HANDOUT DATA

SESSION-1 Introduction In this session we will discuss the following: What is economics? How do we study the market system in economics?

Economics as the Study of the Market System Economics textbooks usually begin by proposing a suitable definition of economics. I find the following definition appropriate: economics is the study of the market system; how does it work, how well does it work, where does it fail and what can be done to correct its failures? The economy, where the economy refers to the organization of production and distribution of material goods and services in a society through individual and social action, has always been an important part of society. When people live in groups some division of labour and specialization is inevitable. For a society to function hundreds or even hundreds of thousands of tasks need to be carried out so that all the tasks that have to be done, get done. But who decides who does what and who gets what? Consider a non-market system economy like pre-colonial India where there were hundreds of castes and sub-castes, each one assigned different occupations. This did not mean that markets were non-existent. Within the economy, markets, exchange and trade (even international trade) played an important, though subordinated, role. Traders and merchants were not only of specific castes, but also each article of trade was carried out by specific sub-castes. Like other professions, trade and exchange were also guided by caste and custom. To summarize, the economy was important but subordinated to the politics, religion and custom. Now cut to present times. Our world does not look like what Buchanan saw. What motivates you to do an MBA, agree to a job offer, write a book, decide which car to buy, or choose your next holiday destination? Its quite certainly not custom, tradition or the government. So what guides us in our decisions concerning the production, distribution and consumption of goods and services? Sometimes it seems as if nothing really does our wanting to do something seems entirely spontaneous, even natural, without compulsion or coercion. Adam Smith, writing more than 225 years ago, used the expression Invisible Hand a hand that guides us in our actions but something which is not seen. We now call this Invisible Hand the market system, a system in which economic activities of society are organized through voluntary exchange on the basis of information transmitted in the form of price signals or prices . It is price that tells us, individually and collectively, what society wants us to do and also who gets what share of the total produce. If there is no coercion or compulsion, how are participants assigned (or assign themselves) tasks that need doing? Is it that people are really voluntarily and freely choosing to do so? Yes and no. There is no doubt that individuals are not forced to do something against their wish; no one can compel you to do an MBA instead of a Ph.D. in Economics. But the market system, as a whole, does exert pressure on and controlling individuals to do what society wants them to do. The mechanism is simple. If society needs more MBAs than economists, the salary of a management professional will increase and that for an Economics Ph.D. will fall. Students will then be motivated to opt for an MBA. If this need is not met, then the signals will become even stronger,

till students are compelled to an MBA, like when an economist wage drops to Rs.15 per day hopefully this doesnt happen. We are free to choose, and do what we want, but are ultimately are controlled by sales and purchases in the market. As Charles Lindblom put it, in market systems people do not go their own way; they are tied together and turned this way or that through market interactions. Now imagine a whole society organized by a market system. Millions of people, thousands of tasks, from providing holidays in the Antarctica to delivery of the newspaper, each of these tasks must be performed each day, day after day. It is not enough for the market system to have just a few isolated markets. Markets have to spread across all these thousands of goods and services, and each, through a system of mutual interaction of millions of people, results in the complete and all-encompassing coordination of the economy. Today such a system has come to control not only nations, but also the globe. The market system is perhaps the best example of social coordination on a massive scale. Examples at a smaller scale can help in understanding some of its important components. All of us have experienced morning and evening peak-hour traffic. Thousands of people moving from one point to another. Chaotic though it might seem it is as an illustration of socia l coordination. Rules and regulations exist. Socia l norms and customs like courtesy, civility and trusting others to follow rules also play a critical part in the movement of traffic. We are supposed to drive on the left, not cut lanes, not cross the yellow lines, stop for the red light, let pedestrians cross at the zebra crossing, etc. There are also regulators (traffic police) to see that people by and large follow rules. Fines and punishments make us act responsibly. Finally, there is also the element of fear not of the law but to prevent injury or death to oneself. It is a subtle combination of all these elements which induces us to make several adjustments give and take so that the system works. In quite the same way as the movement of vehicular traffic, the market system too consists of similar elements for social coordination to yield the desired result: rules and regulations, punishment, socia l norms and customs, and even fear of death from starvation. If an agricultural labourer turns down every job because the daily wage rate is only Rs.100, s/he would perish. Rules, regulations and punishments for violating them also play an important part in making social coordination of a market system work. For instance, stock exchange regulations require that companies disclose certain information or insider trading is a criminal offence. Failure to comply can warrant severe action by authorities. Last but not the least, social customs and norms (like trust) are a vital component in the functioning of market systems. Many socially acceptable practices are taken for granted but without these the system will simply fail. Perhaps the most critical norm that makes us respond to price signals in a market system is that of acquisitiveness and accumulation. The market system has changed social norms over centuries so that we have now come to take these as basic human nature. However, when we look back in time this is not so obvious. The market system would simply not work in societies where people are not allowed to acquire wealth and consume beyond socially acceptable norms. People in these communities may just not be motivated or permitted to acquire wealth. The market system will function only in those societies where acquisitiveness, accumulation and the desire to consume more and more (unlimited wants) are a virtue, not a vice. Insatiability of materia l wants must become pervasive, acceptable and respected throughout society as peoples fundamental nature for incentives to work in a market system. Obviously acquisitiveness and accumulation was not universal before the transition to a market system. It is this characteristic among the people of market systems which provides the necessary incentive for them to react to market signals, or price, inducing them to do what society needs and tasks to be performed.

