Product.

It is natural that economic agents play a zero sum and non-cooperative game until they realise

the bene…ts of coalition and cooperation. When an agreement is made and cooperation is achieved

there is a question on whether such coalition is stable or not. There are always incentives at least

for one of the player to cheat others from this cooperative agreement in order to raise its own share

of the gain. However, it is unlikely that any player can fool all others at all the times. Others

will discover such cheating sooner or later. Therefore a peaceful solution requires credibility and a

punishment mechanism by which any party that tries to cheat on the agreement is punished unless

it amends its uncooperative behaviours toward others.

A coalition of players should ful…l individual rationality, group rationality and coalition rational-

ity. These can be ascertained by the supper-additivity property of coalition where the maximisation

of gain requires being a member of the coalition rather than playing alone. The imputations in the

core guarantees each member of a coalition the value at least as much as it could be obtained by

playing independently. At the core of the game each player gets at least as much from the coalition

as from the individual action, there does not exist any blocking coalition. This is equivalent to

Pareto optimal allocation in a competitive equilibrium (Scarf (1967)). Some imputations are domi-

nated by others; the core of the game is the strong criteria for dominant imputation. Core satis…es

coalition rationality.

Ability of a player to in‡uence the outcome of the game depends on the pivotal status enjoyed by

that player. In a game with 3 players; power of player i is re‡ected by its Shapley value. Consider

six possible ordering of 123 pivotal game. Three players can order themselves in 3!= 6 ways. Each

of these number can appear only twice in the middle out of six possible combinations. A player

located in the middle is pivotal. If parties realise this fact while bargaining, such bargaining is likely

to generate a stable and cooperative solution.

When intention cannot be directly revealed or stated players can signal indirectly to other play-

ers. These signals can take many forms. Signalling plays important roles in strategic choices of

171

individuals, parties, communities, regions, national and the global community as a whole. For-

mation of payo¤ discussed above depends on signalling - players do not know the moves of their

opponents but based on their interpretation of signal they can however, put some numerical values

to the payo¤.

A rational player interprets signals correctly and chooses actions that support each other. This

brings that player up in the progress ladder. Wrong interpretation of signals results in status quo or

even a gradual decline in the standard of that player. Success in the game thus relates very much on

ability and dexterity in providing right signals and accurate interpretation of signals coming from

other players. Interpreting those signals correctly and translating them into actions more accurately

brings success; sending wrong signals or interpreting them incorrectly is a recipe of failure. Status

of player i, si is thus a stochastic process that depends on ability of signal extraction. Such ability

depends on intuition and information set i .

Very few games are plaid only once. Economic agents, political parties, live for a long time and

play games repeatedly. Economists have applied Cournot-Nash bargaining game of oligopoly to

explain the consequences of cooperative and non-cooperative games on the division of gains from

bargaining. It can quantitatively be illustrated using a Nash bargaining oligopoly model.

Players often do not have enough information about other players in the game. They have

to guess intention of other players looking at their choices. People are principals of a political

game, they want better standard of living, peace and prosperity in a country but they do not have

enough information about the true intention of the members of political parties act as their agents

and should in principle be responsible for their principals - the common people who elect political

parties frequently in the parliament. Once elected party with majority forms the government and

tries to ful…l its collective interest. Political contracts are as similar as wage contracts in a labour

market that are designed to match e¤orts put by a worker to their productivities in the labour

maker. Political parties know their type but the people do not.Thus in the presence of information

asymmetry , the e¤orts by the good party is at the …rst best level as the bad e¤ort by him is not as

attractive as the good e¤ort, it is not pro…table for a good party to pretend to be bad party. Good

party is not attracted by the contract for the bad party. Similarly it is costly for the bad party to

act as a good party - it is optimal for it to select the contract appropriate for a bad party, that is

being out of the o¢ ce.

Cournot (1838), Bertrand (1883), Edgeworth (1925) von Neumann and Morgenstern (1944),

Nash (1950);

Kuhn (1953), Shapley (1953),Shelten (1965) Aumann (1966) Luce and Rai¤a (1957) Scarf

(1967), Shapley and Shubic (1969), Harsanyi (1967), Spence (1974),

Myerson (1986), Kreps (1990), Fundenberg and Tirole (1991) and Binmore (1992), Roth

(2008); Sobel (1985), Hey (1987), Kreps (1990)

Mirlees (1971), Maskin and Moore (1999), Maskin and Tirole (1992), Cripps (1997), Perlo¤

(2013)Osborne and Robinstein (1994)

Cripps and Thomas (1995), Gardener (2003)

Bhaskar and To (2004), Mailath and Samuelson (2006)

Texts: Holt (2007), Rasmusen (2007), Dixit, Skeath and Reiley (2009), Varian (2010), Perlo¤

(2014)

172

6.1 Formal de…nitions

Strategic form game is a tuple G = (Si ; ui ) for each player i = 1; :::; N where Si is the strategy

available to player i and ui : xN

j=1 Sj ! R is payo¤ of play i. It is …nite if the strategy set contains

…nitely many elements. For instance strategy set of column player Sj = fR; M; Lg and of the row

player Sj = fT; M; Bg

R M L

T 3,0 0,-5 0,-4

M 1,-1 3,3 -2,4

B 2,4 4,1 -1,8

Strictly dominated strategy ui (bsi ; si ) > ui (si ; s i ) for (si ; s i ) 2 S and sbi 6= si .

Eliminate the dominated strategies for row and column player

R L

T 3,0 0,-4

B 2,4 -1,8

Weak dominance ui (b si ; si ) ui (si ; s i ) for (si ; s i ) 2 S and sbi 6= si .

N

Given G = (Si ; ui )i=1 strategy sbi is pure strategy Nash equilibrium if for each player i ui (b

s)

ui (si ; sb i ) for all si 2 S.

Mixed strategy Mi is probability distribution over Si

Expected utility from Neumann-Morgenstern utility function is:

X

ui (m) = (m1 (s1 ) ::mN (sN )) ui (si ) (1109)

s2S

For given pure strategies s = (s1 ; ::::; sN ) 2 S with probabilities m1 (s1 ) ; ::; mN (sN )

Theorem: Every …nite strategic form game possesses at least one Nash equilibrium.

Proof of Nash equilibrium

De…nitions:

a. m b 2 M is a Nash equilibrium

b. For every player i, ui (m b i ) = ui (si ; m

b i ) for every si 2 Si given positive weight mb i and

b i ) ui (si ; m

ui (m b i ) for every si 2 Si given zero weight m b i.

c. For every player i, ui (mb i ) ui (si ; m

b i ) for every si 2 Si

1. construct a continuous function that maps m into itself.

fi;j (m) = P

n (1110)

1+ max (0; ui (j 0 ; m i ) ui (m))

b

j 0 21

2. Apply Brouwer’s …xed point theorem to …nd a …xed point ; here numerator is a continuous

function and the denominator is continuos and bounded by contraction mapping f : M ! M it

has a …xed point.

3. demonstrate that the …xed point is Nash equilibrium. LSH = RHS in above function.

b i;j then above function is

fi;j (m) = m

173

n

X

max (0; ui (j 0 ; m i ) b = max (0; ui (j; m i )

ui (m)) ui (m)) (1111)

j 0 21

b i)

Multiply both sides by ui (j; m b and sum over j

ui (m)

n

X n

X

b i;j (ui (j 0 ; m

m b i) b

ui (m)) max (0; ui (j 0 ; m i ) b

ui (m))

j 0 21 j 0 21

X n

= (ui (j 0 ; m

b i) b max (0; ui (j; m

ui (m)) b i) b

ui (m)) (1112)

j 0 21

Pn P

n

b i;j (0; ui (j 0 ; m

m b i ) ui (m))

b = b i;j ui (j 0 ; m

m b i) b = ui (m)

ui (m) b b =0

ui (m)

j 0 21 j 0 21

Now the RHS

n

X

0= (ui (j 0 ; m

b i) b max (0; ui (j; m

ui (m)) b i) b

ui (m)) (1113)

j 0 21

b i) b

ui (m) b

0. That implies ui (m) ui (j 0 ; m

b i ). Therefore m

b

is the Nash equilibrium.

N

G = (p; Ti ; Si ; ui )i=1 where p is probability over Ti is the type of the player ui : S T ! R

Associated strategic form of this game is G = (Rj ; vj )j2J where j is set of indices of the form

j = (i; ti ) where ti 2 Ti and i = 1; :::; N .

0

Now the player j = (i; ti ) s strategy and payo¤ are de…ned as :

Rj = Si (1114)

expected payo¤

n

X

vj (r) = p (t i j ti ) ui rj ; r(k;tk ) k6=i

; ti ; t 1i (1115)

t0 1 2T o

Bayesian Nash equilibrium is the Nash equilibrium of this associated strategic form game.

Theorem: Every …nite game of incomplete information possesses at least one Bayesian Nash

equilibrium.

174

6.1.3 Extensive form Game ( )

1. A …nite set of players N.

2. A set of actions, A

3. A set of nodes, histories, X. it includes initial nodes and a complete description of actions

that have been taken so far. A (x) fa 2 A j (x; a) 2 Xg

4. Probability distribution over actions A (x) A:

5. Set of end nodes E fx 2 X j (x; a) 2

= Xg for all a 2 A: Each end node describes the

complete play of the game so far.

6. A function : fX n (E [ fx0 g) j (x) = ig. When the game reaches at node X it tells it is

the turn player i next.

7. Information set belonging to player i ; Ii fI (x) j (x) = i , some x 2 X n (E [ fx0 g)g

8. for each i 2 N ; Neumann-Morgenstern payo¤ functions at the end node ui : E ! R. This

is payo¤ for every possible complete play of the game.

9. Extensive form game is summarised then, = < N; A; X; E; ; ; I; (ui )i2N .

Economic activities of consumers, producers, governments and nations or regions are interde-

pendent.

Game theory provides tools to study the strategic interactions among such economic agents

where decisions taken by one individual depend on actions taken by others.

Each game has a number of players who choose a set of strategies and rules. .Optimal choices

available to one depend on choices made by others.

Pay-o¤s are clearly de…ned for each player strategy pairs.

Strategic modelling like this started with classics such as Cournot (1838), Bertrand (1883),

Edgeworth (1925) von Neumann and Morgenstern (1944), Nash (1950). It is developing very

fast in recent years following works of Kuhn (1953), Shapley (1953),Shelten ( 1965) Aumann

(1966) Scarf (1967), Shapley and Shubic (1969), Harsanyi(1967), Spence (1974), Kreps (1990),

Fundenberg and Tirole (1991) and Binmore (1992).

Elements of a Game

Rational Players

Strategies

Payo¤ matrix

R

1;1 is pay-o¤ to row player if he plays strategy 1 and the column player plays strategy 1.

Players like to maximise their own pay-o¤ given opponent’s strategy; B will choose strategy 1

or 2 that maximises his/her payo¤ looking at the choice of player A.

Most games have equilibrium from which players do not have any incentive to move away.

175

Table 49: Structure of a Game

Player A

Strategy 1 Strategy 2

Player B R C R C

Strategy 1 1;1 ; 1;1; 1;2 ; 1;2

R C R C

Strategy 2 2;1 ; 2;1; 2;2 ; 2;2

Story 1

In the beginning human beings did not know much on how to produce or organise the society

and economy. They believed in a static world and might of their muscles and had very little concern

to others. They obtained resources of nature for themselves and would play a zero sum game. They

believed that there were …xed amount of goods or commodities that were to be distributed among

people; if some one got more another person would get less. Each of them wanted more. This

was the reason for outbreak of frequent …ghts and quarrels among them as seen in movies of early

inter-continental settlers or in history books. Those who lost the war were forced to move to other

less productive or less pleasant places. There were strategic interactions; actions of one depended

on others but in a two person zero sum (TPZS) framework. Such game can be given by a matrix

such as

Storng Hand

pull push

Strong Leg

walk ( 10; 10) (10; 10)

stand (10; 10) ( 10; 10)

b) Find a mixed strategy for strong-leg and strong-hand

c) What is the value of the game?

d) Why this game is not realistic in modern world?

Story 2

Gradually people learnt to cultivate and grow their food. Civilisations started. Then they

realised how the production and consumption can be organised collectively. Each can gain more

from cooperation. Peace of mind would make them more productive and they can reap the bene…t

of economies of scale. This brings the game to the next stage.

Singer

sing quite

Writer

write (5; 5) (2; 6)

read (6; 2) (3; 3)

b) What makes such solution stable one?

176

c) Why the cooperation is Pareto superior than non-cooperation?

d) What is the solution in mixed strategy?

Story 3

Over time people are taken over by greed and self interest. They started competing out others

for material bene…ts. They played non-cooperative game. Private corporations and …rms emerged

to organise people in production process. Property rights and legal provisions for protecting those

rights got built up in the economic system.

Singer

sing quite

Writer

write (5; 5) (2; 6)

read (6; 2) (3; 3)

b) Show gains from bargain in this game in a diagram?

c) What is the Nash Product?

d) What are the threat points?

