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ADVANCED MICROECONOMICS (56278)

Dr. Keshab Bhattarai


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 L2: Consumption: Properties of a Utility Function 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 L3: Production: Supply 47


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 L4: Markets: Perfect and Imperfect Competition 83


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 L5: General Equilibrium Model and Welfare 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 L6: Game theory: Bargaining in Goods and Factors markets 171


6.1 Formal de…nitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
6.1.1 Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

6.1.2 Game of incomplete information: . . . . . . . . . . . . . . . . . . . . . . . . . 174


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 L8: Uncertainty and Insurance 239


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

9 L9:Class Test 259

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 L11: Dynamic Computable General Equilibrium Model: Recent Developments 305


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 Assignment (optional): One in Four 327


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 Regulation Theory and Practice 338


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 Computation and software 374


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 Tutorials in Advanced Microeconomics 396


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.

5. Strategic analysis of decision making my consumers, producers, governments in a competitive


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.

1.1 Microeconomic Theory: Milestones


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.

1.2 Axioms and Consumption Set


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

Let B 2 X be a feasible set such that x % x for all x 2 B:


Axioms of Consumer Choice

9
Axiom 1: Completeness

If x1 and x2; are both in X , x1; x2 X either x1 % x2 or x1 - x2 . Consumer can compare.

Axiom 2: Transitivity

For x1; x2 ; x3 X if x1 % x2 ; x2 % x3 then x1 % x3 . Consumer is consistent.

Axiom 3: Continuity

Preference relations % xi - xi are closed in Rn

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

If x1 % x0 then tx1 + (1 t) x0 % x0 for all t 2 [0; 1] .


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.

1.3.1 Consumer optimisation:


Assuming above axioms are satis…ed, the major objective of a consumer is to maximise utility by
consuming x commodities (u (x))

max u(x) (1)


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):

L (x; ) = u(x) + [y p:x] (3)

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.

1.3.2 Producer optimisation


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+

(p; w) = p:y w:x (9)


subject to

f (x) y (10)
Constrained optimisation (Lagrangian) function:

L (x; ) = py w:x + [y f (x)] (11)

@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.

1.4 A simple computable general equilibrium model with labour leisure


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:

max x = px x pk kx pL LS1x pL LS2x (20)


subject to:

x = kxx LS1x1x LS2x2x (21)

max y = py y pk ky pL LS1y pL LS2y (22)


subject to:

y = kyy LS1y1y LS2y2y (23)

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.

GAMS programe: ge2by2.gms


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

Table 2: E¢ cient allocation in the 2 by 2 model with leisure


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:

x = x1 + x2 = 5:9 + 2:8 = 8:7 (30)

y = y1 + y2 = 1:7 + 1:3 = 3:1 (31)

kx + ky = 35:3 + 14:7 = k1 + k 2 = 44 + 10 = 50 (32)


_
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 Methods for constructing Proofs


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.

1.5.4 Mathematical induction


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.

2 L2: Consumption: Properties of a Utility Function


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 strictly increasing in x if and only if % is strictly monotonic.


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

2.1 Properties of an indirect utility function


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).

max u = x1 x2 subject to 2x1 + 4x2 = a (36)

L (x1 ; x2 ) = x1 x2 + [a 2x1 4x2 ] (37)

@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:

2.1.1 Price elasticities and the elasticity of substitution


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.

Price elasticity of demand


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

Cross price elasticity:


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

Elasticity of substituion bewteen x1 and x2


x1 x1
d x2 = x2
25
= 50
50 25
= = 2 4 =1 (45)
d p2
= p2
4 = 2
p1 p1

Income elasticities of demand Before the change in price:

dx1 =x1 dx1 a 1 200


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:

dx1 =x1 dx1 a 1 200


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:

L (X1 ; X2 ; ) = X10:4 X 0:6 + [150 p1 :X1 p2 :X2 ] (52)

For base equilibrium assume that p1 = 3 and p2 = 2:


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)

Now assume that there is a subsidy in X1 of £ 1 and price reduces from 3 to 2; p1 = 2:

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)

EV = 150 127 = 22:51 (57)

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

CV = 150 176:39 = 26:39 (62)

Summarising the Money Metric Utility Changes Due to Taxes

Table 3: Summary of Equivalent and Compensating Variation


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.

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


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.

2.1.4 Restrictions in estimating a demand function:


Suppose that you are interested in estimating the demand for beer in a country and consider the
following multiple regression model:

ln (Yi ) = 0 + 1 ln (X1;i ) + 2 ln (X2;i ) + 3 ln (X3;i ) + 4 ln (X4;i ) + "i i = 1 :::N (63)

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

F-test can be applied to test the validity of such restrictions as:


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:

Table 4: Consumption of households by sectors in UK, 2008


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,

Food & Rural A¤airsas


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.

McFadden Daniel (1963) Constant Elasticity of Substitution Production Functions, Review


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.

2.2 Exercise 1: Consumer’s problem


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;

subject to the budget constraint with prices p1 and p2 and income y:

p1 :x1 + p2 :x2 = y (67)

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.

Prove Roy’s identity for this problem.

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)

2.2.1 Marshallian demand functions from the CES preferences:


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

Now get the value of


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

2.2.2 Compensated and uncompensated demands


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.

2.2.3 Expenditure functions with the CES utility functions


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

2.3 Slutskey equation ( Decomposition of substituion and income ef-


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)

@x1 @x1 @E @x1


= (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:

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


= = 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.

2.3.1 Comparative static analyis with matrix


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):

0:d px dX py dY = xdpx + ydpy dI (116)

px d + Uxx dX + Uxy dY = dpx (117)

py d + Uyx dX + Uyy dY = dpY (118)


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

Once more to evaluate the comparative static impact of changes in prices of x,


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

Thus the income e¤ect is given by

xpy Ux;y p2y


(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.

2.4 Exercise on Consumption and Demand


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)

u(x1 (p1 ; p2 ; m); x2 (p1 ; p2 ; m)) = V (p1 ; p2 ; m) (142)

Consumer’s Optimisation with Cobb-Douglas utility function:

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

QED. This is the proof of Roy’s identity.

2.4.2 Dual of the consumer’s optimisation problem


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 )

E = p1 x1 (p1 ; p2 ; m) + p2 x2 (p1 ; p2 ; m) = e(p1 ; p2 ; U ) (154)

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)

e= p11 p2 u + p1 p12 u (166)


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.

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


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 )

Value of is generally taken from the literature.


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

In money metric utility terms


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

Generalisation of many goods


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.

2.4.5 Exercise 1.2: comparative static analysis of consumer choice


Consider consumers problems for comparative static analysis

max U = U (X; Y ) (217)

1. subject to the budget constraint as:

I = Px X + Py Y (218)

(a) Illustrate the …rst order conditions for consumer optimisation.


(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

1. Consider a consumer maximisation problem given below:

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:

2. Consider a dual of the above problem:

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

Subject to

U = u(x1 ; x2 ) (222)

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

E = p1 x1 (p1 ; p2 ; m) + p2 x2 (p1 ; p2 ; m) = e(p1 ; p2 ; U ) (223)


@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

3. Derive Shephard’s lemma when preferences are Cobb-Douglas: u(x1 ; x2 ) = x1 x2 where +


= 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

(a) Formulate a constrained optimisation problem .


(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).

2. Consider standard properties of a utility function

(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

Show above properties in the following CES utility maximisation problem


1
max u = (x1 + x2 ) (236)
x1 ;x2

Subject to
M = p1 x1 + p2 x2 (237)

3. Consider standard expenditure function with following properties

(a) e = 0 for u(xi = 0) = 0


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

Show above properties in the following CES utility maximisation problem


Subject to
min E = p1 x1 + p2 x2 (238)
x1 ;x2

Subject to
1
u = (x1 + x2 ) (239)

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


1. Utility function for a consumer is given by

u = x1 x2 (240)
here budget constraint is

I = p1 x1 + p2 x2 (241)

1. What are the Marshallian (uncompensated) demand functions for X and Y?


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

2.4.10 Indierct utility function


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

2.4.11 Expenditure function


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

@x1 @x1 @E @x1


= (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:

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


= = 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.