This desire to acquire and accumulate more and more is not very different from greed. Economists have therefore found a euphemism for this: scarcity. Like a glass, half empty or half full, acquisitiveness and scarcity is quite the same thing. Acquisitiveness means that our wants are unlimited. This makes it impossible to satisfy all our wants. We have a problem now; resources are scarce if not anything else, time is always scarce! The market system has created its own problem, and economists are trying to help us solve it. Scarcity remember is not a universal problem. This brings us to the central question in economics, or of market systems: how do we allocate scarce resources to meet unlimited wants? The economists answer: the market system will do it, and do it in the best possible way (provided certain conditions are met)! Society, as a whole, faces this problem. But society consists of individuals and when each individual responds to price incentives all economic questions will be resolved automatically: how much land to cultivate, how many cars to manufacture, how many doctors to train, and so on? If we let the market system function, then individuals in pursuit of their own self-interest (to acquire and accumulate more wealth) will end up doing what society wants, i.e. how much food society wants, how many cars society wants and how many doctors society needs to train. The concern of economists then shifts to another question; will the market systems allocate resources efficiently? We will return to this problem in a later chapter. The desire to acquire and accumulate for oneself is a critical for the working of a market system but what drives this desire? A key factor is property rights. Property rights can be defined as (Kasper & Streit 1998): a bundle of protected rights of individuals and organizations to hold or dispose of certain assets, for example by acquiring, using, mortgaging and transferring assets, and to appropriate the benefits from the use of these assets. This of course also covers negative returns losses. Property rights thus entail responsibilities for the use of the property as well as benefits (pg. 176). Clear, well-defined private prope rty rights are necessary in a market system to provide the right incentives for people to pursue acquisitiveness and accumulating behaviour. The Peruvian economist, Hernando de Soto has argued that poor people in less developing countries own about U.S. $ 9 trillion in assets. However, because their property rights are not clearly defined, they are unable to utilize this stock of wealth as capital for the purpose of creating new wealth. The need for private property rights also brings us to another important component of the market system: the form of organization of business units. There is nothing to imply that forms must be privately owned in a market system. Price signals could be transmitted between state owned enterprises or worker cooperatives as well. However, as experience as shown, when firms are not privately owned, the incentives through price may not matter. The response of such organizations may therefore not correspond to the needs of society. Bureaucrats may set up a steel plant, rather than a music company, arguing that this is what the country really needs, even though people may want the latter. Ultimately, the steel plant works at 10% of its full capacity for the next 20 years. This surely is not the best way for societys resources to be used. Now if the bureaucrat were a private businessman he would respond differently to the price signals. As a bureaucrat his salary is fixed (apart from possibility of corruption), whether he started a steel plant or a music company. So he did what he thought was best for the country (or himself), though this was not what the society wanted. Incentives, therefore, work best when acquisitive and accumulative behaviour is not restricted, i.e. when private property rights are clearly defined.

Robert Heilbroner (1993) argues that a centrally planned economy was considered as a viable option to the market system in the allocation of resources. Even though there was no price system to provide signals of surpluses and shortages, inventories on the shelves were expected to act as a substitute. What was missing, however, was the incentive for the bureaucrat to respond to those signals. Without claim to profits, the response was slow and indifferent. The centrally planned system was soon ridden with images of long lines for daily necessities. As we all know, it collapsed. The market system may have taken the victory stand but questions remain if the failure of central planning automatically meant full points to the market system. There are still questions as to whether the development of western economies is to be attributed to the market system or if it was because of the Industrial Revolution and subsequent technological progress. Or was it some combination of both? Finally, the study of the market system also entails study of market-system failure or market failure . There are many well-known instances of market failure with macro implications: climate change, the Asian currency crisis, the recession of 2008, and so on. The causes and solutions to market failure is an important subject of study in economics. We began this chapter with some non-market systems, and then looked at what makes the market system tick: acquisitiveness and accumulation, prices and incentives, scarcity and opportunity costs, and private property rights. We mentioned some of the larger issues and crisis that arise in market systems. This Economics course will help you put the market system in perspective. How does it work, how well does it work, where does it fail and what can be done to correct its failures? These are the questions that economics seeks to answer.