Story 4

Now people learnt that inherently human being is sel…sh. They see war not the real solution

of the problem. Gradually clever ones come up with good ideas. They make rules, regulations

and constitutions to build mechanism in order to motivate someone to do good works and punish

some who does bad works. Classical economists had developed models for a perfect world where

information was complete, types and preferences and abilities of economic agents were known. It

was easy to apply rules in such a perfect world based on criteria.

Singer

sing quite

Writer

write (?; ?) (?; ?)

read (?; ?) (?; ?)

Society consists of a large number of individuals. Like minded people enter into a coalition with

speci…c targets and objectives in their mind. They form an alliance that would give them more

than they did not. The core solutions make every one happier than stand alone solutions. Solutions

at the core are more e¢ cient than outside it.

Story 6

World does not have complete information. Market fails to provide certain goods or it disappears

completely under the asymmetric information situation. People take advantage of opportunities

that would make them better even if that hurts others. There are good and bad intentions but it

is very di¢ cult to guess it precisely in the beginning. Insurance companies emerge to make up for

losses.

Story 7

177

Auctioning and competitive bids are mechanism to assign contracts and reveal some information

that would otherwise would not be revealed.

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178

Shapley L and M. Shubik (1969) On Market Games, Journal of Economic Theory, 1:9-25

Varian HR (2010) Intermediate Microeconomics: A Modern Approach, Norton,8th ed..

Player A

Strategy 1 Strategy 2

Player B

Strategy 1 (10; 10) ( 10; 10)

Strategy 2 ( 10; 10) (10; 10)

zero sum game: one’s gain = loss of another ; sports ; market shares

Cooperative Games: Global climate change; bargaining game

Non-cooperative Games: two or many players ;

competition between opposing political parties, countries

Single period of multiple period: static and dynamic

Full information or incomplete information :Firms and consumers; government and pub-

lic;Among individuals, clubs, parties; nations

Dominant strategy

Player A

Advert Dont Advert

Player B

Advert (10; 5) (15; 0)

Dont Advert (6; 8) (10; 2)

Dominant strategy is to advertise for A but B has no dominant strategy.

Solution of Games by Nash Equilibrium (Prisoner’s Dilemma)

Punishment structure for a crime

F in d in g N a sh so lu tio n (u n d e rsc o re th e b e st stra te g y to a p laye r i g ive n th e ch o ic e o f th e o p p o n e nt.

Fact: both players did a crime together. Police suspects and arrest both of them.

179

Table 56: Advertisement Game

Player A

Advert Dont Advert

Player B

Advert (10; 5) (15; 0)

Dont Advert (6; 8) (20; 2)

Player A

Confess Dont Confess

Player B

Confess ( 5; 5) ( 1; 10)

Dont Confess ( 10; 1) ( 2; 2)

Playing non cooperatively each convicts another. Game results in Nash solution (confess,

Confess) = ( 5; 5); Each ends up with 5 years in prison.

By confessing, each gives evidence to the police to determine the highest possible punishment.

If they had cooperated remaining silent, police would not have enough evidence.

Each would have been given only two years of prison ( 2; 2) : This is Pareto optimal

outcome, "where no one could be made better o¤ without making someone worse-o¤".

Cooperation is better but each think that other player will cheat and therefore doesn’t coop-

erate. Therefore stay longer in jail.

There are many example of prisoner’s dilemma game in real world -pricing and output in a

cartel, pollution, tax-revenue.

This game does not have equilibrium in pure strategy. Player B will play H is A plays H but A

will play T if B plays H. If A plays T it is optimal to play T for B, then it is optimal for B to play

H. Game goes in round in circle again.

It can be solved my the mixed strategy.

Flip the coin to randomise the chosen strategies. If each played H or T half of the times optimal

payo¤ is zero to both players. Probability of playing H or T is 0.5.

Solution by mixed strategy

B plays Top p times and Bottom (1 p) times if A plays Left . B plays Top p times and Bottom

(1 p) times if A plays Right.

B likes to be equally well o¤ no matter what A plays.

Solution by the mixed strategy

Expected pay-o¤ for B if A plays Left

Expected pay-o¤ for B if A plays Right

180

Table 58: Prisoners’Dilemma Game

Player A

Confess Dont Confess

Player B

Confess ( 5; 5) ( 1; 10)

Dont Confess ( 10; 1) ( 2; 2)

Player A

Head Tail

Player B

Head (1; 1) ( 1; 1)

Tail ( 1; 1) (1; 1)

p = 0:7 (1119)

B plays Top 70 % of times and Bottom 30% of times.

Subsidy Game Between the Airbus and Boeing

If both Boeing and Airbus produce a new aircraft each will lose -10. If Airbus does not produce

and only Boeing produces Boeing will make 100 pro…t. If Airbus does not produce Airbus can make

100 but then Boeing will decide to produce even at a loss of 10 so that Airbus does not enter in

that market.

Subsidy Game Between the Airbus and Boeing

EU countries want Airbus to produce, they change this by subsidising 20 to Airbus.

Producing new aircraft is dominant strategy for Airbus now, no matter whether Boding produces

or not.

Entry Deterrence Game

In‡ation and unemployment game between public and private sectors

Higher payo¤ is good.

First element represents payo¤ to the row-player (Government). Second element represents

payo¤ to the column-player (private sector).

Nash solution is (H; H) = (4; 4) Cooperative solution would have been better with (L; L) =

(5; 5).

Cost of Cheating

Cooperative solution would have been better with (L; L) = (5; 5) but distrusting each other

results in (H; H) = (4; 4) .

If the game is plaid repeatedly what will be value of the game? It is given by the discounted

present value of the game for any discount rate 0 < < 1:

2 n 5

P V (cooperate) = 5 + 5 + 5 + :::: + 5 = (1120)

1

181

Table 60: Competitive Game

Player A

Left Right

Player B

Top (50; 50) (80; 80)

Bottom (90; 90) (20; 20)

Airbus

Produce Don’t produce

Boeing

Produce ( 10; 10) (100; 0)

Don’t produce (0; 100) (0; 0)

However, there is an incentive to cheat to get 6 instead of 5. when one player deviates from the

cooperative strategy this way another will found out being cheated next period. Then he/she will

punish the cheater by playing non-cooperatively next period. So the value of game :

2 n

P V (cheat) = 6 + 4 + 4 + :::: + 4 (1121)

Cost of Cheating

2 n

P V (cheat) = 6 + 4 + 4 + :::: + 4 (1122)

multiply it by

2 n+1

P V (cheat) = 6 + 4 + :::: + 4 (1123)

taking the di¤erence

2 n+1

(1 ) P V (cheat) = 6 6 +4 4 + :::: + 4 =6+4 (1124)

(1 )

Whether a person cheats or not depends on discount factor

5 1

=6+4 or5 = 6 (1 )+4 1= 2 ; = (1125)

1 (1 ) 2

Extensive form of the game

Solution by Backward Induction (Is there any …rst movers advantage?)

In‡ation and unemployment game in a diagram

In‡ation and unemployment game in a diagram

Economic policy game between the …scal and monetary authority

Binmore K. (1990) Fun and Games: A text on Game Theory, Lexington, Heath.

Cripps, M.W.(1997) Bargaining and the Timing of Investment, International Economic Review, 38:3

:Aug.:527-546

182

Table 62: Subsidy Game

Airbus

Produce Don’t produce

Boeing

Produce ( 10; 10) (100; 0)

Don’t produce (0; 120) (0; 0)

Entrant

Enter Dont Enter

Incumbent

Enter ( 10; 10) (100; 0)

Dont Enter (0; 100) (0; 0)

Mailath G. J. and L. Samuelson (2006) Repeated Games and Reputations: long run relationship,

Oxford.

Osborne M.J. and A. Robinstein (1994) A course in game theory, MIT Press.

Equilibrium concepts:

Backward induction; subgame perfect equilibrium, sequential equilibrium, Bayes’s rule.

The very common example for bargaining game is splitting a pie between two individuals.

The sum of the shares of the pie claimed by both cannot exceed more than 1, otherwise each

will get zero.

If we denote these shares by i and j then i + j 1 is required for a meaningful solution

of the game where each get i 0 and j 0 payo¤. When i + j > 1 then and i = 0 and

j =0 .

Standard technique to solve this problem is to use the concept of Nash Product

max U = ( i 0) ( j 0) (1126)

183

Table 64: Subsidy Game

Entrant

Enter Dont Enter

Incumbent

Enter ( 10; 10) (100; 0)

Dont Enter (0; 120) (0; 0)

Private Sector

H L

Government

H (4; 4) (6; 3)

L (3; 6) (5; 5)

subject to

i + j 1 (1127)

or by non-satiation property i + j =1

L ( i; j; )=( i 0) ( j 0) + [1 i j] (1128)

First order conditions of this maximization problem are

L ( i; j; )

= j =0 (1129)

@ i

L ( i; j; )

= i =0 (1130)

@ j

L ( i; j ; )

=1 i j =0 (1131)

@

From the …rst two …rst order conditions j = i implies j = i and putting this into

the third …rst order condition j = i = 12 . This is called focal point.

Thus Nash solution of this problem is to divide the pie symmetrically into two equal parts. Any

other solution of this not stable. Roy Gardner (2003) and Charles Holt (2007) have a number of

interesting examples on bargaining game.

Application of Bargaining Game

Money to be divided between two players

M = u1 + u2 (1132)

The origin of this bargaining game is the disagreement point d(0; 0), the threat point.

184

Here the utility of player one (u1 ) is plotted against the utility of player two u2 and the line

u1 u2 is the utility possibility frontier (UPF).

Starting of bargaining can be (0; M ) or (M; 0) where one player claims all but other nothing.

But this is not stable.

1 1

O¤ers and counter o¤ers will be made until the game is settled at u = 2 M; 2 M where

each player gets equal share.

Suppose there is 1000 in the table to be split between two players. What is the optimal solution

from a symmetric bargaining game if the threat point is given by d(0,0)? Using a Lagrangian

function for constrained optimisation

First order conditions of this maximization problem are

L (u1; u2 ; )

= u2 =0 (1134)

@u1

L (u1; u2 ; )

= u1 =0 (1135)

@u2

L (u1; u2 ; )

= 1000 u1 u2 = 0 (1136)

@

From the …rst two …rst order conditions u2 = u1 implies u2 = u1 and putting this into

the third …rst order condition u2 = u1 = 1000 2 = 500. This is called focal point.

Numerical Example of Bargaining Game

The Nash bargaining solution is the values of u1 and u2 that maximise the value of the Nash

product u1 u2 subject to the resource allocation constraint,u1 + u2 = 1000.

This bargaining solution ful…ls four di¤erent properties: 1) symmetry 2) e¢ ciency 3) linear

invariance 4) independence of irrelevant alternatives (IIA).

Symmetry implies that equal division between two players and e¢ ciency implies no wastage of

resources u1 + u2 = M or maximisation of the Nash product, u1 u2 .

Linear invariance refers to the location of threat point as can be shown in a bankruptcy game

say dividing 50000. If u is a solution to the bargaining game then u + d is a solution to the

bargaining problem with disagreement point d.

Numerical Example of Bargaining Game

Suppose the player 1 has side payment d1 = 15000

185

L (u1; u2 ; )

= u2 =0 (1139)

@u1

L (u1; u2 ; )

= u1 15000 =0 (1140)

@u2

L (u1; u2 ; )

= 50000 u1 u2 = 0 (1141)

@

Numerical Example of Bargaining Game

implies u2 = u1 15000 and

putting this into the third …rst order condition

50000 15000

u2 + 15000 = u1 ; u2 = 2 = 17500; u1 = 15000 + u2 = 32500.

A risk averse person loses in bargaining but the risk neutral person gains. Suppose the utility

0:5

functions of risk averse person is given byu2 = (m2 ) but the risk neutral person has a linear

utility u1 = m1 .

m1 + m2 = M

.u1 + u22 = 100

Using a Lagrangian function for constrained optimisation

L (u1; u2 ; )

= u2 =0 (1143)

@u1

L (u1; u2 ; )

= u1 2 u2 = 0 (1144)

@u2

L (u1; u2 ; )

= 100 u1 u22 = 0 (1145)

@

Numerical Example of Bargaining Game

From the …rst two …rst order conditions uu1;2 = 2 u2 implies u1 2u22 and putting this into the

third …rst order condition .3u22 = 100 ; u22 = 100

3 = 33:3 ; u2 = 5:77

2 2

u1 = 2u2 = 2 (5:77) = 66:6

u1 + u22 = 66:6 + 33:3 = 100

Thus the risk-averse player’s utility is 66.7 and risk neutral player’s utility is only 5.7.

Morale: do not reveal anyone if you are risk averse, otherwise you will lose in the bargaining.