2.4.13 Shephard’s Lemma


@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)

e= p11 p2 u + p1 p12 u (275)


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

This is the proof of Roy’s identity.

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)).

2.5.1 Slutsky equation from the Revealed Preference Theory


Following Gravelle and Rees (2004) now derive the Slutskey equation from the Revealed preference
theory as follows:

x1j x0j = x2j x0j + x2 x0j


Divide by pj

x1j x0j x2j x0j x2 x0j


= +
pj pj pj
or

x1j x0j x2j x0j x2 x0j


= 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.

Richter M. K. (1966) Revealed Preference Theory, Econometrica, 34, 3, 635-645


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

2.5.2 Further Developments in Consumer Theory


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.

Emprical analysis of consumer demand


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.

2.5.3 Emprical analysis


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] **

3 L3: Production: Supply


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

1 China $1 48.7 B $42.7 B $3,1 24.9 B $21 5.6 B


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].

3.0.4 Popular production functions


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?

3.1 Supply function: an example


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

3.1.1 Properties of a pro…t function


1. Increasing in p
2. decreasing in w
3. homogenous of degree one in p and w
4. concave in y and convex w

These properites satisfy in this example:


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

1. Homogeniety of degree zero y (tp; tw) = y (p; w) for all t > 0


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

Elasticity of scale of the production function at point x


Xn
d ln (f (tx)) f (x) xi
i=1
(x) = lim = (295)
t !1 d ln (t) f (x)

3.1.3 Variable returns to scale


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+

c(w; y) = min w:x (304)


subject to

f (x) y (305)
Constrained optimisation

L (x; ) = w:x + [y f (x)] (306)

@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

Some studies on cost and production:

Barmby T. A., M. G. Ercolani and J. G. Treble ( 2002) Sickness Absence: An International


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.

3.2 CES and Cobb-Douglas production functions


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

For the CES production function

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

1< <0 >1


=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:

GAMS programe CobbDg.gms


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

3.3 Comparative static: derivation of the CES cost function.


A …rm’s objective is to minimise cost
C = rK + wL (326)

1. subject to CES technology constraint as:


1
Y = [ L + (1 )K ] (327)

(a) Determine the demand for labour and capital.


(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)

Taking the …rst order conditions:


@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

Now put the value of K in the production function:


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 ;

demand for labour


8 2 2
39 1
< r 1
1 =
L= + (1 )4 5 Y (337)
: w 1 ;

Plugging the value of labour in the demand for capital


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

Cobb_Douglas technology and the cost of production:

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 + + +

substituting these into the cost function:

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:

3.3.1 Exercise 5: cost minimisation


Consider a problem of producer

min w1 :x1 + w2 :x2 (348)


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)

Substitute these values in the cost function

c = w1 :x1 + w2 :x2 (361)

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

3. for all input price w 0 strictly increasing and unbounded above in y


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:

f (x) = max fy 0 = w:x c (w; y) ; 8w 0g (367)


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

(p; w) = p:y w:x (368)


subject to

f (x) y (369)
Constrained optimisation

L (x; ) = py w:x + [y f (x)] (370)

@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

3.3.3 Exercise 6 : CES and Cobb-Douglas supply functions


1
1.For a CES production function y = (x1 + x2 )

De…ne the corresponding pro…t function.


Derive supply function

Derive input demand function for both of the inputs


Determine the long run pro…t.

2. Consider a Cobb-Douglas output function Y = L K . Determine the corresponding short


run supply and pro…t functions.

3.3.4 Short run supply function


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.

3.3.5 Hotelling’s Lemma


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:

= py(r; w; p) rK(r; w; p) wL(r; w; p) = V (r; w; p) (386)


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:

= (x; ) = py rK wL + K 0:4 L0:4 y (390)


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)

1. (a) Write the pro…t function for this form


(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)

with production technology


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:

(a) Derive supply function of the …rm using Hotelling’s Lemma.


(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?

3. A …rm’s objective is to minimise cost

C = rK + wL (395)

64
subject to technology constraint as:
1
Y = [ L + (1 )K ] (396)

1. (a) Determine the demand for labour and capital.


(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.

Consider a cost minimisation under the perfect competition:

A …rm’s objective is to minimise cost

C = rK + wL (397)

subject to CES technology constraint as:


1
Y = [ L + (1 )K ] (398)

1. (a) Determine the demand for labour and capital.


(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)

Taking the …rst order conditions:


@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

Now put the value of K in the production function:

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 ;

demand for labour


8 2 2
39 1
< r 1
1 =
L= + (1 )4 5 Y (408)
: w 1 ;

Plugging the value of labour in the demand for capital


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:

= py(r; w; p) rK(r; w; p) wL(r; w; p) = V (r; w; p) (425)


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.

Hotelling’s Lemma: Another example


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:

= py(r; w; p) rK(r; w; p) wL(r; w; p) = V (r; w; p) (435)


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

= (x; ) = py rK wL + K 0:4 L0:4 y (439)


0:4 0:4
Repeat the same proces to technology y = K L

= (x; ) = py rK wL + K 0:4 L0:4 y (440)

p 0:4K 0:4 L 0:6


=w (441)

0:6
p 0:4K L0:4 = r (442)

K 0:4 L0:4 y=0 (443)


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

wb pb ln (0:4) 0:4 0 0:6 wb pb ln (0:4) 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:

= py(r; w; p) rK(r; w; p) wL(r; w; p) = V (r; w; p) (446)


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:

C = dQ3 eQ2 + f Q + 845 (458)


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.

3.4.2 Linear programming problem of a …rm


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:

max R = 2X1 + 5X2 (460)


Subject to
X1 + 4X2 100 (461)
4X1 + 2X2 200 (462)
where X1 0 and X2 0;

Table 8: Simplex Table 1


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 = 0 0 0 100 200


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

Q1 Now change coe¢ cients slightly as:

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

Table 10: Simplex Table 3


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

max R = 2X1 + 5X2 (463)


Subject to
X1 + 4X2 100 (464)
3X1 + X2 150 (465)
where X1 0 and X2 0;

Q2 Solve the following minimisation problem using a simplex method.

min C = 0:6X1 + X2 (466)

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 ?

max R = 10X1 + 5X2 (470)

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

Table 12: Simplex Table 2


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

Table 13: Simplex Table 3


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

Basic feasible solution R X1 X2 S1 S2 = 17500/42 700/21 700/42 0 0


R X1 X2 S1 S2 = 416.7 33.3 16.7 0 0

3.4.3 Duality in Linear Programming


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.

GAMS programme: lp.gms; lp_2014.gms, lp_min.gms, lp2.gms, lp_min_x3.gms


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

3.5 Input-Output Model


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

Table 15: Leontief Technology and Primary Input Coe¢ cients


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

3.5.1 Numerical Example of Input Output Model


Leontief coe¢ cients
Input-Output Model: Structural Equations

X1 = X11 + X12 + F1 (478)

X2 = X21 + X22 + F2 (479)

X11 X12 X21 X22


a11 = ; a12 = ;a = ; a22 = ; (480)
X1 X2 21 X1 X2

X1 = a11 X1 + a12 X2 + F1 (481)

X2 = a21 X1 + a22 X2 + F2 (482)


Input-Output Model

X1 a11 X1 a12 X2 = F1 (483)

a21 X1 + X2 a22 X2 = F2 (484)

(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

0 0:9 0:3 0:9 0:1


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.

3.5.2 Impact analysis


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

X1 1 0:9 0:1 70 0:15


=
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.

GAMS programe input_output.gms

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.

Table 16: Input-output Transaction Table of UK 2009


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

A gri 3127 12686 250 1622 8 0 0 15 112 20

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

O thrsrv 77 938 100 1725 3085 939 51 2201 4869 6628

Note: Constructed from the ONS data.