How do we study the market system in economics? Economics studies the market system with the help of analytical models. Models are built on the basis of abstracting from reality in order to say something important, and not so obvious, about reality itself.
Ex-1: To emphasize the need for abstracting or constructing a model when explaining economic relationships, look at the following crude face.

Figure 1-1 Wha t is thi s drawing i t is a face. Desc ribe this face, have you ever met anyone who looks like this ca ricature. You do not need a Rembrandt depic tion to ascertain certain informa tion and tha t relevance, ra ther than realism, is the essence of theorizing.

Ex-2: Pick up a large piece of paper and start folding it Hold it up, ask, "Wha t i s this?" Someone in the class inevitably responds, "A paper airplane". "How do you know it is an airplane?" The usual response is "It looks like an airplane." or "It has wings." (Sometimes, a member of the class will come up with the word "model"). Then, introduce the idea tha t there are certain, specific variables or factors which indicate tha t this is a "model" of a plane. While i t is clearly a "plane," it does not include all the details of an actual plane, i.e. no motor, no propeller or jets, no wheels, etc . Nonetheless, it has been clearly recognized as a paper airplane or model of an airplane. Then draw the analogy between the "plane" and economic models or theories as abstractions from reality, which are nonetheless representations and which describe the entire economy (macro) or specific areas of the economy, such as specific markets (micro). Further, these abstractions may contain only key variables, (give examples) and still represent a complex economy, just as the paper airplane is recognizable by its wings. The second stage of this demonstration is to ask, "Will it fly?" Of course, the students know tha t it potentially will and usually respond, "Try it" or "Test it." This leads into a discussion of the use and usefulness of models not only for initial description of the economy, but also to show tha t change in the variables permits analysis of resulting changes which occur in the system. At this point, add ailerons on the wings or paper-clip ballast to the paper airplane and see what happens to the direction of flight to demonstrate changing or adding variables to the system.

One of the most common fallacies in economic methodology is that association (or correlation) is causation. Simply because two variables are found to be statistically correlated does not necessarily imply that they are causally related. A high correlation may reflect a spurious or nonsensical relationship. Moreover, once we begin with this fallacy, further steps in logic are taken, starting from the error.
Ex-3: Ask the students why rain dancing could arise and persist for over a century when it does not affect whether rain falls. All it takes is a view of God as one who needs appeasement and we have a classic example of a fallacy. Once they get the idea of dancing to appease the rain god (whose anger is shown by the fact tha t it hasn't rained when it should have), and it rains after such a dance, the conclusion tha t the dancing caused the rain is easily reached. Once thi s is established as a theory, there is no natural tendency to correc t the error. If the tribe dances long enough, it will rain; if it doesn't rain, they didn't dance well enough, or long enough, or their hearts weren't in it or i t wasn't enough like the ancestors did it rather than examining the initial error.

Economists usually distinguish between positive and normative economics. Positive economics purportedly concerns what is ("the facts") while normative economics pertains to what should be ("value judgments"). However, some economists have long viewed this as largely a false dichotomy. They argue that facts and value judgments are not so easily separated. For example, one's beliefs (ideology) impact the choice of problems undertaken and consequently which "facts" are discovered.

Ex-4: The passage cited below captures the interdependence (circularity) between fact (reality) and value (belief) quite nicely. Read it to the class, pausing at the end of each sentence to ask if there is any disagreement. When finished, reitera te the first and last sentence. "Reality" i s what we take to be true. What we take to be true i s what we believe. What we believe is based upon our perc eptions. What we percei ve d epend s on what we look for. What we look for d epend s upon what we think. What we think depends upon what we perc eive. What we percei ve d etermines what we believe. What we believe determines what we take to be true. What we take to be true is our reality. Gary Zukav, The Dancing Wu Li Masters: An Overview of t he New Physics, p. 310

Moreover, if economics is value-free, why does unrest in the profession and disagreement among economists seem to be the norm? The answer is that ideology underpins economic paradigms and colors our policy prescriptions. Here is a tangible example of how ideology influences our reasoning and resultant policy formulation. This request poses a unique problem. The example must be of a nature such that ideology itself is not relied upon to expla in ideological conditioning. Although economics cannot be as mechanical as physics, after years of searching, the following concrete example is useful: Directions: Connect these nine dots with four straight lines, but do not retrace any lines or pick up your pencil.