Coalition Possibilities

186

2N -1 rule for possible coalition

Consider Four Players A,B,C,D

A, B, C, D

AB, AC, AD

BC, BD, CD

ABC, ABD,ACD, BCD,

ABCD

16 -1=15

In many circumstances optimal decisions of an economic agent depends on decisions taken by

others. Dominants …rms competing for a market shares, political parties contesting for power and

research and scienti…c discoveries aimed for path-breaking innovations are in‡uenced by decision

taken by others. In all these circumstances there are situations where collective e¤orts rather

than individual ones generate the best outcome for the group as a whole and for each individual

members of the group. Concepts of bargaining, coalition and repeated games developed over years

by economists such as Cournot (1838), Bertrand (1883), Edgeworth (1925) von Neumann and

Morgenstern (1944) and Nash (1950, 1953) is developing very fast in recent years following works

of Kuhn (1953), Shapley (1953),Shelten ( 1965) Aumman (1966) Scarf (1967), Shapley and Shubik

(1969), Harsanyi(1967), Spence (1974), Hurwicz (1973), Myerson (1986),Gale (1986), Maskin and

Tirole (1989), Kreps (1990), Fundenberg and Tirole (1991) and Binmore (1992), Rubinstein (1982)

Sutton (1986) Cho and Kreps (1987) Sobel (1985) Machina (1987) Riley (1979) McCormick (1990),

Ghosal and Morelli (2004) and others. These have generated models that can be applied to analyse

the relative gains from coalitions rather than without these coalitions.

It is natural that economic agents play a zero sum and non-cooperative game until they realise

the bene…ts of coalition and cooperation. When an agreement is made and cooperation is achieved

there is a question on whether such coalition is stable or not. There are always incentives at least

for one of the player to cheat others from this cooperative agreement in order to raise its own share

of the gain. However, it is unlikely that any player can fool all others at all the times. Others will

discover such cheating sooner or later.

A coalition of players should ful…l individual rationality, group rationality and coalition rational-

ity. These can be ascertained by the supper-additivity property of coalition where the maximisation

of gain requires being a member of the coalition rather than playing alone.

This can be explained using standard notations. Let us take three players [ in the current

Nepalese context N = (1= CPM and 2 =UML, 3 =NC)]. Superadditivity condition implies that the

value of the game in a coalition is greater than the sum of the value of the game of playing alone

by those individual members.

v (1 [ 2 [ 3) v1 (1) + v (2) + v (3) (1146)

Coalitions (parties) playing together generate more value for each of its member than by playing

alone. Team spirit generates extra bene…ts. When normalised to 0 and 1 the value of the gains

from a coalition are:

v (1) = 0; v (N ) = 1 for n = 1; :::; N

The fact that payo¤ of the merged coalition is larger than the sum of the payo¤ to the separate

coalitions is shown by following imputations, that shows ways on how to value of the game can be

distributed among N di¤erent players. The imputations of values characterise these allocations:

187

1 2 3

= + + (1147)

X N

X

i i

v (N ) = = (1148)

i2N i=1

Group rationality implies that total payo¤ to each players in the coalition equals at least the

payo¤ of its independent actions.

i

v (fig) ; i2N (1149)

In the dynamic context players like to maximise the present value, V, of the gain from in…nite

period, with a given discount rate r over years:

Z t=1

V = v (i) e rt dt (1150)

t=0

The imputations in the core guarantees each member of a coalition the value at least as much as

it could be obtained by playing independently. At the core of the game each player gets at least as

much from the coalition as from the individual action, there does not exist any blocking coalition.

This is equivalent to Pareto optimal allocation in a competitive equilibrium (Scarf (1967)). Some

imputations are dominated by others; the core of the game is the strong criteria for dominant

imputation. Core satis…es coalition rationality.

A unique imputation in the core is obtained by Shapley value. This re‡ects additional payo¤

that each individual can bring by adding an extra player to the existing coalition above the pay-o¤

without this player. This is the power of that player. Consider a game of three players in which

the 3rd player always brings more to the coalition than the 1st or the 2nd player.

Payo¤ for coalition of empty set: v ( ) = 0

Payo¤ from players acting alone: v (1) = 0; v (2) = 0; v (3) = 0 ;

Payo¤ from alternative coalitions: v (1; 2) = 0:1; v (1; 3) = 0:2; v (2; 3) = 0:2;

Payo¤ from the grand coalition: v (1; 2; 3) = 1

Power of individual i in the coalitions is measured by the di¤erence that person makes in the

value of the game v (S [ fig v (S)) = 1 , where S is the subset of players excluding i, S [ fig is

the subset including player i. The expected values of game for i is found by taking account of all

possible coalition that person i can enter with N number of players, where is the weighting factor

that changes according to the number of people in a particular coalition. This is the probability

that a player joins coalition,S 2 N and there are (2N -1) ways of forming in N player game:

X s! (n s 1)

i

= n (S) v (S [ fig v (S)) ; n (S) = (1151)

n!

S2N

v (1) v ( ) = 0

v (1; 2) v (1) = 0:1

v (1; 3) v (1) = 0:2 0 = 0:2

v (1; 2; 3) v (2; 3) = 1 0:2 = 0:8

s! (n s 1) 0! (3 0 1) 2! 2

0 (S) = = = = (1152)

n! 3! 3! 6

188

s! (n s 1) 1! (3 1 1) 1! 1

1 (S) = = = = (1153)

n! 3! 3! 6

s! (n s 1) 2! (3 2 1) 2! 2

2 (S) = = = = (1154)

n! 3! 3! 6

Shapley value for player 1 is thus

X 2 1 1 2 19

1

= n (S) v (S [ fig v (S)) = (0) + (0:1) + (0:2) + (0:8) = (1155)

6 6 6 6 60

S2N

For player 2

X 2 1 1 2 19

2

= n (S) v (S [ fig v (S)) = (0) + (0:1) + (0:2) + (0:8) = (1156)

6 6 6 6 60

S2N

Note as before

v (2) v ( ) = 0

v (1; 2) v (1) = 0:1

v (2; 3) v (1) = 0:2 0 = 0:2

v (1; 2; 3) v (1; 3) = 1 0:2 = 0:8

For player 3

X 2 1 1 2 22

3

= n (S) v (S [ fig v (S)) = (0) + (0:2) + (0:2) + (0:9) = (1157)

6 6 6 6 60

S2N

v (3) v ( ) = 0

v (1; 3) v (1) = 0:2 0 = 0:2

v (2; 3) v (2) = 0:2 0 = 0:2

v (1; 2; 3) v (1; 2) = 1 0:1 = 0:9

As the player 3 brings more into the coalition its expected payo¤ is higher than of players 1

and 2. Similar con…gurations can be made where players 1 and 2 can bring more in the coalition.

In the context of Nepal which of three parties mentioned above are pivotal depends on the value

they add to the game. The value of grand coalition is the largest possible value of the game with

N players. This fact is shown by the core of the game in Figure 1.

Figure 1

189

Solutions towards the core are more stable than those towards the corners which are prone to

con‡icts. This is equivalent to …nding a central ground in politics. Ego centric solutions are less

likely to bring any stable solution to the game. In the most stable equilibrium all players gain in

equal proportions to their supporters.

Ability of a player to in‡uence the outcome of the game depends on the pivotal status enjoyed by

that player. In a game with 3 players; power of player i is re‡ected by its Shapley value. Consider

six possible ordering of 123 pivotal game. Three players can order themselves in 3!= 6 ways. Each

of these number can appear only twice in the middle out of six possible combinations. A player

located in the middle is pivotal. If parties realise this fact while bargaining, such bargaining is

likely to generate a stable and cooperative solution. In the 123 game given in Table 1 the player 3

is pivotal in game (2) and (4); player 1 in (3) and (5) and player 2 in (1) and (6). The marginal

contribution (Shapley value) of each player can be presented then as

Therefore each player has 1/3 chance of being pivotal. If 1 is pivotal into the coalition any

coalition with 1 will win - player 1 is powerful. Players 2 and 3 are powerless. When a party

has majority in a parliament that party is in pivotal position. This outcome is reversed in a hung

parliamnet where none is pivotal. There is always a chance that a pivotal player now may have to

give up that position for other players later on.

Another con…guration is to assume that certain party is pivotal all the times. As shown below,

in this situation the Shapley value of player 1 is 1 no matter which position it is in the coalition and

it is 0 for players 2 and 3. In the context of Nepal’s Constituent Assembly, it seems that depending

on circumstances, players NC, CPM and UML each have equal chance of being a pivotal player.

Thus non-pivotal con…gurations are more applicable than pivotal con…gurations.

190

Table 66: No Pivotal Player in a Bargaining Game

orderings M(1,S) M(2,S) M(3,S)

1 123 0 1 0

2 132 0 0 1

3 213 1 0 0

4 231 0 0 1

5 312 1 0 0

6 321 0 1 0

orderings M(1,S) M(2,S) M(3,S)

1 123 1 0 0

2 132 1 0 0

3 213 1 0 0

4 231 1 0 0

5 312 1 0 0

6 321 1 0 0

Simple game theoretic models applicable to analyse the current Nepalese situation could be

developed taking seminal ideas of Shapley and Shubik (1969), Rubinstein (1982), Myerson (1986),

Sutton (1986), Dixit (1987), Maskin and Moore (1999) and Riley (2001).

There are N parties in the game indexed by i = 1; ::::; N . Each party i is interested in its own

pay-o¤ xi (e.g the number of ministries it should have under its command) which it computes using

a payo¤ function Ui that depend on strategies available to players and its information set about

the reactions of other players:

where S1 ; S2 ; ::::; Sn denote the strategies available to players, a0 is common knowledge, and a1 ; a2 ; ::::; an

denote the unknown characteristic of player i. Each player knows which strategy is better for it

given the strategy space of other players but they have less information about the reactions of other

players, aj . They make some subjective estimates about other’s actions while calculating its payo¤

xi . This value gives their reservation or threat point in bargaining. The agreement takes place

when actual bargaining and negotiation ends up giving zi and when this value is greater than or

equal to what the party i had expected, zi = xi . Negotiation breaks down whenever zi 6 xi .

Parties need to learn from each other to create a more realistic beliefs (bj ) about other players

replacing unknown characteristics (a0 ; a1 ; a2 ; ::::; an ) by more accurate representation parameters

(b0 ; b1 ; b2 ; ::::; bn )

191

xi = Li (S1 ; S2 ; ::::; Sn ; b0 ; b1 ; b2 ; ::::; bn ) (1159)

Beliefs on these parameters could be formed on the basis of history, principles and values of parties

and key personalities of the party and studying their relations to other players. Convergence on

beliefs among all parties occurs when they understand and trust each other. This gives credibility

to the outcome of the game. Equilibrium in such case is more certain and e¢ cient and generates

greater payo¤ for parties and welfare of the country.

When the …rst CAN dissolved without promulgating a constitution of Nepal on May 28, 2012 people

changed their beliefs about the true intention and commitment of the UCPN (Maoists) towards

development and their ability to promulgate a constitution of Nepal. They re…ned their beliefs

about the Nepali Congress and UML and other Tarai based parties. This change is re‡ected in the

structure of the second CAN that was elected on November 19, 2013. Still this was a hung CAN

as before but the share of the Nepali Congress increased to 33.9 from 19.3 percents and that of

UML increased to 30.4 from 18.0 percents. The share of UCPN (Maoist) reduced to 14 from 38.1

percents. The UCPN (M) is no longer in a position of dreaming a totalitarian system in Nepal.

After this verdict parties have committed to promulgate the constitution of Nepal by Jan 22, 2015.

Committees in the CAN-II have been able to resolve many disputes but still have not converged

in their opinions regarding the structure of governance or that of federal system till the end of

September 2014.

Total Maoist NC UML MPRF TMLP Others

Total 601 229 116 108 53 21 74

FPTP 240 120 38 33 29 9 11

Proportional 335 100 73 70 22 11 59

Nomination 26 9 5 5 2 1 5

Percentage 100% 38.1% 19.3% 18.0% 8.8% 3.5% 12.3%

Source: Constituent Assembly of Nepal (CAN).

Total NC UML Maoist MPRF RPP Others

Total 601 204 183 84 15 11 103

FPTP 240 105 91 26 4 0 14

Proportional 335 91 84 54 10 10 86

Nomination 26 8 8 (0) 4 (0)1 1 (0)3

Percentage 100% 33.9% 30.4% 14.0% 2.5% 1.8% 17.1%

Source: Constituent Assembly of Nepal (CAN).

Still leaders of Nepal seem to be confused in understanding the basic fact that the gains from

he commitment and cooperation should be much larger than of noncooperation to form coalition

192

or in releasing that the bene…ts of dynamic optimisation are far greater than zero sum game being

played at the moment. It is important to rethink about the true and realistic social welfare function

such as W (Y; S) where Y denotes the level of aggregate economic activities and its growth rates

and S the stability of the system, can be one way to redirect resources wasted in the process of

unsuccessful coalition formation to bring more e¢ cient and Pareto optimal solution. Reinvigorate

the spirits of April 2006 Revolution. Nepal’s per capita income is one third of India and about 12

percent of China though it had similar per capita income with them till 1980. Political instability

in the last two decades has been very costly to Nepal. These could have been decades of spectacular

growth but turned into disaster. There cannot be bigger irony than this in the context of Nepal and

cooperative strategies of each political party is the only way to sort out this problem. Credibility,

respect and commitment only can make this happen.