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

A gri 3394 7916 15502 815 0 2242 9121 -32 80 0 .0 6 5 0 .4 5 5

P ro d 108572 76281 374956 47256 6131 226785 314104 4081 0 .9 4 7 1 .9 9 6

C onstr 47246 39310 7167 112246 0 1604 1409 817 0 .0 7 4 0 .1 8 6

D ist 161281 63465 131456 802 0 29884 29596 10034 -0 .8 0 5 -0 .9 5 0

In fco m 47434 28579 38161 24372 3116 20342 12514 1087 0 .1 3 0 0 .2 3 6

F in in s 56890 67445 54928 118 0 52559 11823 2559 -0 .0 2 7 -0 .0 9 5

R le st 6794 84153 139527 4576 0 614 909 -53 3 0 .0 5 4 2 .1 6 9

P rfsp p 95617 51781 15387 6108 0 54111 33824 1157 0 .1 2 5 0 .2 0 3

G h lth e d 220102 32561 65419 1431 313401 3817 2188 380 0 .0 2 4 0 .0 1 1

O thrsrv 29542 11099 51602 313 4701 3630 5737 1168 -0 .0 0 6 -0 .0 0 7

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.

Stone Richard (1961) Input-output and National Accounts, Paris:OECD.


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.

3.5.3 Exercise 10: Input Output Model


Input Output Model

1. Consider an input-output model for an economy.

80
X1 = X1;1 + X1;2 + ::::: + X1;n + C1 + I1 + G1 + N X1 (504)

X2 = X2;1 + X2;2 + ::::: + X2;n + C2 + I2 + G2 + N X2 (505)

::::::: (506)

Xn = Xn;1 + Xn;2 + ::::: + Xn;n + Cn + In + Gn + N Xn (507)


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.

Table 18: Employment and Capital Share in Ouput


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

Input-Output Coefficents for Hull -Borrowed from the National Model


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

Compstion of Final Demand


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.

(a) What is the impact on employment of an increase in public spending by 10 percent?


(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 L4: Markets: Perfect and Imperfect Competition


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 :

Qd1 = K1 P1a11 P2a12 Y b1 (514)

Qd2 = K2 P1a21 P2a22 Y b2 (515)

Qs1 = M1 P1n1 (516)

Qs2 = M2 P2n2 (517)


Linearise the above market system taking log both sides

k1 + a11 p1 + a12 p2 + b1 y = m1 + n1 p1 (518)

k2 + a21 p1 + a22 p2 + b2 y = m2 + n2 p2 (519)


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

(m2 b2 y k2 ) ( a11 + n1 ) a21 (m1 b1 y k1 )


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 :

k1 + a11 ln (1 + t1 ) + a11 p1 + a12 p2 + b1 y = m1 + n1 p1 (526)

k2 + a21 ln (1 + t1 ) + a21 p1 + a22 p2 + b2 y = m2 + n2 p2 (527)


solve for equilibrium prices p1 and p2 and q1 and q2

( a11 + n1 ) a12 p1 m1 a11 ln (1 + t1 ) b1 y k1


= (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

(m1 a11 ln (1 + t1 ) b1 y k1 ) (a22 n2 ) a12 (m2 a21 ln (1 + t1 ) b2 y k2 )


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.

Simon C. P. and L. Blume (1994) Mathematics for Economists, Norton.

Consider a pro…t maximisation under the perfect competition

Q1. Derive the short run pro…t function for a …rm under the perfect competition

= PY wL rK (534)

with production technology


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:

(a) Derive supply function of the …rm using Hotelling’s Lemma.


(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?

Q2. Burden of Taxes in Partial Equilibrium Analysis (it depends on elasticities)

Consider linear demand and supply model

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)

D = 150 3P D = 150 3 PS + 2 (540)

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.

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


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

1 = (30 q1 q2 ) q1 6q1 (545)

2 = (30 q1 q2 ) q2 6q2 (546)


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)

Consumer surpluses from both …rms


1
CS1 = CS2 = 16 8 = 64 (552)
2
Total welfare under duopoly

W = 1 + 2 + CS1 + CS2 = 64 + 64 + 64 + 64 = 256 (553)

4.1.2 Price-Leadership by …rm 1 in Stackelberg equilibrium


When the Firm 1 is the leader and …rm 2 is the follower. Leader incorporates follower reaction
function into its pro…t function.

1 = (30 q1 q2 ) q1 6q1 = 30q1 q12 q1 q2 6q1


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

W = 1 + 2 + CS1 + CS2 = 72 + 36 + 108 + 54 = 270 (562)

Collusion (cartel): maximise industry pro…t

= PQ C = (30 Q) Q 6Q = 30Q Q2 6Q (563)

@
= 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

W = 1 + 2 + CS1 + CS2 = 72 + 72 + 36 + 36 = 216 (569)


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.

GAMS programme: cartel.gms; cournot.gms;Pdiscrimn.gms

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

4.2 Dixit-Stiglitz Model of Monopolistic Competition


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)

subject to their budget constraint:


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:

max = (pi c) qi f (575)


pi

For optimisation apply M R = M C condition.

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).

4.2.1 Monopolistic competition and Trade


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:

T C = 20X 2X 2 + 0:1X 3 (581)


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

a 2X = 20 4X + 0:3X 2 =) 20 a = 2X 0:3X 2 (584)

AR =AC implies

a X = 20 2X + 0:1X 2 =) 20 a=X 0:1X 2 (585)


From both of these equations

2X 0:3X 2 = X 0:1X 2 =) X = 5 (586)


Now price can be determined

a = 20 X + 0:1X 2 = 20 5 + 0:1 25 =) 17:5 (587)

P =a X = 17:5 5 = 12:5 (588)

4.2.2 Monopolistic competition in an industry with two …rms


There are two …rms in a market, I and II. The marked demand and cost functions faced by each is
as following

P1 = 105 2q1 q2 ; C1 = 5q12 (589)

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:

1 = P1 q1 C1 = (105 2q1 q2 ) q1 5q12 = 105q1 q2 q1 7q12 (591)

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

56q1 + 4q2 = 420 (595)

q1 + 4q2 = 35 (596)

385
55q1 = 385 =) q1 = = 7; q2 = 7 (597)
55

P1 = 105 2q1 q2 = 105 2 7 7 = 84 (598)

P2 = 35 q1 q2 = 35 7 7 = 21 (599)

C1 = 5q12 = 5 72 = 245 (600)

C2 = q22 = 72 = 49 (601)

1 = P1 q1 C1 = 84 7 5 72 = 588 245 = 343 (602)

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)

1 = P1 q1 C1 = 86 5 5 52 = 430 125 = 305 (605)

2 = P2 q 2 C2 = 21 9 92 = 189 81 = 108 (606)

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.

P1 = 105 2q1 q2 ; =) 82 = 105 2q1 (14 q1 ) =) q1 = 9 C1 = 5q12 (609)


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

1 = P1 q1 C1 = 82 9 5 92 = 738 405 = 333 (611)

2 = P2 q2 C2 = 19 7 72 = 133 49 = 84 (612)

C1 = 5q12 = 5 92 = 405 (613)

C2 = q22 = 72 = 49 (614)
Summary of the Monopolistic Competition Model

Table 20: Firm Behaviour in Monopolistic Competition


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

Bhaskar, V. 1988. "The Kinked Demand Curve: A Game-Theoretic Approach" International


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.

4.3 Natural Monopoly


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

T C = AC X = 50X 0:125X 2 (617)


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

P = 100 X = 100 28:57 = 71:43 (621)

95
AC = 50 0:125X = 50 0:125 (28:57) = 46:43 (622)

= PX C = 71:43 28:57 46:43 28:57 = 714:25 (623)


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

P = 100 X = 100 66:7 = 33:33 (625)

= P X 50X+0:125X 2 = 66:7 33:33 50 66:7+0:125 66:72 = 2222 2778:88 = 556:9 (626)

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

P = 100 X = 100 58:14 = 41:86 (628)

= P X 50X+0:125X 2 = 58:14 41:86 50 58:14+0:125 58:142 = 2433:74 2907+422:5 = 50:76


(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

P = 130 (q1 + q2 ) ; C = 10qi (630)


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

Cournot Nash equilibrium


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)

A = (a PA + bPB ) PA c (a PA + bPB ) (641)

B = (a PB + bPA ) PB c (a PB + bPA ) (642)


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.

4.4 Price War: stability analysis


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)

C1 R cos( t) + C2 R sin( t) a11 C1


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

yt+1 = yt (yt xt ) (651)


Price set by the …rst …rm against price of the rival yt

xt+1 = xt (xt yt ) (652)


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

yt = C1 r1t + C2 r2t (658)


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 ) =)

C2 = (y0 C2 x0 ) =) C2 = (y0 x0 ) (667)


+

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)

y1 (t) = C1 er1 t + C2 er2 t + y 1 (676)

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

P (t) = C1 er1 t + C2 er2 t + p (679)


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:

GAMS programme: state.gms;

Bresnahan T. F. (1987) Competition and Collusion in the American Automobile Industry:


The 1955 Price War,The Journal of Industrial Economics, 35, . 4, , 457-48
Chang MC and Y-H Chiu (2008) The analysis of a price war strategy under market demand
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

4.5 Monopolistic competition and trade


1. Consider a …rm in monopolistically competitive industry ( refer to chapter 6 of Krugman and
Obstfeld (2000))
Q=A B P (685)

Prove that its marginal revenue is given by


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.

4.5.1 Monoply, Oligopoly and tax


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

= (a bQ) Q cQ f tQ = aQ bQ2 (c + t) Q f (693)


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

total cost including taxes (ignore …xed cost for a while)

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

Optimal output of …rm 1 is


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

(R2 R3 1) a bc1 (R3 1) a bc2 + (1 R2 ) a bc3


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

4.7 Multinational Company: Microeconomic Theory of FDI


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:

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.

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.

Table 21: Motivations of multinational corporations for their foreign operation


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.

Table 22: Perfect Competition

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.

Table 23: Under Monopoly

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

130 2Q1 = 10 (769)


Marginal revenue and marginal cost principle (M R = M C) for country 2 implies

90 2Q2 = 20 (770)
The solution of these two markets

Table 24: Price Discrimination

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

1 = 90q1 q12 q1 q2 20q1 (774)


foreign form tries to maximise

2 = 90q2 q22 q1 q2 30q2 (775)


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

P = 90 43:33 = 46:7 (778)

1 = pq1 C1 = 46:7 26:6 20 26:6 = 710:2 (779)

2 = pq2 C2 = 46:7 16:7 30 16:7 = 278:9 (780)

Table 25: Nash Equilibrium


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

If they had cartel. host gains more relative to the MNC

Table 26: Cartel


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

P = 90 (q1 + q1 ) = 90 (40 + 10) = 40 (782)

Table 27: Price Leadership


Q P R C Pro…t
MNC 40 40 1600 800 800
Rival 10 40 400 300 100

4.8 Predatory pricing


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.

Table 28: Predatory Pricing


Q P R C Pro…t
MNC 61 29 1769 1220 549
Rival 0 29 0 0 0

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


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)

Inserting this value function in above two equations

mY = l ( )Y F (791)

1 1
mY = l ( )Y (792)
Solving these we get
2 3
1 F
Y =4 5 (793)
l ( )

The parameter is determined by the quadratic root:


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

B = (pX wLx + p X w Lx F) (802)

Global pro…t after taxes: tax credit in source country

C = (p X w Lx )t (803)
Global pro…t after taxes:

= B(1 t) B t +C r Kx rKx (804)


= (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.

pXL (LX ; KX ; S) = YL (LY ; Ky ) (811)

p XL (LX ; KX ; S ) = YL (LY ; Ky ) (812)

p(l t)XK (LX ; Kx; S) = p (l t )XK (Lx ; Kx ; S ) (813)

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)

p (l t )Xk (Lx ; Kx ; S ) = p(l t)Xk (Lx ; K x Kx ; S) (819)


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

Employment level in the MNC and Local …rms

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

p XLL + YLL p XLK 0


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

Investment level in the host …rm

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:

yi;t = i + 1 yi;t 1 + 2 Fi;t + 3 Ti;t + 4 Ii;t 1 + ei;t


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)

Panel Data regression: an example


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.

4.9.2 Exercise 9: markets and competition


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

T R = 15Q1 + 18Q2 (829)


TC = 2Q21 + 2Q1 Q2 + 3Q22 (830)

What are the pro…t maximising levels of output of this …rm?


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.

Balasubramanyam„V.,N., M. Salisu and D. Sapsford, Foreign Direct Investment and Growth


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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)

subject to the budget and time constraints as:

P C + wL = wL (832)

L = L + LS (833)

Firm’s problem

max P Y = wLS + rK (834)

Subject to
Y = LS K (835)

Here U is utility, C consumption, L leisure, LS labour supply, K capital, w wage rate, P


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 L5: General Equilibrium Model and Welfare


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

see Intriligator (1971), Shoven and Whalley (1992)

Arrow, K.J. and G. Debreu (1954) “Existence of an Equilibrium for a Competitive Economy”
Econometrica 22, 265-90.
Balasko Y. (1975) Some results on uniqueness and on stability of equilibrium in general
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Kehoe T. J. (1984) Computing all of the equilibria of economies with two factors of production.
Journal of Mathematical Economics, 13:207–223.

123
T.J.Kehoe and J.Whalley (1985) Uniqueness of equilibrium in large-scale numerical general
equilibrium models. Journal of Public Economics, 28:247–254.
McKenzie L. (1954).On equilibrium in Graham’s model of world trade and other competitive
systems. Econometrica, 22:147–161.

Negishi T(1962). The stability of a competitive economy: A survey article, Econometrica,30:635–


669.

Properties of excess demand function

1. The excess demand functions are single valued continuous function,


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.

5.1.1 Existence, uniqueness and stability of general equilibrium


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 Theorems: Existence of general equilibrium


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

Scarf algorithm (Shoven and Whalley (1992)


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

First welfare therem: Every Walrasian equilibrium is Pareto E¢ cient


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
.

Uniqueness of Equilibrium One approach to establish the uniqueness of the equilibrium is


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

lim p (t) = p given jp (t0 ) p j< (841)


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.

5.2 Two fundamental theorems of welfare economics


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

This is a contradiction. x0i is not feasible.


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

Cornwall, R. R. (1984) Introduction to the use of general equilibrium analysis, Amsterdam :


North-Holland.

Demand supply Leisure demand and supply

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.

5.3 Pure exchange general equilibrium model


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.

Main Features of Applied General Equilibrium Model

Three conditions

1. Demand = supply ; n markets, n-1 relative prices


2. Income = expenditure

129
3. Firms maximise pro…t: zero economic pro…t in competitive markets

Relative Prices

1. Preferences and technology parameters determine relative prices in

2. equilibrium.
3. Relative prices are determined by forces of demand and supply.
4. Numeraire or anchor price; normalised to 1.

Markets allocations depend on relative prices.

1. Demand for a commodity depends on preferences and income.


2. Income of a household is determined by her endowment and price of that
endowment.

Exchange or trade of goods is mutually bene…cial.


Each consumer/ producer optimises in equilibrium.

Problem of representative households


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)

Table 31: Parameters in Pure Exchange Model


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

max Ui = X1;i X2;i X1;i (866)

subject to

Ii = p1 X1;i + p2 X2;i + p3 X3;i (867)

Endowments of each country respectively is f(! 1 ; 0; 0) ; (0; ! 2 ; 0) ; (0; 0; ! 2 )g


Solve for prices and allocations at equilibrium. Apply this model to a realistic situation for
countries producing food, oil and manufacturing commodities.