F e b r u a r y, 1 - 4

B h a t t a r a i K . ( 2 0 1 1 ) C o n s t it u t io n a n d E c o n o m ic M o d e ls fo r t h e Fe d e r a l R e p u b lic o f N e p a l, E c o n o m ic J o u r n a l o f N e p a l, Vo l. 3 3 , N o .1 ,

J a nu a ry _ M a rch , Issu e N o . 1 2 9 , p . 1 -1 5

1 2 6 ,M a rch 2 0 1 1

E c o n o m ic s a n d B u sin e ss, 5 :2 :3 1 5 -3 2 1 .

K u h n H . W . ( 1 9 9 7 ) C l a s s i c s i n G a m e T h e o r y, P r i n c e t o n U n i v e r s i t y P r e s s .

P a th a k P a n d T S ö n m e z (2 0 1 3 ) S ch o o l A d m is s io n s R e fo rm in C h ic a g o a n d E n g la n d : C o m p a rin g M e ch a n is m s b y T h e ir Vu ln e ra b ility to

R o t h A E . ( 2 0 0 8 ) W h a t h a v e w e l e a r n e d f r o m m a r k e t d e s i g n ? , E c o n o m i c J o u r n a l , 1 1 8 ( M a r c h ) , 2 8 5 –3 1 0 .

S h a p le y L lo y d S . a n d M a r t in S h u b ik ( 1 9 6 9 ) P u r e C o m p e t it io n , C o a lit io n a l P o w e r , a n d Fa ir D iv is io n , In t e r n a t io n a l E c o n o m ic R e v ie w ,

10 , 3, 33 7-36 2.

193

6.6 Equivalence of Core in Games and Core in a General Equilibrium

Model

Both game theory and general equilibrium models analyse optimal choices of consumers and pro-

ducers faced with resource constraints in which the essential process involves bargaining over the

gains from the intra and intertemporal trade on goods, services and …nancial assets. In terms of

game theory the core of a bargaining game is given by the payo¤ from a non-blocking coalition. It

is a Pareto e¢ cient point. Similarly core of a general equilibrium lies in the contract curve where

it is di¢ cult to make one economic agent better o¤ without making another worse o¤. The core

of the coalition in the game and core of the equilibrium in a general equilibrium model represent

basically the same thing. The optimal allocation of resources to economic agents possible with given

endowments con…rm to the …rst and second theorems of welfare economics. Abstract solutions of

both models can characterise the optimal allocation of resources after more complex bid and o¤er

interactions among economic agents. Debreu and Scarf (1963) have proven the equivalence of a

competitive equilibrium to the core of the game for economies with and without production by con-

tradiction when preferences are non-satiable, strictly convex and continuous. Scarf (1967) theorem

states that a balanced n person game has a nonempty core. This is best illustrated in terms of a

Venn diagram with three players as given in Figure below.

Assume a pure exchange economy in which each individual i is endowed with ! i endow-

ments,

X i =1. . . n. Let the competitive allocations

X X beX

xi . Then the competitive equilibrium implies

xi = ! i with usual preferences, u xSi u (xi ). In the n person game,T = fSg , the

i i i i

collection of coalitions, is called balanced X

collection if it is possible to …nd factors to weight value

of allocations to each coalition such that i = 1 . Competitive allocations are proven to be in

T =fSg

S fig

core using these weights as:

X n X

X X X X X n

X X X

S

xi = i xi = S xSi = S !i = !i S = !i (1160)

i i T =fSg T =fSg i2S S2T i2S i T =fSg i

S fig S fig

194

Consider three player game as presented in Figure 3. By 2N 1 rule for possible number of

coalitions in N person games, there are seven possible coalitions: f1g,f2g ,f3g ,f1; 2g , f1; 3g,f2; 3g

,f1; 2; 3g . There is some parallel between the value of a property in the central business district as

the values of coalition in intersection can be far greater than values under no coalition; in addition

in a bargaining game there

X can be externality from the bargain as shown by points E around three

circles. The condition i = 1 required for the core thus represents summative weight assigned

T =fSg

S fig

to these individual coalitions.

Thus the competitive equilibrium is equivalent to the allocation at the core, “An exchange

economy with convex preferences always gives rise to a balanced n person game and such will

always have a nonempty core (Scarf (1967)).”

Above state principle is generally true under full information. However, it does not work under

incomplete information. Competitive …nancial markets are perfect under when all agents that have

complete information and are e¢ cient in processing such information. This assumption, however,

is not always correct. Financial markets are full of asymmetric information, activities of one set of

players depend on actions taken by another set of players and the amount of information they have

impacts on the likely choices of others. This requires incentive compatible mechanisms for e¢ cient

allocation of …nancial resources.

Bejan C and J C Gomez (2009) Core extensions for non-balanced TU-games, International

Journal of Game Theory, 38:3-16.

Bullard James, Alison Butler (1993) Nonlinearity and Chaos in Economic Models: Implica-

tions for Policy Decisions, Economic Journal, 103, 419: 849-867

195

Lipsey R. G. and K. Lancaster (1956 - 1957) The General Theory of Second Best, Review of

Economic Studies, 24, 1,11-32

Nash J. (1951) Non-cooperative games, Annals of Mathematics, 54:286-295

Roth, A., Erev, I., 1995. Learning in extensive-form games: Experimental data and simple

dynamic models in the intermediate term. Games Econ. Behav. 8, 164–212

Scarf H. (1967) Core of n Person Game, Econometrica, 35:50-69.

Shapley L (1953) A Value for n Person Games, Contributions to the Theory of Games II,307-

317, Princeton.

52:6:1327-1350.

Producers use labour to produce goods and services. A production function shows how labour

complements with other inputs in production and the marginal productivity of labour shows the

additional unit of output produced by each additional unit of labour. Thus demand for labour is

derived from the demand for output. On the supply side every working age person has 168 hours

a week, 720 hours per months or 8760 hours per year of time endowment which can be allocated

between work and leisre. How many hours does one work and how much is spent in free time really

depends upon the preference between consumption and leisure on one side and the job vacancies

on the other. In theory ‡exibility of real wages guarantees equality between demand and supply

in the labour in a competitive labour market. However, the labour is far from being a perfectly

competitive market. Firms exercise monopoly powers, acting as monopsonists in the labour market

or use their market power in order to retain more e¤ective workers. Hiring decisions of …rms also are

dependent on the aggregate demand. Firms hire more workers during expansion but are reluctant

of recruit any workers during the contraction. A signi…cant number of workers become unemployed

as a consequence.

Given a production fucntion that related output (Yt ) to capital (Kt ), technology (At ) and labour

(Lt )

1

Yt = Kt (At Lt ) 0< <1 (1161)

Wage rate should be paid according to the marginal productivity of labour as:

wt = (1 ) Kt (At Lt ) At (1162)

Supply of labour occurs through the utility maximising behavour of the household.

1

X

t

max U (ct ; 1 lt ) (1163)

t=0

subject to

ct + kt+1 = wt lt + (1 + rt ) kt (1164)

196

This results in labour supply to be:

(1 )

Lt Lt = Lt (1165)

(1 ) + (1 )b

Income patterns over time are di¤erent for di¤erent individuals. Some people start at a very low

level of earnings and experience a rapid rise in income as they gain more job speci…c experience.

Others may have a steady and stagnant income process over years. Still others may even have to

face declining growth in income. What are the factors that lead to higher income growth rates and

what are the factors that setback the process of income growth has been an issue of great interest

among the labour economists.

The years of schooling and job market experience are the most important factors associated

with higher income levels. Given other things constant, generally it is believed that an individual

with greater number of schooling years earns more than a person with a few years or no schooling.

Similarly a person with greater experience earns higher income. Both schooling and experience are

perceived to be the main factors enhancing productivity of an individual.

There are a number of factors that set back the income process. Gender bias has been an area

of continuous research in the labour economics. Females earn less than male either because of a

structural breaks in their career for family reasons or due to gender discrimination in the labour

market. Similarly there are cross regional variation in the income process.

Thinks of millions of workers in the economy. They work for earnings; in Mincerian traditions

earnings depend on quali…cations and status of health and many other conditions as shown in a

regression table below.

2

wi;t = ai + i Si;t + i Ai;t + i Ai;t + i Gi;t + i Ri;t + i Pi;t + t t + "i;t

where wi;t is the wage rate of individual i in year t; Si;t is years of schooling; Ai;t is age of

individual i in time t; Gi;t is the gender of an individual, Ri;t is regional location, t is wave t,

Pi;t is professional background of individual i. Coe¢ cients of such earning functions are estimated

using cross section or panel dataset. For instance using the cross section of the APS:

In addition to above variable earning di¤er by location of the labour markets. Local, regional,

national, urban, rural, global labour market function di¤erently. Earning also veray by profession.

Teachers, lawyers, doctors, engineers, scientists, artists have di¤erent levels of earning. Skilled

workers are paid more than unskilled or semi-skilled workers. Labour market institutions mater.

Job prospects are less in the rigid and opaque labor markets than in ‡exible and transparent labour

markets. Labour earning also vary by the term of employment. Earnings are less in short term

compared to medium term and long term employments. There are professions where labour supply

occurs in intergenerational setting.

As discussed in Pissarides (2013) and in Bhattarai and Dixon (2014) "the phenomenon of equilib-

rium unemployment results from the interaction among N number of …rms and unions (representing

H number of households) which bargain over wages and employment. Following the market sig-

nals of demand and relative prices and costs of inputs, pro…t maximising …rms create vacancies

for speci…c tasks and hire workers when they …nd suitable candidates for these jobs. Similarly

there are workers seeking jobs that match their skills and others who quit jobs and join the pool of

unemployed who may choose to quit jobs and become unemployed. Market speci…c idiosyncratic

shocks cause such entries and exits in the labour market. Equilibrium unemployment and wage

rates result from a Nash-bargain between workers and …rms. Whether the rate of unemployment

falls or rises depends on the relative proportion of entry and exit into the labour market.

197

Source | SS df MS Number of obs = 368525

-------------+------------------------------ F( 17,368507) = 8.76

Model | 139225393 17 8189728.98 Prob > F = 0.0000

Residual | 3.4450e+11368507 934864.212 R-squared = 0.0004

-------------+------------------------------ Adj R-squared = 0.0004

Total | 3.4464e+11368524 935198.879 Root MSE = 966.88

------------------------------------------------------------------------------

GRSEXP | Coef. Std. Err. t P>|t| [95% Conf. Interval]

-------------+----------------------------------------------------------------

ILLDAYS2 | .5135184 3.158899 0.16 0.871 -5.67783 6.704866

ILLDAYS1 | 2.180592 2.085396 1.05 0.296 -1.906723 6.267907

ILLDAYS3 | -4.435447 3.853808 -1.15 0.250 -11.9888 3.117903

ILLDAYS4 | 8.066717 4.485219 1.80 0.072 -.7241797 16.85761

ILLDAYS5 | -5.238917 3.738412 -1.40 0.161 -12.56609 2.08826

ILLDAYS6 | -1.988442 6.544168 -0.30 0.761 -14.81482 10.83793

ILLDAYS7 | -.1315924 8.270102 -0.02 0.987 -16.34075 16.07756

QUAL_14 | 4.705906 5.354454 0.88 0.379 -5.788664 15.20048

QUAL_15 | -6.997297 16.48718 -0.42 0.671 -39.31169 25.3171

QUAL_16 | -12.89791 11.85998 -1.09 0.277 -36.14313 10.3473

QUAL_17 | 97.47657 34.51317 2.82 0.005 29.83178 165.1214

QUAL_18 | -13.84225 32.57728 -0.42 0.671 -77.69276 50.00826

QUAL_19 | 3.716753 4.476542 0.83 0.406 -5.057138 12.49064

QUAL_2 | 13.91868 12.39392 1.12 0.261 -10.37304 38.2104

QUAL_20 | 32.4236 7.656584 4.23 0.000 17.41692 47.43028

QUAL_21 | 43.351 4.285564 10.12 0.000 34.95142 51.75058

QUAL_22 | -1.453274 6.644386 -0.22 0.827 -14.47607 11.56953

_cons | -5.248379 52.42735 -0.10 0.920 -108.0044 97.50769

------------------------------------------------------------------------------

Matching and bargaining functions across all N industries are key elements determining equilib-

rium unemployment . The Matching function (Beveridge curve) gives equilibrium conditions in the

labour market balancing entry and exit from unemployment by aggregating sector and skill speci…c

h h

vacancies Vi;t and unemployment U Ni;t with job creation as:

(1 t)

Mt = M (Vt ; U Nt ) = Vt t U Nt (1166)

where Mt ; Vt and U Nt denote the aggregate number of matching, vacancies and unemployment

respectively among job seekers at time t and aggregate variables are geometric means of household

level variables2 . The matching parameter t is between zero and one and varies over time. It can be

adjusted for prosperous period when there are more vacancies than job seekers or in recession when

there are more unemployed than vacancies. In steady state it should be about 0.5 to re‡ect the

balance between job creation and job destruction. Heterogeneity in the labour market is re‡ected

h h h

by sector and skill speci…c Mi;t ; Vi;t and U Ni;t . These capture the labour market conditions where

production sectors su¤er from shortages of certain skills while facing abundance of other skills.