5.4 Simplest general equilibrium model


Households and …rm optimise subject to their constraints

– Utility maximisation by households and pro…t maximisation by …rms

System of prices when all markets clear simultaneously (all goods and factor markets)

D (p1 p2 p3 ; ::::pn ) = S (p1 p2 p3 ; ::::pn ) (868)

Excess demand is zero in equilibrium.

Income of agents equals their expenditure


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.

A simple general equilibrium model represents an economy in which a representative household


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:

= p (hs ) whd (875)


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

Demand for leisure


w
p (1 ) p
L=1 w (883)
p

First order conditions for households:


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

Preference for consumption ( )and leisure (1 )

pro…t of the …rms

First order conditions for …rms


@ 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

Equilibrium real wage


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 )

Optimal labour supply and leisure demand


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 )

and the leisure

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 )

5.5.1 A numerical example for the general equilibrium tax model


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

Table 33: Parameters of the model in the base scenario


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.

E¢ ciency Gains in the UK from elimination of all taxes and transfers

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

(Measured as a percent of benchmark utility level of a representative household)


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.

GAMS programe: A1model.gms and A2model.gms, macrotax.gms


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;

Firms’Problem: maximise pro…t

M ax = PY w Lf (897)
Lf

Y = Lf (898)
Y > 0; Lf > 0;
Household Problem: Maximise Utility

Household gets utility from consuming goods and leisure

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:

Firms’Problem: maximise pro…t

= 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)

Lf + Lh = L; Lf = 1600 960 = 640 (909)

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

Lf + Lh = 640 + 960 = 1600 = L (913)

Parameters and shadow prices

142
Table 38: Parameters of the General Equilibrium Model
Parameters Value
0.4
0.5
L 1600
w (normalised) 1

Lh 0:6 640 0:6


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

Table 39: General Equilibrium Solutions


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 .

5.6 Social Welfare Function


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

Y1 = 3Y2 = 3 (250) = 750 (924)


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

Y1 = 3Y2 = 3 (250) = 750 (944)


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.

Y1 = 600; Y2 = 400 (946)

3 1 p 3
4 p 1
4 3 1
W = U14 U24 = 600 400 = 600 8 400 8 = 23:3 (947)

5.7 Exercise 12: Social Welfare and General Equilibrium


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?

3. Consider an economy consisting of a representative household and a representative …rm. A


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.

The household maximisation problem can be stated as the following:

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.

1. (a) Form a Lagrangian maximisation problem for this household.


(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)

Table 40: Parameters in production of the two sector model


K A
Necessity sector 0.5 100 1
Luxury sector 0.5 144 1

Demand for labour and supply function of necessities

Table 41: Parameters in consumption of the two sector model


1 2 3
Workers 1 0 0
Capitalist 0.2 0.6 0.2

1 = P1 Q1 wL1 rK1 = P1 A1 K1 1 L11 1


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

= P2 Q2 wL2 rK2 = P2 A2 K2 2 L21 2


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)

Demand for necessities and luxury goods

P1 Qd1 = YL + 0:2YK = 50w + 0:2 (50w) = 60w (965)

w
Qd1 = 60 (966)
P1
Demand for luxury goods

P2 Qd2 = 0:6YK + I = 0:6 (50w) + 0:2 (50w) = 40w (967)

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

L1 + L2 = 29:97 + 19:9 50 (979)


Consumption:
workers’demand for necessity good

YL = C1;;L ; 50w = 50 0:913 = 45:65 (980)


Capitalist’s demand for necessity good

0:2YK = C1;K ; 0:2 ( 50w) = 0:2 (50 0:913) = 9:13 (981)


Total demand for necessity good

C1;L + C1;K = 45:65 + 9:13 54:8 (982)


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

I 0:2 (50 0:913) 9:13


= = = 13:43 (984)
P2 P2 0:680

C2;;K + I = 40:23 + 13:43 = 53:7 (985)

GAMS programme: UK10.gms

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.

5.9.1 Two Country Ricardian Trade Model


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.

Two Country Ricardian Trade Model

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

I1 = w1;1 L1;1 + w1;2 L1;2 + T R1 (994)

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

X1;1 = a1;1 :L1;1 (995)


where a1;1 is the productivity of labour in sector 1 in country 1.
Technology constraints in sector 2 in country 1

X1;2 = a1;2 :L1;2 (996)


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:

L1 = L1;1 + L1;2 (997)


Production possibility frontier of country 1 now can be de…ned as
1 1
L1 = :X1;1 + :X1;2 (998)
a1;1 a1;2

X11 = a11 :L11 (999)


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

5.9.2 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.

Analytical solutions of autarky and specialisation

Proposition 1 Autarky solution is Pareto dominated by trade equilibrium for reasonable pa-
rameters of preferences and technology.

This is proven below by analytical and numerical solutions.

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

Analytical solutions of in autarky


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

I2 = w2;1 L2;1 + w2;2 L2;2 + T R2 (1012)


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

X2;1 = a21 :L2;1 (1013)


where a2;1 is the productivity of labour in sector 1 in country 2.
Technology constraints in sector 2 in country 2

X2;2 = a2;2 :L2;2 (1014)


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:

L2 = L2;1 + L2;2 (1015)


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.

This is proven below by analytical and numerical solutions.

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

Analytical solutions in autarky

X1;2 = 2 a2;1 L2 (1025)


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.

Table 42: Parameters of the Autarky Model


a1 a2 L
country 1 0.4 5 2 200
country 2 0.6 2 5 400

Summary of two country trade model in autarky

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.

Table 43: Parameters of the Autarky Model


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

Prices adjcountry 1t until this equilibrium condition holds.


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

I 1 = P1 X1 = 1 1000 = 1000 (1037)


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:

I 2 = P2 X2 = 200 5 P2 = 2000 P2 = 1825 0:5 = 1000 (1040)


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

Table 44: Comparing Specialisation and Autarky Regimes


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

Analytical solutions for trade equilibrium under specialisation

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

Edwards S. (1993) Openness, Trade Liberalization, and Growth in Developing Countries,


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.

Melitz M. T. (2003) The Impact of Trade on Intra-Industry Reallocations and Aggregate


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)

Table 46: Endowment and Technology

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.

5.11 General equilibrium with taxes


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

max u2 = u2 (x2 ; G) (1055)


and the resource contraint

x1 + x2 + c (G) = w1 + w2 (1056)
Constrained optimisation for this is

L = u1 (x1 ; G) [u2 u2 (x2 ; G)] [x1 + x2 + c (G) w1 w2 ] (1057)


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

@u1 (x1 ;G) @u2 (x2 ;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

Simplest General Equilibrium Tax Model: Demand Side


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.

Supply Side of the General Equilibrium Model


Firms’pro…t maximisatin problem

max = p:Y w:LS (1070)


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

L + LS = 100 + 100 = 200 = L (1079)


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:

R = p:t:C = 1 0:2 8:33 = 1:67 = G (1081)

Markets clear in this case too

C + G = 8:33 + 1:67 = 10 = Y (1082)

Houswhold’s welfare before tax

U = C L = 10 100 = 1000 (1083)

Welfare after tax


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

Household gets utility from consuming goods and leisure

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:

Firms’Problem: maximise pro…t

= 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)

Lf + Lh = L; Lf = 1600 960 = 640 (1095)

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

Lf + Lh = 640 + 960 = 1600 = L (1099)

Parameters and shadow prices

167
Table 47: Parameters of the General Equilibrium Model
Parameters Value
0.4
0.5
L 1600
w (normalised) 1

Lh 0:6 640 0:6


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

Table 48: General Equilibrium Solutions


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.

5.12 Exercise 13: Monopolistic Competition


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.

Problem of a Multinational Corporation

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.

Demand in home country

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.

Meade J (1978) Structure of Direct Taxation, Institute of Fiscal Studies, London.


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.

Main budget: http://www.hm-treasury.gov.uk/; Green Budget: http://www.ifs.org.uk/

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 .