In each case job seekers and employers bargain over expected earnings by maximising the Nash-

h h

product N Pi;t of the bargaining game over the di¤erence between the earnings from work (Wi;t )

h h h

than in being unemployed (U Ni;t ) and earnings to …rms from …lled Ji;t and vacant jobs Vi;t .

h h

h h h b h h 1 b

N Pi;t = Wi;t U Ni;t Ji;t Vi;t (1167)

Market imperfections in the labour market create opportunity of gains from bargains which is

divided between …rms and workers as indicated by parameter hb that can assume any value be-

tween zero and one, re‡ecting the relative strength of unions (workers) over …rms in such bargains.

Symmetric solution of this satis…es joint pro…t maximisation condition as:

N N N N

2V = V h ; U Nt = h ;M =

U Ni;t h =

Mi;t h ; UNh .

M Vi;t

t t

i=1 i;t i=1 i=1 i=1 i;t

198

h h h h h h h

Wi;t U Ni;t = b Ji;t + Wi;t Vi;t U Ni;t (1168)

In aggregate the job search model can be explained using three simple equations as summarised

by Pissarides (1979, 2000).

First, for each skill type h the dynamics of unemployment depends on the rate of job destruction,

h

t 1 unht , and the rate of job creation, ht q ht unht as unht = ht 1 unht h

tq

h h

t unt .

The steady state equilibrium implied by this is:

h

t T

unht = ; unT = (1169)

h

+ h h + Tq( T)

tq

T

t t

where ht is the rate of idiosyncratic shock of job destruction of household type h and ht is the ratio of

vacancy to the unemployment and q ht is the probability of …lling a job with a suitable candidate

through the matching process explained in (1166). Then unT is the equilibrium unemployment rate

average across all households expressed in terms of avarages of ht ht and q ( T ) given by T , T

and q ( T ) respectively.

Secondly the upward sloping wage curve in ( ht ; wth ) space shows positive links between the

reservation wage (zth ) the price of product p and cost of hiring ( ht cht ) implying higher wage rates

for tighter labour markets as:

h h h h h

wi;t = zth 1 b + b pt 1+ t ct (1170)

h pt c h

Finally there is a downward sloping job creation curve wth = pt rt + t q( h

t

; where pt

t)

h pt c h t

is the price of product, wth the wage rate, and rt + t q( h

, is the cost of hiring and …ring. It

t)

shows the possibility of job creation at lower wage rates and creation of fewer jobs at higher wage

rates. The optimal job creation (demand for labour curve) occurs when …rms balance the marginal

revenue product of labour to wage and hiring and …ring costs" (see some details in Bhattarai and

Dixon (2014)).

Search Equilibrium

Matching function aggregates vacancies and unemployment with job creation as:

M =V U (1171)

where M denote the number of matching of vacancies and job seekers, V is number of vacancies

and U the number of unemployed, is the parameter between zero and one.Job seekers and

employers bargain over expected earnings by maximising the Nash-product of the bargaining

game over the di¤erence between the earnings from work (W) rather than in being unemployed

(U) and earnings to …rms from …lled and vacant jobs.

199

(Wi U ) (Ji V) (1172)

(a) Show that the dynamics of unemployment depends on the rate of job destruction, (1 u)

, and the rate of job creation,

1. (a) Optimal job creation or (demand for labour curve) shows how …rms balance the marginal

revenue product of labour to wage and hiring and …ring costs. Derive the Beveridge curve.

and Auctions

7.1 Original Ideas

Issues of priciple agent games are disscuss in general terms in articles by Harsanyi (1967) Shapley

and Shubik (1969). Hurwicz (1973), Spence (1977) , Riley (1979),Sobel (1985), Myerson (1986)

Sutton (1986), Milgrom , Roberts (1986), Dixit Avinash (1987) Cho and Kreps (1987) , Roger-

son (1988), Moore (1988), Dawes and Thaler (1988), McCormick (1990) Caminal (1990), Frank,

Gilovich, and Regan (1993), Jin (1994), Markusen (1995), Camerer and Thaler (1995), Lundberg

and Pollak (1996), Mookherjee and Ray (2001),Fehr, Gächter and Simon (2000), Besley and Ghatak

(2001), Acemoglu (2001) and Mailath and Samuelson (2006) (see also Watt (2011) and Snyder and

Nicholson (2011)). These explain how the moral hazard and adverse selection -asymmetric infor-

mation in‡uence in decision making of economic agents.

Moral hazard Owners of a …rm principals (P) and workers as agents (A) play a production game

in which agent exerts e¤orts (a) in return of income (y) and principal maximises net pro…t. Agent

can put high or low e¤orts and P cannot observe it. Utility of agent at work is given by

V = u(y) a V0 (1173)

0

This must be greater than a reservation utility V that is available from alternative work. The

income level that an individual worker requires is then given by

1

y=V V0+a (1174)

Less informed P can make sure that A exerts good e¤ort by making wage contract as

Principal’s objective when a is observable is then to maximize pro…t by producing x subject to

the participation constraint

subject to

200

i v(y1 ) + (1 i ) v(y2 ) ai V0 (1177)

There is uncertainty in production resulting in x1 and x2 levels of production, x1 < x2 . Because

of this uncertainty x1 may happen despite A putting high level e¤ort, which P cannot observe.

L= i (x1 y1 ) + (1 i ) (x2 y2 ) + i v(y1 ) + (1 i ) v(y2 ) ai V0 (1178)

First order conditions (for high e¤ort case)

@zh

= h + v 0 (y1 ) = 0 (1179)

@y1

@zh 0

= (1 h) + (1 h) v (y2 ) = 0 (1180)

@y2

@zh 0

= (1 h) + (1 h) v (y1 ) = 0 (1181)

@

Thus in the full information case

1

v 0 (y1 ) = v 0 (y2 ) = =) y1 = y2 (1183)

Thus the owners of the company force managers to put the same level of e¤orts. Risk-neutral

owers bear all risk.

P can design contracts similarly if they like A to put low e¤orts.

P cannot observe a of A; therefore they must design a contract which makes A put ah

This requires adding an incentive compatibility constraint.

Then the problem is modi…ed as

subject to

and

201

h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) + (1 l ) v(y2 ) al (1188)

[ h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) (1 l ) v(y2 ) + al ] (1189)

@zh

= h + v 0 (y1 ) + ( h l) v

0

(y1 ) = 0 (1190)

@y1

@zh 0 0

= (1 h) + (1 h) v (y2 ) + ( h l) v (y2 ) = 0 (1191)

@y2

@zh

= l v(y1 ) + (1 l ) v(y2 ) al V0 =0 (1192)

@

@zh

= h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) (1 l ) v(y2 ) + al = 0 (1193)

@

From these conditions

( h l) 1

+ = (1194)

h v 0 (y1 )

( h l) 1

= (1195)

h v 0 (y2 )

1 1

< < =) y1 > y > y2 (1196)

v 0 (y1 ) v 0 (y2 )

Payment to A now varies according to the contribution in the gross pro…t. It given A an incentive

to choose ah and al

0

( h l ) [v (y1 ) v 0 (y2 )] = ah al (1197)

202

Adverse selection

First best

max xi yi (1198)

subject to

Second best

[v(y2 ) l v(x2 ; 1 ) v(y1 ) + l v(x2 ; 1 )] (1200)

Lx1 =

Ly1 =

Lx2 =

Ly2 =

L =

L =

Example (Tirole): Consider a model of shareholders (P ) and managers (A) with continous

e¤orts e.

203

Managers’utility function is positively related with wages and negatively with the e¤orts as

Re2

u w (1201)

2

Here R is a disutility from work parameter; u0 (w) > 0 and u00 (w) < 0. and reservation wage is

w0 . Thus the participant constraints for A is

Re2

Eu w w0 (1202)

2

Full knowledge equilibrium

Pro…t is a stochastic variable with a random variable

=e+" (1203)

Here " is a random variable with E" = 0

If the shareholder could observe e¤orts, the optimal contract would be w = w is a …xed wage.

Here this from the participation constraint is

Re2

w = w0 + (1204)

2

maximisationof shareholder’s expected pro…t is :

Re2 Re2

E( )=E e+" w0 =e w0 (1205)

2 2

@E ( ) 1 1

= 1 Re = 0 () e = if w0 (1206)

@e R 2R

This is the optimal solution when shareholders could obseve the e¤ort of managers.

Now suppose the e¤orts are not observable. Consider a linear incentive scheme:

w( ) = a+b (1207)

What is the expected utility of A with linear scheme:

Re2 b

Eu a + be + b" () b Re =) e = (1208)

2 R

E¤ort grows with the slope of the incentive scheme. If b = 1; then e = e :

The expected utility at this level of e¤orts is

b2 b2 b2

Eu a + + b" () Eu a + + b" (1209)

R 2R 2R

Shareholder’s expected pro…t

e b b2 b

= E [e + " a be b"] = a = (1 b) a (1210)

R R R

Linear optimal scheme:

204

e b

max = (1 b) a (1211)

R

subject to

b2

Eu a + + b" w0 (1212)

2R

Substitute a from the participation constraint

e b b2

Eu + + b" = w0 (1213)

R 2R

di¤erentiating wrt b

1 b

Eu0 + Eu0 " = 0 (1214)

R

This gives b = 1:

This value of the linear scheme optimises pro…t for the shareholder as the agent puts maximum

e¤orts at work.

Principal Agent Action

Shareholders CEO Pro…t maximisation

Landlord Tentants work e¤ort

People Government Political power

Manager Workers Work e¤ort

Central Banks Banks Quality of credit

Patient Doctor Intervention

Owner Renter Maintenance

Insurnace company Policy holder Careful behaviour

Equilibrium is ine¢ cient relative to full information case

Screening: revealing the risk type of agent

Credit history from credit card companies

Government can improve the market by setting high standards of business contracts or bailing

out troubled ones (Northern Rock, Bear Stearns, Lehman Brothers)

Right regulations –Financial Services Authority, Fair trade commissions; O¢ ce of standards;

Bank of England

205

Moral hazard (hidden action)

iPeople who have theft insurance are likely to haven low quality locksthat are easy to break

(in cars, houses, bicycle (car)) most likely to claim insurances

Remedy: deductible amount; to ensure that some customers take care in security.

Uncertainty about the quality of good or services

honest borrowers less likely to borrow at higher interest rates.

low quality items crowd out high quality items

risky borrowers drive out gentle borrowers in the …nancial market.

people from safe area are less likely to buy theft insurance; only

unsafe customers end up buying theft insurance

healthy people are less likely to buy health insurance

Equilibrium is a¤ected when sellers have more information than buyers.

Seller knows his quality of cars but buyers do not

Market for good cars disappear because of existence of bad cars in the market.

Demand for high quality car falls and demand for low quality cars rise.

signals: warranty and Guarantee

Providing warranty less costly for high quality cars as they last long.

Warranty is costly for low quality cars as they frequently break down.

Buyers can decide whether a car is good or bad looking at the warrantee and pay appropriately.

Right signalling can remove ine¢ ciency due to incomplete information.

Markets for both types of car can operate e¢ ciently by right signals of warranty and Guarantee

206

Pooling, Separating and Mixed Equilibrium

pooling equilibrium (same price for good and bad cars; good cars disappear from the market)

Separating equilibrium where players act as they should according to the signal (prices according

to quality)

(both good and bad cars are bought, some feel cheated)

Near Market failure (mixed strategies) Bayesian updating mechanism at work

1.Education as a signal of productivity

Level of education signals quality of a worker. Given the cost of education it is easier for a high

quality worker to complete a degree than for a low quality worker. In an e¢ cient market potential

employers take level of education as a signal in hiring and deciding wage rates paid to its employees.

Spence (1973) model was among the …rst to illustrate how to analyse principal agent and role of

signalling in the job market.

Pooling equilibrium Consider a situation where there are N individuals applying to work. In

absence of education as the criteria of quality employers cannot see who is a high quality worker

and who is a low quality worker. Employers know that proportion of workers is of high quality

and (1- ) proportion is of bad quality. Therefore they pay each worker an average wage rage as:

w = wh + (1 ) wl (1215)

Every worker gets the average wage rate ; there is no wage premium for higher quality in pooling

equilibrium. If more productive worker is worth 40000 and less productive worker is worth 20000

and =0.5 then the average wage rate will be 30000;

w = wh + (1 ) wl = 0:5 (40000) + 0:5 (20000) = 30000.

Let c denote the cost of education. It is worth for high quality worker to go to school only if

the wage di¤erence having and not having education is greater than the cost of education which is

given by

wh w = wh [ wh + (1 ) wl ] (1216)

Simpli…cation of this condition implies a signalling condition

c

<1 (1217)

wh wl

Going to school is not worth if the wage premium of school is less than the cost of educa-

tion

wh wl < c (1218)

207

If the cost of education is 15000, the net of education wage for high quality worker is 25000

which is less than wage at the pooling equilibrium. Therefore no signalling occurs in this case.

Employers pay average wage rate to each worker without any consideration of their abilities. This

pooling equilibrium remains ine¢ cient as productive workers do not have enough incentive to put

their full e¤orts at work.

wh wl > c (1219)

This is possible if the cost of education is 5000; then wage net of education cost for high quality

is 35000 which is above the pooling wage rate. This makes sense to signal by choosing higher

education. Signalling is optimal in this case; fraction of workers will signal by going to education.