6.1.1 Nash equilibrium

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.

mi;j + max (0; ui (j; m i ) ui (m))


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

Here the left hand side


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

RHS is zero only if ui (j 0 ; m


b i) b
ui (m) b
0. That implies ui (m) ui (j 0 ; m
b i ). Therefore m
b
is the Nash equilibrium.

6.1.2 Game of incomplete information:


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

6.2 Story of GAME made easy


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

Table 50: Two Person Zero Sum Game


Storng Hand
pull push
Strong Leg
walk ( 10; 10) (10; 10)
stand (10; 10) ( 10; 10)

a) Explain this TPZS game


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.

Table 51: Two Person Cooperative Game


Singer
sing quite
Writer
write (5; 5) (2; 6)
read (6; 2) (3; 3)

a) What is the solution for cooperative solution in this game?


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.

Table 52: Non Cooperative Game


Singer
sing quite
Writer
write (5; 5) (2; 6)
read (6; 2) (3; 3)

a) What is the non-cooperative solution of this game?


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.

Table 53: Incomplete Information Game


Singer
sing quite
Writer
write (?; ?) (?; ?)
read (?; ?) (?; ?)

Story 5 N person games


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.

Binmore K. (1990) Fun and Games: A text on Game Theory, Lexington, Heath.
Bhattarai K. (2013) Coalition for constitution and economic growth in Nepal, International
Journal of Global Studies (IJGS), 1:1, Feb, 1-4
Cripps, M.W.(1997) Bargaining and the Timing of Investment, International Economic Re-
view, 38:3 :Aug.:527-546
Dixit A., S. Skeath and D. F. Reiley (2009) Games of Strategy, Norton.
Gardener R (2003) Games of Business and Economics, Wiley, Second Edition.
Hey J. D. (2003) Intermediate microeconomics, McGraw Hill.
Holt Charles (2007) Markets, Games and Strategic Behaviour, Pearson, .
Hurwicz L (1973) The design of mechanism for resource allocation, American Economic Re-
view, 63:2:1-30.
Kreps D. M. (1990) A Course in Microeconomic Theory, Princeton.
Maskin E, J. Moore (1999) Implementation and Renegotiation The Review of Economic Stud-
ies, Vol. 66, No. 1, Special Issue: Contracts Jan, pp. 39-56
Maskin E and J Tirole (1992) The principal-agent relationship with an informed principle:
common values, Econometrica, 60:1:1-42
Mailath G. J. and L. Samuelson (2006) Repeated Games and Reputations: long run relation-
ship, Oxford.
Mirlees, J.A. (1971) "An exploration in the theory of optimum income taxation." Review of
Economic Studies,38:175-208.
Myerson R (1986) Multistage game with communication, Econometrica, 54:323-358.
Osborne M.J. and A. Robinstein (1994) A course in game theory, MIT Press.
Pathak P and T Sönmez (2013) School Admissions Reform in Chicago and England: Com-
paring Mechanisms by Their Vulnerability to Manipulation." American Economic Review,
103(1): 80-106.
Perlo¤ J. M. (2013) Microeconomics: Theory and Applications with Calculus, Pearson, 3rd
Edition.
Rasmusen E(2007) Games and Information, Blackwell.
Roth A E. (2008) What have we learned from market design?, Economic Journal, 118 (March),
285–310.
Shapley L (1953) A Value for n Person Games, Contributions to the Theory of Games II,
307-317, Princeton.

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..

6.3 Types of games

Table 54: Zero Sum Game


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

two or many players; Chess, football


Cooperative Games: Global climate change; bargaining game
Non-cooperative Games: two or many players ;

Competition and Collusion


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

Solution of Games by the Dominant Strategy

Dominant strategy

Table 55: Advertisement Game


Player A
Advert Dont Advert
Player B
Advert (10; 5) (15; 0)
Dont Advert (6; 8) (10; 2)

Dominant strategy is to advertise for both A and B. With a slight change


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.

Nash Equilibrium: Prisoner’s Dilemma

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)

Table 57: Prisoners’Dilemma Game


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.

Solution by the mixed strategy


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

E( B;L ) = 50p + 90(1 p) (1116)


Expected pay-o¤ for B if A plays Right

E( B;R ) = 80p + 20(1 p) (1117)

180
Table 58: Prisoners’Dilemma Game
Player A
Confess Dont Confess
Player B
Confess ( 5; 5) ( 1; 10)
Dont Confess ( 10; 1) ( 2; 2)

Table 59: Game of matching penny: mixed strategy


Player A
Head Tail
Player B
Head (1; 1) ( 1; 1)
Tail ( 1; 1) (1; 1)

Making these two payo¤s equal

50p + 90(1 p) = 80p + 20(1 p) =) 100p = 70 (1118)

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)

Table 61: Subsidy Game


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

Dixit A., S. Skeath and D. F. Reiley (2009) Games of Strategy, Norton.

182
Table 62: Subsidy Game
Airbus
Produce Don’t produce
Boeing
Produce ( 10; 10) (100; 0)
Don’t produce (0; 120) (0; 0)

Table 63: Subsidy Game


Entrant
Enter Dont Enter
Incumbent
Enter ( 10; 10) (100; 0)
Dont Enter (0; 100) (0; 0)

Gardener R (2003) Games of Business and Economics, Wiley, Second Edition.

Holt Charles (2007) Markets, Games and Strategic Behaviour, Pearson, .

Mailath G. J. and L. Samuelson (2006) Repeated Games and Reputations: long run relationship,
Oxford.

Kreps D. M. (1990) A Course in Microeconomic Theory, Princeton.

Osborne M.J. and A. Robinstein (1994) A course in game theory, MIT Press.

Perlo¤ J. M. (2008) Microeconomics: Theory and Applications with Calculus, Pearson.

Rasmusen E(2007) Games and Information, Blackwell,.

Varian HR (2010) Intermediate Microeconomics: A Modern Approach, Norton,8th ed..

Equilibrium concepts:
Backward induction; subgame perfect equilibrium, sequential equilibrium, Bayes’s rule.

6.4 Bargaining game


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

Nash Product in Bargaining Game

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)

Table 65: In‡ation and unemployment game


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

Using a Lagrangian function

L ( i; j; )=( i 0) ( j 0) + [1 i j] (1128)

First Order Conditions


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.

Numerical Example of Bargaining Game


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

L (u1; u2 ; ) = u1 u2 + [1000 u1 u2 ] (1133)


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

L (u1; u2 ; ) = (u1 d1 ) (u2 d2 ) + [50000 u1 u2 ] (1137)


Suppose the player 1 has side payment d1 = 15000

L (u1; u2 ; ) = (u1 15000) (u2 d2 ) + [50000 u1 u2 ] (1138)

First order conditions of this maximization problem are

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

From the …rst two …rst order conditions u2 = u1 15000


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.

Then u1 + u2 = 17500 + 32500 = 50000.

Risk and Bargaining


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 ; ) = u1 u2 + 100 u1 u22 (1142)

First order conditions of this maximization problem are

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

6.4.1 Coalition and Shapley Values of the Game


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.

6.5 Pivotal player in a voting game in Nepal


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

Table 67: Pivotal Player in a Bargaining Game


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).

6.5.1 Model of fruitless bargaining and negotiation


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:

xi = Ui (S1 ; S2 ; ::::; Sn ; a0 ; a1 ; a2 ; ::::; an ) (1158)


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 .

6.5.2 Model of commitment, credibility and reputation


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.

6.5.3 Endogenous intervention: change in beliefs


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.

Table 68: Members of First Constituent Assembly by Political Parties in Nepal


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).

Table 69: Members of Second Constituent Assembly by Political Parties in Nepal


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.

B h a tta ra i K . (2 0 1 3 ) C o a litio n fo r c o n stitu tio n a n d e c o n o m ic g row th in N e p a l, Inte rn a tio n a l J o u rn a l o f G lo b a l S tu d ie s (IJ G S ), 1 :1 ,

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

B h a tta ra i K . (2 0 1 1 ) E m p ty C o re in a C o a litio n : W h y N o C o n s titu tio n in N e p a l? , In d ia n J o u rn a l o f E c o n o m ic s a n d B u s in e s s , 1 0 :1 :1 1 9 -

1 2 6 ,M a rch 2 0 1 1

B h a tta ra i K . (2 0 0 7 ) M o d e ls o f E c o n o m ic a n d P o litic a l G row th in N e p a l, S e ria ls P u b lic a tio n , N e w D e lh i.

B h a tta ra i K . (2 0 0 6 ) C o n se q u e n c e s o f A p ril 2 0 0 6 R e vo lu tio n a ry C h a n g e s in N e p a l: C o ntinu a tio n N e p a le se D ile m m a , In d ia n J o u rn a l o f

E c o n o m ic s a n d B u sin e ss, 5 :2 :3 1 5 -3 2 1 .

C rip p s, M .W .(1 9 9 7 ) B a rg a in in g a n d th e T im in g o f Inve stm e nt, Inte rn a tio n a l E c o n o m ic R e v ie w , 3 8 :3 :A u g .:5 2 7 -5 4 6

D ix it A v in a sh (1 9 8 7 ) S tra te g ic B e h av io u r in C o nte sts, A m e ric a n E c o n o m ic R e v ie w , D e c ., 7 7 :5 :8 9 1 -8 9 8 .

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 .

M a sk in E , J . M o o re (1 9 9 9 ) Im p le m e nta tio n a n d R e n e g o tia tio n , R e v ie w o f E c o n o m ic S tu d ie s, 6 6 ,1 , 3 9 -5 6

M a ila th G . J . a n d L . S a m u e lso n (2 0 0 6 ) R e p e a te d G a m e s a n d R e p u ta tio n s: lo n g ru n re la tio n sh ip , O x fo rd .

M ye rso n R (1 9 8 6 ) M u ltista g e g a m e w ith c o m m u n ic a tio n , E c o n o m e tric a , 5 4 :3 2 3 -3 5 8 .

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

M a n ip u la tio n ." A m e ric a n E c o n o m ic R e v ie w , 1 0 3 (1 ): 8 0 -1 0 6 .

R ile y J G (2 0 0 1 ) S ilve r S in g a ls : T w e n ty -F ive Ye a rs o f S c re e n in g a n d S ig n a llin g , J o u rn a l o f E c o n o m ic L ite ra tu re , 3 9 :2 :4 3 2 -4 7 8

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 .

R u b in ste in A (1 9 8 2 ) P e rfe c t e q u ilib riu m in a b a rg a in in g m o d e l, E c o n o m e tric a , 5 0 :1 :9 7 -1 0 9 .

S h a p le y L (1 9 5 3 ) A Va lu e fo r n P e rso n G a m e s, C o ntrib u tio n s to th e T h e o ry o f G a m e s I I, 3 0 7 -3 1 7 , P rin c e to n .

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.

S u tto n J . (1 9 8 6 ) N o n -C o o p e ra tive B a rg a in in g T h e o ry : A n Intro d u c tio n , R e v ie w o f E c o n o m ic S tu d ie s, 5 3 , 5 ., 7 0 9 -7 2 4

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

Shapley Shubik Core in a Venn Diagram

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.

Wooders HM and WR Zame (1984) Approximate cores of large games, Econometrica,


52:6:1327-1350.

6.7 Labour Market and Search and Matching Model


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)).

6.8 Exercise 14: Search Equilibrium


Search Equilibrium

1. Consider a bargaining model between …rms and workers


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,

q ( ) u. Derive the job creation curve.

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.

7 L7: Game theory: Principal Agent and Mechanism Games


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

V = v(y ) + (1 ) v(y1 ) < V 0 (1175)


Principal’s objective when a is observable is then to maximize pro…t by producing x subject to
the participation constraint

max zi = i (x1 y1 ) + (1 i ) (x2 y2 ) i=h,l (1176)


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.

7.1.1 Full information scenario


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)
@

i v(y1 ) + (1 i ) v(y2 ) ai V0 =0 (1182)


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.

L= l (x1 y1 ) + (1 l ) (x2 y2 ) + l v(y1 ) + (1 l ) v(y2 ) al V0 (1184)

7.1.2 Incomplete information scenario


P cannot observe a of A; therefore they must design a contract which makes A put ah
This requires adding an incentive compatibility constraint.

h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) + (1 l ) v(y2 ) al (1185)


Then the problem is modi…ed as

max zi = i (x1 y1 ) + (1 i ) (x2 y2 ) i=h,l (1186)


subject to

i v(y1 ) + (1 i ) v(y2 ) ai V0 (1187)

and

201
h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) + (1 l ) v(y2 ) al (1188)

L = l (x1 y1 ) + (1 l ) (x2 y2 ) + l v(y1 ) + (1 l ) v(y2 ) al V0 +


[ h v(y1 ) + (1 h ) v(y2 ) ah l v(y1 ) (1 l ) v(y2 ) + al ] (1189)

The optimising conditions in this case are given by


@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

v(y) a V 0 and xi = x (ai ; i ) (1199)


Second best

L = (x1 y1 ) + (1 ) (x2 y2 ) + v(y1 ) l v(x2 ; 1 ) V0 +


[v(y2 ) l v(x2 ; 1 ) v(y1 ) + l v(x2 ; 1 )] (1200)

First order conditions


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.

Table 70: Principal Agent Games


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

7.1.3 Impacts of Assymetric (incomplete) Information on Markets


Equilibrium is ine¢ cient relative to full information case

Signalling can improve the e¢ ciency: warranty and guarantee


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)

Probability of bad event is raised by the action of the person

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.

7.1.4 Adverse Selection (hidden information) Problem


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.

Theft insurance; health insurance;


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

Asymmetric information in Used Car Market -Akerlof’s Model of Asymmetric Information

Sellers know exactly quality of cars but buyers do not.


Equilibrium is a¤ected when sellers have more information than buyers.

Market has plums: good cars and lemons: bad cars


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.

Ultimately only low quality cars remain in the market.


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

Complete market failure

pooling equilibrium (same price for good and bad cars; good cars disappear from the market)

Complete market success

Separating equilibrium where players act as they should according to the signal (prices according
to quality)

Partial market success

(both good and bad cars are bought, some feel cheated)
Near Market failure (mixed strategies) Bayesian updating mechanism at work

7.1.5 Signalling and Incentives


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.

Separating equilibrium It is worthwhile for more productive worker to signal if

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.

7.1.6 Education Level- A Signal of Productive Worker


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.

Education Level- A Signal of Productive Worker


Consider a level of education e

c1 e c2 e =) c1 c2 (1220)

Cost of eduction of unproductive worker is much higher

c2 e < (a2 a1 ) < c1 e (1221)


Cost of education relative to productivity of low and high quality workers for education e

(a2 a1 ) (a2 a1 )
<e < (1222)
c1 c2

7.2 Spence model of education


Players consisting of {workers, …rms and nature}.

There are two types of workers [t = {1, 2}].


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

Nature decides whether a worker is high or low productivity type.


Level of education signals the quality of worker

Spence model of education: Preferences over wage and level of education

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

It is costly to get education.


The utility function satis…es the single-crossing property

210
Spence model of education: Problem of Choosing Right Level of Education

Max ut (w; e) = f (w (e)) kt g (e) kt > 0 t = 1; 2 (1223)


e

kt . indicates the cost of education for the worker type t.

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

In perfect information equilibrium, …rms pay according to the marginal productivity

Wage of less productive worker: w1 = e;


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

Level of education chosen by more productive worker

Wage of less productive worker: w2 = 2e;

The type 1 worker’s optimisation problem


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.

Government Policy and Signalling

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.

7.3 Popular Principal Agent Games


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.

Principal o¤ers the agent a wage contract W(q).


Worker accepts or rejects this contract based on self-selection and participation constraints.

Objective of Principal and Agents

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¤.