Aggregate labour cost will be the same but wages will be paid according to the productivity of

workers as re‡ected by the level of education of workers.

208

Excel calculations

While making a hiring decision employers take level of education as a signal of quality of workers.

Government Policy and Signalling

It is important to have optimal amount of signalling –too little or too much signalling generates

ine¢ cient result. Empirical …nding on signalling is mixed. Public policy could be designed to

generate right amount of signalling as following:

1. It can create separating equilibrium by subsidizing education of more able workers. It can

ban on wasteful signalling by banning schools that do not produce good workers.

2. High education provides signals, employers pay according to this signal, this will a¤ect the

distribution of wages.

An employer does not know is more productive and who is less productive

It pays the same wage rate to both productive and unproductive workers

market is ine¢ cient, it drives out more productive workers.

Workers can signal their quality by the level of educational attainment, then market may

work well.

Less costlier for high quality worker to get education.

costlier for low quality worker to get the speci…ed education.

209

so the low quality worker gets no education, but the higher quality worker gets education.

Employers pay according to the level of education.

Education works as a signalling device and makes the market e¢ cient.

Education separates the equilibrium.

Consider a level of education e

c1 e c2 e =) c1 c2 (1220)

Cost of education relative to productivity of low and high quality workers for education e

(a2 a1 ) (a2 a1 )

<e < (1222)

c1 c2

Players consisting of {workers, …rms and nature}.

Type 1 is less productive and type 2 more productive.

Employer does not know which one is low or high quality worker but sees level of education

Level of education signals the quality of worker

Workers choose level of education according to their beliefs about its impact on wage o¤er:

wt (e).

Utility from wage and education is given by ut (w; e).

@ut (w;e):

Utility is rising in wage received @w >0

@ut (w;e):

Utility falls in work e¤orts @e <0

The utility function satis…es the single-crossing property

210

Spence model of education: Problem of Choosing Right Level of Education

e

It is more expensive for less productive worker to produce education signal k1 > k2

More Speci…cally

p

ut (w; e) = 42 wt kt e1:5 k1 = 2; k2 = 1 w1 = e; w2 = 2e (1224)

Level of education chosen by less productive worker

The type 1 worker’s optimisation problem

p p

Max ut (w; e) = 42 wt kt e1:5 = 42 e 2e1:5 (1225)

e

@ut (w; e) : 1 1

= 42 p 3e 2 = 0 (1226)

@e 2 e

1 1 42

42 p = 3e 2 =) e1 = =7 (1227)

2 e 6

It is optimal for the less productive worker to takes only seven years of education

p p

Max ut (w; e) = 42 wt kt e1:5 = 42 2e e1:5 (1228)

e

@ut (w; e) : 1 1

= 42 p 2 1:5e 2 = 0 (1229)

@e 2 2e

1 1 1 42

42 p = 1:5e 2 ; 42 p = e =) e2 = = 19:8 (1230)

2e 1:5 2 2:121

It is optimal for the more productive worker to takes 19.8 years of education.

211

It is important to have optimal amount of signalling – too little or too much signalling gen-

erates ine¢ cient result. Empirical …nding on signalling is mixed. Public policy could be

designed to generate right amount of signalling as following

It can create separating equilibrium by subsidizing education of more able workers. It can

ban on wasteful signalling by banning schools that do not produce good workers.

High education provides signals, employers pay according to this signal, this will a¤ect the

distribution of wages.

Principal Agent Model in Job Market: Incomplete Information and Adverse Selection

Principal wants to produce output employing workers with a scheme of wage contract that

matches e¤orts put by a worker to produce.

Worker knows his type but the principal does not.

Principal knows the distribution of quality of workers F(s), where s denotes either good or

bad state such as probability of observing good is 0.5 and of bad 0.5.

Worker accepts or rejects this contract based on self-selection and participation constraints.

Basically worker evaluates the utility from the wage and disutility from work and decides the

amount of work to put in.

Output from good workers is q (e; good) = 3e and from bad state is q (e; bad) = e

If agent rejects the contract there is no work both worker and principal get zero payo¤.

Agent’s utility:

UA (e; w; s) = w e2 (1231)

Principal’s pro…t: . .

Vp (q; w) = q w (1232)

M ax UG = wG e2G = 3eG e2G (1233)

eG

The …rst part is wage income and the second part of disutility of work.

212

The optimal level of e¤orts by good agent is:

eB

The principal does not know what levels of e¤orts are appropriate for good and bad workers.

Principal’s Objective

Principal maximises expected pro…t

qG ;qB ;wG ;wB

by designing separate contracts for good (qG ; wG ) and bad workers (qB ; wB ) and .

Wage for good worker: wG = q (e; good) = 3e or e = q3G

Wage for bad worker: wB = q (e; bad) = e or e = qB

Incentive Compatibility Constraints for Agents

Self selection constraint for good worker

qG 2 qB 2

UG = wG e2G = wG UG = wB e2B = wB (1238)

3 3

Self selection constraint for bad worker

2

UB = w B e2B = wB (qB ) UB = w G e2G (1239)

Participation constraints for good worker

qG 2

UG = wG 0 (1240)

3

Participation constraint for bad worker

2

UB = wB (qB ) 0 (1241)

Binding Constraints

Participation constraint of bad worker

2

wB = qB (1242)

Self selection constraint for good worker

qG 2 qB 2 qG 2

2 qB 2

wG = + wB =) wG = + qB (1243)

3 3 3 3

Principal’s Optimal Solution

213

M ax UP = [0:5 (qG wG ) + 0:5 (qB wB )]

qG ;qB ;wG ;wB

h i

qG 2 2 qB 2 2

M ax UP = 0:5 qG 3 + qB 3 + 0:5 qB qB

qG ;qB ;wG ;wB

Now principal decides how much to produce from each type of worker

First order conditions with respect to qG and qB

@UP 2qG

= 0:5 1 = 0 =) qG = 4:5 (1244)

@qG 9

@UP 2qB

= 0:5 2qB + 0:5 (1 2qB ) = 0 =) 34qB = 9 =)

@qB 9

qB = 0:265 (1245)

2 2

wB = qB = (0:265) = 0:07 (1246)

2 2 2 2

qG 2 qB 4:5 2 0:265

wG = + qB = + (0:265) = 2:32 (1247)

3 3 3 3

Thus in the presence of information asymmetry , the e¤orts by the good worker is at the …rst

best level as the bad e¤ort by him is not as attractive as the good e¤ort.

It is not pro…table for good worker to pretend as a bad worker. Good worker is not attracted

by the contract for bad worker.

It is very costly for the bad worker to accept the contract of good worker. Bad worker’s …rst

best to put low e¤ort.

If a worker puts x amount of e¤ort, the land produces y = f (x)

Then the land owner pays worker s(y).

The land owner wants to maximise pro…t = f (x) s(y) = f (x) s(f (x))

Worker has cost of putting e¤ort c(x) and has a reservation utility, u

The participation constraint is given by . s(f (x)) c(x) u

Including this constraint maximisation problem becomes

max = f (x) s(f (x))

subject to

sf (x) c(x) u

Solution: marginal productivity equals marginal e¤orts f 0 (x)) c0 (x)

214

Incentive compatible game on rending a piece of agriculatural land

(a) renting the land where the workers pays a …xed rent R to the owner and takes the residual

amount of output, at equilibrium

f (x ) c(x ) R = u (1248)

(b) Take it or leave it contract where the owner gives some amount such as

B c(x ) = u (1249)

(c) hourly contract

(d) sharecropping, in which both worker and owner divide the output in a certain way.

In (a)-(c) burden of risks due to ‡uctuations in the output falls on the worker but it is shared

by both owner and worker in (d).

Which of these incentives work best depends on the situation.

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Problem 10: Asymmetric information: Principal Agent Problem

1. Project B earns more but is riskier than project A. Probability of success of projects A and

B are given by PA and PB respectively.

a. Illustrate how the rate of interest rate should be lower in project A than in project B

in equilibrium?

b. Probability of types A and B agents is given by PA and PB respectively. Prove under

the asymmetric information a lender charging a pooling interest rate is unfair to the safe

borrower A and more generous to the risky borrower B.

c. How can agent signal its worth? How can the lender ascertain the degree of moral

hazard in B?

2. Principal wants to produce output by employing workers with a scheme of wage contract

that matches e¤orts put by a worker to produce. Worker knows his type but the principal

does not but the principal knows the distribution of quality of workers F (s), where s denotes

either good or bad state. Probability of observing good is 0.5 and of bad 0.5. Principal

o¤ers the agent a wage contract W (q) worker accepts or rejects this contract based on self-

selection and participation constraints. Basically worker evaluates the utility from the work

and disutility from work and decides the amount of work to put in. Output from good worker

is q(e; g) = 3e and from bad state is q(e; b) = e . Both of them are risk neutral. If agent

rejects the contract there is no work both worker and principal get zero payo¤ otherwise the

agent = U (e; w; s) = w e3 and . principal = V (q w) = q w

(b) Formulate the participation and incentive compatibility constraint for workers.

(c) What is the principal’s objective function?

(d) What wage rates are paid to good and bad workers?

7.5 Mechanism Design for Price Discrimination: Low Cost Airlines Ex-

ample

There are three steps in mechanism design.

1. Principal designs a mechanism or contract

2. agents accept or reject mechanism

3. Those who accept the mechanism play the game.

Consider a case of monopolist which supplies q with marginal cost c and tari¤ (price) T. Its

objective is

217

U1 (q; T; ) = V (q) T (1251)

V is a common knowledge, is private information. There are high and low type buyers.

= with probability p

= with probability p

and p+ p = 1

First best solution: If the seller knew its tari¤ would be V (q) = T Its pro…t would be

V (q) cq and V 0 (q) = c: Most often it does not know , therefore o¤ers q; T and q; T

bundles. Then the expected pro…t will be

Eu0 = p q; T + p q; T (1252)

Sellers’constraints

1. consumers need to be willing to purchase and this requires ful…llment of individual rationality

constraint and participation constraint.

IR1 : V q T 0 (1253)

Incentive compatibility requires that consumers consume the bundel intended for them.

Sellers problem is to choose q; T and q; T bundles to maximise her pro…t.

218

Binding constraints are IC1 and IR2 This implies

T = V q T + V (q) (1257)

T = V (q) V q (1258)

c

V q = (1260)

p( )

1 p

V (q) = c (1261)

Allocation is socially optimal

Reference Fundenbege and Tirole (1995)), Game Theory, MIT press.

Economy and Business Class Ticket Problem for Airlines (Based on Dixit et. al. (2009))

219

Assume 100 travellers and 70 of them economy type tourists and 30 business type …rst class.

Cost of Reservation Price Airline’s Pro…t

the Airlines Tourists Business Tourists Business

Economy 100 140 225 40 125

First Class 150 175 300 25 150

Economy class tickets cost less than the business class.

Business traveller is ready to pay higher price than economy class for both economy and …rst

class but the airlines cannot separate them out.

Why Mechanism Design for Price Discrimination: Low Cost Airlines Example

Economy class tickets cost less than the business class.

Business traveller is ready to pay higher price than economy class for both economy and …rst

class but the airlines cannot separate them out.

Business traveller may well buy economy class ticket rather then business class.

Airlines likes to build a mechanism so that business class buy business class tickets and

economy class buy economy class ticket.

What is the pro…t to the airlines if it knows reservation prices of tourists and business group

of travellers?

How would this pro…t change in business type buy the economy class ticket?

What is the incentive compatible price that the airlines can o¤er to the business group?

Incentive Compatible Mechanism

What would happen if the split between the business and economy class is 50/50? What will

be the optimal reaction of the airlines?

Pro…t in an ideal scenario ( perfect price discrimination; if the airlines knew each customer type)

= 4500 + 2800 = 7300 (1262)

Business travellers have consumer surplus of 225 -140 = 85 in economy class ticket. For this all

30 of may decide to buy economy class ticket. Then the pro…t of the airlines when the airlines fails

to screen customers will be

Airlines should give consumer surplus of 85 to business traveller and charge them (300-85) =

215. This will alter their pro…t

= 1950 + 2800 = 4750 (1264)

Incentive Compatible and Participation Constraints

220

Airline initially does not have enough information on types of customers

It should design incentive compatible pricing scheme so that business class travellers do not

defect to economy class.

This requirement is contained in the incentive compatible constraint. If it charges 240 for the

business class then the their consumer surplus will be equal (300-240) = 60 from business

class travel and (225-165)=60

However 140 is the maximum the tourist class traveller is ready to pay. If the airline raises price

to 165 they will lose all tourist travellers. Mechanism requires ful…llment of the participation

constraint.

Airlines should operate taking account of the participation constraint of tourists and incentive

compatible constraint of the business travellers.

X < 140 is the participation constraint; incentive compatible constraint is 225 -X < 300-Y

or Y < X+75

Charging 215 for the business class and 140 for the economy class is the solution to the mecha-

nism design problem.