If worker accepts the contract


Agent’s utility:
UA (e; w; s) = w e2 (1231)

Principal’s pro…t: . .
Vp (q; w) = q w (1232)

Optimal level of e¤orts by good and bad workers

Good worker maximises


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:

3 2eG = 0 =) eG = 1:5 (1234)

Bad worker’s Objective and Optimal E¤orts

M ax UB = wB e2B = eB e2B (1235)


eB

1 2eG = 0 =) eG = 0:5 (1236)

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

M ax UP = [0:5 (qG wG ) + 0:5 (qB wB )] (1237)


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

Principal includes agents’optimal choices into his utility function

213
M ax UP = [0:5 (qG wG ) + 0:5 (qB wB )]
qG ;qB ;wG ;wB

Including binding constraints of agents:


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)

Incentive Compatible First Best Choices of Good and Bad Worker

Now wages can be found from the constraints

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.

Incentive compatible game on renting a piece of agriculatural land


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

s(f (x)) = wx + K (1250)


(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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7.4 Exercise 15: Principal Agent Problem


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

(a) Determine the level of e¤orts by good and bad workers.


(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)

IR2 : V (q) T 0 (1254)


Incentive compatibility requires that consumers consume the bundel intended for them.

IC1 : V q T V (q) T (1255)

IC2 : V (q) T V q T (1256)


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)

p T cq + p T cq = p p V q pcq + p V (q) cq (1259)

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))

Two types of travellers: economy and business

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)

30(300 150) + (140 100) (70) = 30 150 + 40 70


= 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

(140 100) (100) = 4000 (1263)


Airlines should give consumer surplus of 85 to business traveller and charge them (300-85) =
215. This will alter their pro…t

30(215 150) + (140 100) (70) = 30 65 + 40 70


= 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

Mechanism when the composition of travellers change


Charging 215 for the business class and 140 for the economy class is the solution to the mecha-
nism design problem.

30(215 150) + (140 100) (70) = 30 65 + 40 70


= 1950 + 2800 = 4750 (1265)

Suppose the composition of travellers changes to 50% of each. Pro…t with the above price
mechanism

50(215 150) + (140 100) (50) = 50 65 + 40 50


= 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.

7.5.1 Mechanism for e¢ cient contract for a CEO


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

(s + 0:8b) (s + 0:6b) > 50; 000 (1268)

0:2b > 50; 000 (1269)


b = 250,000
b) Participation constraint:

(s + 0:8b) > 150; 000 (1270)

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

(0 + 0:8b) > 150; 000 (1272)

200; 000 > 150; 000 (1273)


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.

7.5.2 E¢ cient contracts of Land


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

P = 24 0:5q C = 12q (1274)

222
Revenue

R = P:q (1275)
Mechanism design in renting lands
Under the joint pro…t maximisation agreement

(q) = P:q C = (24 0:5q) q 12q = 24q 0:5q 2 12q (1276)


Under the …xed fee contract tenant maximises

(q) = P:q C F = (24 0:5q) q 12q F = 24q 0:5q 2 12q F (1277)


Under both these arrangements
0
(q) = 24 q 12 = 0 (1278)

q = 12; p = 18; R = 216; C = 144; (q) = 72 (1279)


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

(q) = P:q C = (24 0:5q) q 14q = 24q 0:5q 2 14q (1280)

0
(q) = 24 q 14 = 0 (1281)

q = 10; p = 19; R = 190; C = 120; LL (q) = 50; T (q) = 20 (1282)


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

q = 12; p = 18; R = 216; C = 144; (q) = 72;


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.

7.5.3 Mechanism for Poverty Alleviation


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

Mechanism for Poverty Alleviation: Proposition 3


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:

Ttp (s; l; k) < Tt+1


p p
(s; l; k) < Tt+1 p
(s; l; k) < ::::: < Tt+T (s; l; k) (1293)

Ytp (s; l; k) < Yt+1


p p
(s; l; k) < Yt+1 p
(s; l; k) < ::::: < Yt+T (s; l; k) (1294)

YtR (s; l; k) < Yt+1


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

Testing above propositions in a real world situation is very challenging exercise.


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

7.6 Repeated Game


Market demand for a product is

P = 130 (q1 + q2 ) (1297)


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.

= (130 Q) Q 10Q = 130Q Q2 10Q (1299)

@ 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.

Game will be non-cooperative, resulting in a Cournot Nash equilibrium.


Each …rm produces 40 units, market price is set at 50 and each gets £ 1600 pro…ts.

1 = (130 (q1 + q2 )) q1 10q1 and 2 = (130 (q1 + q2 )) q2 10q2

with reaction functions 2q1 + q2 = 120 and q1 + 2q2 = 120


Total supply is 80, each supplying 40 and making pro…t of 1600 and market price 50.

Trigger Strategy and Perpetual Punishment

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 .

P = 130 (q1 + q2 ) = 130 45 30 = 55 (1302)

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.

For whom is it pro…table to Cheat?


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

Show above results in a diagram


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.

Home Work: Show above results in a diagram,

7.7 Moral Hazard and Adverse Selection


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

subject to participation constraint:

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

First order condition


" 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.

Adverse Selection: Insurance Game with Asymmetric Information Insurance company


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

subject to participation constraint:


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

Incentive compatibility constraint


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

subject to participation constraint


L
X
l (e) u (w p l + BL ) d (e) u (1323)
l=0

and incentive constraint

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

Auction: Vickrey-Clark-Grove (VCG) mechanism

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

prob (b1 > b2 ) (v1 b2 ) (1325)

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.

Auction: Financing Mechanism for Public Goods

Let x be a public good such as streetlight or road; x = 1 if it is provided x = 0 if not.


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.

Auction:Financing Mechanism for Public Goods


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

State chooses x to maximise


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
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Osborne M.J. and A. Robinstein (1994) A course in game theory, MIT Press.

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Varian HR (2010) Intermediate Microeconomics: A Modern Approach, Norton,8th ed.Chapter 17,35.

7.9 Exercise 16 :Optimal production of a multiproduct …rm


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):

C(e); C 0 (e) > 0 and C 00 (e) > 0 (1329)


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:

E( n) = E (e + " s) = e E (s) (1331)


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.

Linear programming problem


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:

1) Labour constraint (workers)


2Y1 + Y2 1000 (1336)
2) capital constraint (machine hours)

12Y1 + 40Y2 30000 (1337)

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)

C1 = rK1 + wL1 (1341)

C2 = rK2 + wL2 (1342)


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)

C1 = rK1 + wL1 (1346)

C2 = rK2 + wL2 (1347)


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

7.9.1 A Microeconomic Model of FDI


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

T C > C2 C1 = 800 200 = 600 (1350)

R+D F C < 2M F C < 2R FC (1351)


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

P1 = 210 10q1 (1353)


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

C1 = 200 + 10q1 (1356)

at home but it is costlier to set up business in foreign country because of higher …xed costs,

C2 = 800 + 10q2 (1357)

(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

R1 = P1 q1 = (210 10q1 ) q1 = 210q1 10q12 (1359)

. Therefore, the marginal revenue from home market sales would be

M R1 = 210 20q1 (1360)

.. Similarly, the total revenue from the sales in the foreign market would be

R2 = P2 q2 = (125 2:5q2 ) q2 = 125q2 2:5q22 (1361)

and associated marginal revenue would therefore be

M R2 = 125 5q2 (1362)

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)

M R2 = M C2 ) 125 5q2 = 10 ) q2 = 23 =) P2 = 125 2:5q2


=) 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:

R1 = P1 q1 = 110 10 = 1100; R2 = P2 q2 = 67:5 23 = 1552:5 (1366)


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

C1 = 200 + 10q1 : = 200 + 10 10 = 300 (1367)

C2 = 800 + 10q2 = 800 + 10 23 = 1030 (1368)


Now it is possible to calculate pro…ts to the MNC from home and foreign markets:

1 = P1 q1 C1 = 1100 300 = 800 (1369)

2 = P2 q 2 C2 = 1552:5 1030 = 525:5 (1370)


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