= 1950 + 2800 = 4750 (1265)

Suppose the composition of travellers changes to 50% of each. Pro…t with the above price

mechanism

= 3250 + 2000 = 5250 (1266)

It is more pro…table to scrap the tourist class tickets instead and charge the business class its

full reservation price

50(300 150) = 50 150 = 7500 (1267)

There are relatively few customers but all are willing to pay higher price. There is no problem

of screening as the airlines now does not serve to the tourist class at all.

Owners of a company are concerned about a project that would earn them 600,000 if successful.

Probability of success with normal e¤ort from the manager is 60 percent and this can increase

up to 80 percent if the manager puts extra e¤orts.

The basic salary of the manager is 100,000. He would put extra e¤orts only if he is paid

additional amount of at least 50,000. Owners cannot monitor whether the manager is putting

high or low e¤orts.

221

a) Is it pro…table to pay extra for the manager?

Pro…t without paying extra: 0.6 * 600,000 - 100,000 = 260, 000

Pro…t with extra incentive payment: 0.8 * 600,000 - 150,000 = 330, 000

Extra payment can make up to 70,000 with probability of 0.8.

Once extra payment is made how can owners make sure that he puts extra e¤orts? This requires

evaluation of incentive compatibility and participation constraints.

Mechanism to ensure high e¤orts by a CEO

a) Incentive compatibility constraint

b = 250,000

b) Participation constraint:

s = 150; 000 0:8b; s = 150; 000 0:8 (250; 000) = 50; 000 (1271)

It is not possible to hire manager with negative salary. At most managers can be conditioned

to bonus payment but with zero salary.

Mechanism to ensure high e¤orts by a CEO

Pay 200,000 and the manager will put maximum e¤ort.

c) Is it pro…table to pay extra 200,000 as an incentive payment?

Pro…t with incentive payment

0.8 * 600,000 - 200,000 = 280, 000

Pro…t without incentive payment

0.6 * 600,000 - 100,000 = 260, 000

Thus pro…t increases by 20,000 with the incentive payments.

Proposition 1: Results of …xed fee contract and joint pro…t maximisation are equivalent

Proposition 2: Hire contract is incentive incompatible and leads to production ine¢ ciency

Proposition 3: Moral hazard problem and production ine¢ ciency exists in revenue sharing

contingent contract

Proposition 4: Pro…t sharing contract is e¢ cient and free of moral hazard problem

Price and cost

222

Revenue

R = P:q (1275)

Mechanism design in renting lands

Under the joint pro…t maximisation agreement

Under the …xed fee contract tenant maximises

Under both these arrangements

0

(q) = 24 q 12 = 0 (1278)

Mechanism design in renting lands

72 is the total pro…t. It is divided between the tenant and the landlord by their mutually

agreed arrangement. Under the …xed fee contract landlord may …x the amount that he needs

at 48.

Then the residual 24 pro…t goes to the tenant.

This arrangement achieves production e¢ ciency, is incentive compatible, ful…ls the participa-

tion constraint and motivates to put the optimal e¤ort and solves the moral hazard problem.

Hire contract

Landowner can hire workers in …xed fee basis, say 12 per unit of output a.

This does not motivate tenant to work because his cost per a is also 12 and so does not make

any pro…t. Landlord has to raise payment to tenant to say 14 to motivate him to work.

Then the pro…t maximisation problem of the landlord will be

0

(q) = 24 q 14 = 0 (1281)

The tenant has incentive to overproduce whenever is paid more than 12.

Revenue sharing contract

223

Let the landlord enter into a revenue sharing contract whereby she gets 14 th of the revenue

and leavening 34 of revenue to the tenant who also bears all production cost. The pro…t

function of the tenant is now modi…ed as

3 3

(q) = P:q C= (24 0:5q) q 12q (1283)

4 4

0 3

(q) = 6 q=0 (1284)

4

3

q = 8; p = 20; R = 160; C = 96; LL (q) = (160)

4

1

= 120; T (q) = (160) = 40 (1285)

4

Pro…t of tenant = 120 - 96 =24

This level of production is not incentive compatible for the land-lord who would be interested

in maximising revenue by producing 24.

Pro…t sharing contract

Now let us assume the landlords and tenants enter into a pro…t sharing deal, say 1/3rd of

pro…t goes to the tenant and 2/3rd to the landlord.

1 1 1

(q) = (P:q C) = 24q 0:5q 2 12q (1286)

3 3 3

0 1

(q) = 4 q=0 (1287)

3

LL (q) = 48; T (q) = 24 (1288)

There are many other situations, including optimal tax designs, optimal price discrimination,

fund management, management of theme-park, renting of buildings, collection of taxes or tari¤s,

union-management contracts, where these types of models have been applied.

There are three players in the poverty game -poor, rich and government; each has three

strategies available to it to play, s, l, and k , cooperation, indi¤erence and non cooperation.

The outcome of the game is the strategy contingent income for poor and rich, ytp (s; l; k) and

ytR (s; l; k) with the probability of being in particular state like this is given by pt (s; l; k) and

R

t (s; l; k) respectively and tax and transfer pro…les associated to them.

The state-space of the game rises exponentially with the length of time period t. T

224

he objective of these rich and poor households is to maximize the expected utility that is

assumed to be concave in income.

The government can in‡uence this outcome by choices of taxes and transfers that can be

liberal, normal or conservative.

Mechanism for Poverty Alleviation: Proposition 1

Proposition 1: The state contingent expected money metric utility of poor is less than that of

rich, which can be expressed as:

s X

X l X

k X

T

p p p

t (s; l; k) t u (yt (s; l; k))

s=1 l=1 k=1 t

s X

X l X

k X

T

R R

< t (s; l; k) t u ytR (s; l; k) (1289)

s=1 l=1 k=1 t

where pt (s; l; k) gives the probability of choosing one of strategies by poor given that the rich

and the government has chosen l and k strategies. Utility is derived from income as given by

u (ytp (s; l; k)) and pt = (1+r

1

p is the discount factors for poor and R 1

t = (1+r R ) the discount factor

t) t

for rich.

Mechanism for Poverty Alleviation: Proposition 2

Proposition 2: Transfer raises money metric expected utility of poor and reduces the utility of

rich.

l X

s X k X

T

" T

#

X p p p

X

t (s; l; k) t u (yt (s; l; k)) + Ttp (s; l; k)

s=1 l=1 k=1 t t

s X

l X

k

" T T

#

X X X

R R

< t (s; l; k) t u ytR (s; l; k) TtR (s; l; k) (1290)

s=1 l=1 k=1 t t

Proposition 3: Incentive compatibility requires that

s X T

k X

l X

" T

#

X p p p

X

t (s; l; k) t u (yt (s; l; k)) + Ttp (s; l; k)

s=1 l=1 k=1 t t

X l X

s X k X

T

p p p

> t (s; l; k) t u (yt (s; l; k)) (1291)

s=1 l=1 k=1 t

and

s X

X l X

k X

T

R R

t (s; l; k) t u ytR (s; l; k)

s=1 l=1 k=1 t

s X

l X

k

" T T

#

X X X

R R

> t (s; l; k) t u ytR (s; l; k) + TtR (s; l; k) (1292)

s=1 l=1 k=1 t t

225

Mechanism for Poverty Alleviation:Proposition 4

Proposition 4: Growth requires that income of both poor and rich are rising over time:

p p

(s; l; k) < Tt+1 p

(s; l; k) < ::::: < Tt+T (s; l; k) (1293)

p p

(s; l; k) < Yt+1 p

(s; l; k) < ::::: < Yt+T (s; l; k) (1294)

R R

(s; l; k) < Yt+1 R

(s; l; k) < ::::: < Yt+T (s; l; k) (1295)

Mechanism for Poverty Alleviation:Proposition 5

Proposition 5: Termination of poverty requires that every poor individual has at least the level

of income equal to the poverty line determined by the society. When the poverty line is de…ned one

half of the average income this can be stated as:

N

!

1 1X h

Yt (s; l; k) >

p

Yt (s; l; k) (1296)

2 N

h=1

Above …ve propositions comprehensively incorporate all possible scenarios in the poverty game

mentioned above. Propositions 2-5 present optimistic scenarios for a chosen horizon T .

Mechanism for Poverty Alleviation: Tests

It requires modelling of the entire state space of the economy.

Moreover in real situation consumers and producers are heterogeneous regarding their pref-

erences, endowments and technology and economy is more complicated than depicted in the

model above.

In essence it requires a general equilibrium set up of an economy where poor and rich house-

holds participate freely in economic activities taking their share of income received from

supplying labour and capital inputs that are a¤ected by tax and transfer system as illustrated

in the next section.

Bhattarai K. (2010) Strategic and general equilibrium models of poverty, Romanian Jounral

of Economic Forecasting, 13:1:137-150

Market demand for a product is

Cost of production for each of two …rms is .

Ci = 10qi (1298)

If played in…nite number of times two …rms form a cartel and monopolise the market.

226

Each will supply only 30, set market price to monopoly level at £ 70 and divide total pro…t

£ 3600 equally; each getting £ 1800.

This is shown by (1800,1800) point in the diagram.

It pays to cooperate in the long run; it is sub-game perfect equilibrium.

Cooperative Solution

It pays to cooperate in the long run; it is sub-game perfect equilibrium.

@ 120

= 130 2Q 10 = 0 =) Q = = 60 (1300)

@Q 2

Price:

P = (130 Q) = 130 60 = 70;

Cost:

C = 10Q = 10 60 = 600;

Pro…t:

= P Q C = 60 70 600 = 3600

Non-Cooperative Nash Equilibrium

If any one …rm cheats and tries to supply more in order to get more pro…t; it will be found

out by another …rm.

Opponent …rm will react to this.

Each …rm produces 40 units, market price is set at 50 and each gets £ 1600 pro…ts.

Total supply is 80, each supplying 40 and making pro…t of 1600 and market price 50.

If …rm 1 plays Cournot game but …rm 2 still plays cartel and supplies just 30.

Then from the …rm 1’reaction function . 2q1 + q2 = 120

1 1

q1 = 60 q2 = 60 (30) = 45 (1301)

2 2

If …rm 1 supplies 45, market price will be .

This makes pro…t margin of …rm 1 to be 45 and its pro…t . 1 = (55q1 10q1 ) = 45q1 =

45 45 = 2025

227

Firm 2 will …nd out that …rm 1 has cheated. If it does not react its pro…t will be down to

1350.

It will also produce according to its reaction curve.

Thus the Nash equilibrium will result with each …rm producing 40 and earning 1600 pro…t

for the rest of the periods and the market price will be 50.

Does …rm 1 gain or lose by deviation from the agreement. For this evaluate the in…nite series

of pro…ts in deviation and in compliance with agreement.

Present value of pro…t in case of cheating

2

1 = 2025 + 1600 + 1600 + :::: + ::: = 425 + 1600 + 1600 + 1600 2 + :::: + :::

1 = 2025 1600 + 1600 + 1600 + 1600 2 + :::: + :::

(Note just with –and + 1600)

Using operator to maintain

h a constant

i payo¤ from the game

1600

(1 ) 1 = (1 ) 425 + (1 ) = [425 (1 ) + 1600] = 425 425 + 1600 = 2025 425

By comparing pro…ts with and without cheating

225 9

2025 425 < 1800 or ; 425 > 2025 1800; > 425 =) > 17

Whether the …rm 1 will stick to agreement or not depends on whether its discount factor if

9 9

greater than > 17 . For discount factor < 17 it is bene…cial to stick to the agreement, which is

very high, about 53 percent.

Home Work

Illustrate repeated game for multiple periods using brach nodes

Workout Bertrand type competition for above game and illustrate "cut-throat" price com-

petion in a diagram.

Moral Hazard: Insurance Game with Symmetric Information Under symmetric in-

formation full insurance is optimal; insurance company can charge premium according to level of

e¤orts exerted by the agent to prevent accident (see Jehle and Reny (2001, Chapter 8))

Let p be insurance premium. (e) probability of accident with e¤ort e, this diminishes with

greater care (higher e). Level of bene…t o¤ered in case of accident is BL speci…c to losses L =1,2,. . . .L

. The Moral hazard problem is for insurance company to set the premium according to e¤orts

L

X

max p (e) Bl (1303)

e;p;Bo ;::::BL

l=0

228

L

X

l (e) u (W p l + BL ) d (e) u (1304)

l=0

Lagrangian function

L

" L

#

X X

L= p (e) Bl + l (e) u (W p l + Bl ) d (e) u (1305)

l=0 l=0

" L #

@L X 0

= 1 l (e) u (W p l + BL ) d (e) u =0 (1306)

@p

l=0

@L 0

= 1 l (e) u (W p l + BL d (e) u) = 0 (1307)

@Bl

" L #

@L X

= l (e) u (W p l + Bl ) d (e) u =0 (1308)

@

l=0

From above

u0 (W p l + Bl ) = d (e) + u (1309)

Under full insuranceBl = l this implicitly de…nes the insurance premium for e¤ort level .

u0 (W p) = d (e) + u (1310)

Since low e¤ort is less costly than more e¤ort for the costumer d (e) d (1) ; the premium under

lower e¤ort must be set higher than for the higher e¤ort: p (0) p (1) for pro…t maximisation

L

X

p (e) :l (1311)

l=0

This is the prediction of moral hazard with complete information but uncertainty with con-

sumer’s hidden action.

cannot observe the consumer’s choice of accident prevention e¤orts. But the insurance company

continues to seek maximize he expected pro…t. It now need to add incentive compatibility constraint.

L

X

max p (e) Bl (1312)

e;p;Bo ;::::BL

l=0

L

X L

X

l (e) u (W p l + BL ) d (e) l (e0 ) u (W p l + BL ) d (e0 ) (1313)

l=0 l=0

229

L

X

l (e) u (W p l + BL ) d (e) u (1314)

l=0

for low e¤orts again full insurance is the best policy from

u0 (W p) = d (e) + u (1315)

however the incentive compatibility requires d (0) d (1). Therefore lower insurance avoidance

costs more for the costumer.

For high e¤orts case e = 1

Lagrangian function

L

" L

#

X X

L = p (e) Bl + l (e) u (W p l + Bl ) d (e) u

l=0 l=0

2 ( L ) 3

X

6 l (e) u (W p l + BL ) d (e) 7

6 7

+ 6

6 (l=0

L

) 7

7 (1316)

4 X 5

0

l (e ) u (W p l + BL ) d (e0 )

l=0

" L #

@L X 0

= 1 l (1) + ( l (1) l (0)) u (W p l + BL ) = 0 (1317)

@p

l=0

@L 0

= l (1) + l (e) + [( l (1) l (0))] u (W p l + BL ) = 0 (1318)

@Bl

" L #

@L X

= [( l (1) l (0))] u (W p l + Bl ) + d (0) d (1) = 0 (1319)

@

l=0

" L #

@L X

= [( l (1) l (0))] u (W p l + Bl ) + d (0) d (1) 0 (1320)

@

l=0

1 l (1)

= + 1 (1321)

u0 (W p l + Bl ) l (0)

since > 0 the RHS is strictly decreasing, this implies that u0 (W p l + Bl ) must be

strictly increasing for this to happen l Bl be must increase with e¤ort levels and losses l =

0; 1; 2; ::::L:Optimal high policy does not provide full insurance but the deductible payment in-

creases size of loss.

Problem

Consider a moral hazard insurance model with an insurance policy fp; B0 ; B1 ; :::::; BL g where p

is insurance premium and B0 ; B1 ; :::::; BL denote the bene…t from the insurance company against

230

loss l. Normally the insurance company can observe the loss but not the level of accident avoidance

e¤ort (e) of the consumer. The problem of the insurance company is:

L

X

max p l (e) BL (1322)

e;p;B0 ;B1 ;:::::;BL

l=0

L

X

l (e) u (w p l + BL ) d (e) u (1323)

l=0

L

X L

X

l (e) u (w p l + BL ) d (e) l (e0 ) u (w p l + BL ) d (e0 ) u (1324)

l=0 l=0

1. Show that it is Pareto optimal to do full insurance under symmetric information when the

insurance company can observe the level of e¤orts of the consumer.

2. How could the insurance company design an e¢ cient contract to induce e¤orts to minimise

cost under the assymetric information? Is full insurance still optimal?

7.8 Auction

Types of Auction

First price, sealed-bid: person who bids the highest amount gets the good.

Second-price, Sealed-bid: Each submit a bid. Higher bidder wins and pays second-highest bid

for the good.

Dutch Auction: Seller begins from very high price and reduces it until someone raises a hand.

English Auction: Begins with very low price, bigger drops out by raising a hand.

Which one of these four mechanism is good for the seller??

Online auctions -ebay (http://www.ebay.com/); car auction (http://www.carandvanauctions.co.uk/);

Art auction (http://www.artinfo.com/artandauction/); Online advertisement auctions in Google,

Microsoft, Yahoo, Facebook, You Tube

Honesty is the best policy in Vickery auction; truth telling is the winning strategy.

Proof

Let there be two bidders bidding b1 and b2 but with true values v1 and v2 . Highest bidder

wins the auction at the price of the second-highest bid. English auctions and second-highest

sealed-bid auctions are equivalent.

231

Expected value for bidder 1 is then given by

If (v1 > b1 )it is in the best interest of bidder 1 to raise the probability of winning prob (b1 > b2 )

, this can happen when (v1 = b1 )

Similarly If (v1 < b2 ) then it is in the interest of bidder 1 to make prob (b1 < b2 ) as small as

possible. It happens when .(v1 = b1 ) Thus the truth telling is the best interest in such action.

If state knew that how much each person is willing to pay for this it could bill e¢ ciently.

Each would pay according to the value they put in such public good. Unfortunately it is

impossible to know preferences of individuals.

Individuals do not tell true value when asked that how much they are ready to pay for this.

Let N individuals be indexed by i. Then the utility from the public good to an individual i is

given by Ui (x).

There is free rider problem with public goods. Individuals may underreport their utility

thinking that others will pay higher for it if they act like this but they will have opportunity

of full bene…t.

Under Vickrey-Clark-Grove mechanism it is in the best interest of individuals to tell the truth.

Under Grove mechanism each individual is asked to report his her utility; which is ri (x). . Then

PN

the state chooses x* that maximises the sum of reported utilities R = ri (x): Each individual

i=1

P

N

receives a side-payment Ri = ri (x):.

j6=1

With side payment the total utility of an individual is

N

X

Ui (x) + ri (x) (1326)

i=1

N

X

ri (x) + ri (x) (1327)

i=1

Therefore it is in the best interest of an individual to tell the truth Ui (x) = ri (x). All agents

tell truth like this and this mechanism generates e¢ cient outcome. (page 27 of the new handbook

on sum of MRS =MC of public good.)

(See Varian HR (2010) Intermediate Microeconomics: A Modern Approach, Norton,8th edition).

232

Binmore K. (1990) Fun and Games: A text on Game Theory, Lexington, Heath.

Cripps, M.W.(1997) Bargaining and the Timing of Investment, International Economic Review, 38:3

:Aug.:527-546

Mailath G. J. and L. Samuelson (2006) Repeated Games and Reputations: long run relationship,

Oxford.

Moore J (1984) Global Incentive Constraints in Auction Design Econometrica, 52:. 6 pp. 1523-1535

Osborne M.J. and A. Robinstein (1994) A course in game theory, MIT Press.

Q1. Consider a principal agent model where the gross pro…t ( g) of a …rm depends on e¤orts (e)

of the manager and is subject to random shocks (") as:

g =e+" (1328)

Cost of e¤orts to the manager is given by C(e):

Net pro…t ( n) for the …rms is gross pro…t ( g) minus manager’s salary (s) as:

n = g s=e+" s (1330)

Then the expected net pro…t becomes:

Manager’s utility takes the form:

A 2 A 2

E (u) = E (s) C(e) = e C(e) (1332)

2 s 2 e

where 2s is the variance of salary and A is a risk aversion parameter. Manager dislikes volatility

in salary 2s . Two scenarios could be considered in this game; …rst when owens can observe the

e¤orts put in by the manager and another where they cannot observe it.

233

A. What is the …rst best solution if the owners can observe the level of e¤orts by

the manager? What will be the variance of salary 2s in the …rst best solution?

What is the relation between the marginal cost of e¤orts and marginal bene…ts

of the manager in this case?

If owners are not able to observe the level e¤orts by the managers, they will o¤er him a perfor-

mance based salary contract subjecting it to gross pro…t as:

s( g) =a+b g (1333)

Owners set salary by setting parameters a and b …rst where a is …xed component and b is

incentive payment. Then the manager decides the level of e¤orts conditional on the contract. If

the cost of e¤orts is given by:

e2 2

C(e) = ; = 1; A = 2 (1334)

2

B. What will the optimal value of incetive coe¢ cient (b) be in the second best solu-

tion? What will the optimal level of e¤orts (e ) be ? What will the …xed component

of the salary (a) be? What will the expected pro…t for the owners be? Solve this

game by backward induction to …nd answers to these questions.

Q2 This exerice aims to investigate how di¤erent production technologies adoped by a …rm results

in di¤erent level of output, employment and investment in each sector.

First exercise is …xed input process under the linear programming framework with limited

price based substitution.

The second problem contains adoption of the Cobb-Douglas technology with elasticity of

substituion equal to 1.

Third process involves usign the CES production technology with a constant elasticity of

substitution. Overall resource available to this …rm is given in each case.

A multinational …rm produces two products Y1 and Y2 , these products are sold at 6 and 3

respectively.

Linear programming problem

max R = 6Y1 + 5Y2 (1335)

1. Subject to:

2Y1 + Y2 1000 (1336)

2) capital constraint (machine hours)

1. where Y1 0 and Y2 0;

234

What are the revenue maximising levels of output of Y1 and Y2 . How many workers /machine

hours are devided between producing these two products to maximise revenue. If wage rate is 2

and capital cost is 0.05 per hour what would be total pro…t?

Cobb-Douglas Technology

= P1 Y1 + P1 Y1 C1 C2 (1338)

Subject to

(1 )

Y1 = K1 L1 (1339)

(2 )

Y2 = K2 L2 (1340)

CES technology

= P1 Y1 + P2 Y2 C1 C2 (1343)

Subject to

1

Y1 = [ 1 K1 + (1 1 ) L1 ] (1344)

2

Y2 = [ 2 K2 + (2 2 ) L2 ] (1345)

Comparision of results among technologies

Y K L R C Pr

Firm 1

Linear Programming

Cobb-Douglas

CES

Firm 2

Y K L R C Pr

Linear Programming

Cobb-Douglas

CES

235

Impacts of microeconomic policies in …rms output decision.

1) cost of capital doubles to …rms because of credit crisis. How would this a¤ect these variables.

2) Wage dispute between the management and workers caused wage rate to rise by 25 percent.

Given no change in capital market conditions how would this a¤ect the production.

3) There is a change in preferences of consumers because of substitutable product in the market.

How does these variables.

Y K L R C Pr

Firm 1

Linear Programming

Cobb-Douglas

CES

Firm 2

Y K L R C Pr

Linear Programming

Cobb-Douglas

CES

Hymer (1976) and Caves (1982), Batra and Ramachandran (1980) and Batra (1986) Rossel (1985),

Hortmann and Markusen (1987) and Markusen (1995).

MNCs move to a foreign country for a number of reasons: cost advantages in producing there

rather than exporting commodities;

ownership (O) of …rm speci…c capital;

location (L) based advantages of production;

licensing abroad for reasons of natural resources or customer bases;

internalisation (I) of bene…ts of technical know how by …rms doing R & D.

1 = P1 q1 C1 (1348)

2 = P2 q2 C2 (1349)

where 1 ,P1 ,q1 ; C1 and 2 ,P2 ,q2 ; C2 are pro…t, price, demand and cost of production at home

and foreign markets

where R is the rental income from licensing of a partner foreign …rm, (M is the pro…t from

subsidiary is FDI takes the form of subsidiary operation), D is the payments made in case the

licensee defects in the second period (this deters the licensee from supplying the market itself after

gaining the know-how from the MNC in the …rst period), and FC is the …xed cost of FDI to the

MNC.

Let us assume that the demand of the monopolist in the home market is given by

236

q1 = 21 0:1P1 (1352)

and its inverse demand is

If demand abroad is

q2 = 50 0:4P2 (1354)

and the inverse demand abroad is

P2 = 125 2:5q2 (1355)

Cost of production is di¤erent across counties di¤er.It is

at home but it is costlier to set up business in foreign country because of higher …xed costs,

(marginal costs may also be di¤erent). The optimal condition for pro…t maximisation is given by a

point where the marginal revenue equals marginal cost in each market:

M R1 = M C1 and M R2 = M C2 (1358)

Given the above information, the total revenue from the home market is

.. Similarly, the total revenue from the sales in the foreign market would be

Fixed costs of production are di¤erent across countries, but the marginal costs are assumed to

be the same in both countries.

M C1 = M C2 = 10 (1363)

Now it is possible to solve the model for the optimal amount of goods supplied at home and

abroad by using conditions where the marginal revenue in each market needs to equal its marginal

cost.

237

M R1 = M C1 ) 210 20q1 = 10 ) q1 = 10 =) P1 = 210 10q1

=) P1 = 110 (1364)

=) P2 = 67:5 (1365)

Thus, the amount supplied at home is much smaller than amount supplied abroad and prices

charged at home are much higher than prices charged abroad. Corresponding revenues are:

The cost function is assumed to be known here for simplicity. It must be derived from the cost

minimisation principle subject to a production technology constraint. The total cost of production

at home and abroad are given by

Now it is possible to calculate pro…ts to the MNC from home and foreign markets:

Conclusion

In this paper, the microeconomic e¤ects of FDI have been illustrated with an example of

a multi-plant MNC that faces a di¤erent structure of demand and costs between home and

foreign countries with strategic consideration of licensing or subsidiary production in foreign

countries.

On the macro side, the total FDI aggregated over MNCs accounts for a signi…cant proportion

of total investment and has a signi…cant impact on economic growth. This growth e¤ect is

shown theoretically using an endogenous growth model with FDI in which foreign capital

complements domestic capital and contributes to both investment and growth rate of output.

Our model predictions have been tested using panel data growth regressions for 30 OECD

countries over 1990 to 2004. Our analysis establishes positive im

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