Figure 1

Figure 2

We think in certain ways and tend to follow established patterns of thought. We resist violating established boundaries. The eye senses a boundary established by the dots at the outer edges of the puzzle and the mind seeks a solution within these boundaries. Such attempts will be futile. Only people who are not restricted by perceived boundaries can easily solve the puzzle. Compare the puzzle to real world problems. The connection is quickly made that ideologies, by their very nature, establish the boundaries of accepted thought and beliefs. We are now ready to begin our study of the market system.

SESSION-2 How Does the Market System Work? In this session we will discuss the following: The demand curve or law of demand The supply curve or law of supply Equilibrium Shifts in demand and supply curves As we have seen the key problem facing modern societies is scarcity: we have unlimited wants but limited (or scarce) resources. How does market system allocate or apportion these resources amongst various competing wants (or ends)? You can think of the market system as essentially a rationing mechanism, which is based on voluntary exchange rather than (say) under command and control of the state.
Ex-1: To understand how difficult a task it is to allocate resources under competing ends, consider you as the Direc tor of a hospi tal face a si tua tion and must take a decision. Your hospi tal ha s one dialysis mac hine. To be effective the patient requires a t lea st 8 hours of use (which includes ti me for compulsory equipment maintenance) of the mac hine every day. Usually the hospi tal does not have more than a pa tient a day. Most unusually you ha ve got five pa tients today and they a re all in critical condition and cannot be moved to another hospi tal. It will take your hospi tal a t least 48 hours to procure another mac hine. The profile of your patients is as follows: Patient 1: Patient 2: Patient 3: Patient 4: Patient 5: A 4 year old boy A poor woman aged 41, who has two small children A man aged 71, who has a depend ent wife, aged 67 who is suffering from Parkinsons dis ea se A 7 year old girl A wealthy businessman, with no fa mily.

Your doctors want you to decide the ord er in which the patients must be given dialysis. They must begin thei r work in the nex t 5 minutes.

This is similar to the situation that society faces. Should it use its resources (the dialysis machine) for movie theatres (Patient-1) or hospitals (Patient-2) or cars (Patient-3) or schools (Patient-4) or ..? And also how many, or how few, of each? In the case of our example, the market systems rationing system would be based on the ability and willingness of each patient (or his/her guardians) to pay for the dialysis machine. One can immediately see that Patient 2 might lose out whereas Patient 5 might get access to the machine. This is positive economics how things work in the market system. But is this fair, is it just? Thats a normative question.

Let us now formally understand the working of the market system using models for analysis. Economists divide the world into two parts: buyers (or consumers) and sellers (producers, firms). We begin by trying to understand how consumers behave, or how do they make decisions as to what they buy, and how much of it. You walk into a department store and fill your cart. But why did you buy what you did? We first assume that each consumer is rational, i.e. she wants to maximize utility or satisfaction derived from consumption of a good or service. However, the consumer faces a constraint, her budget. This is the scarcity problem for each consumer and for society as a whole as well. Now given her ability to buy a certain good (which depends on her income), each consumer would be willing to buy different quantities of a good at different prices.
Ex-2: A high quality orange juice (1 liter) pack costs Rs.80/-. You walk into a store and find the following prices. How many packs would you buy? Usual price per pack Rs. 8 0 Rs. 8 0 Rs. 8 0 Rs. 8 0 Rs. 8 0 Price in the store Rs. 8 0 Rs. 6 0 Rs. 4 0 Rs. 2 0 Rs. 10 Quantity that you might buy

We can derive the demand curve for each student, which plots the relation between price of orange juice and quantities that each consumer is willing and able to buy. What you have done while making your decision is, however, to keep many other variables constant like the weather, your tastes, income, the price of other juices in the store, and so on. Economists say that your demand for orange juice depends on many factors. We can write this as: qoj = D(poj , paj , consumers tastes, income, weather, ) Where qoj is the amount of orange juice that you desire to consume, poj is the price of orange juice and paj is the price of apple juice. For each student, we derive his/her demand curve as in Figure1, where only price of orange juice changed, everything else remained constant (ceteris paribus). P oj

80 60 do j 1 Figure-1 3 qoj

We can do the same for all individuals in the economy and plot their demand curves. When we add all of them horizontally1 we arrive at the market demand curve for orange juice as in Figure-2. P oj 80 P oj 80 doj1 do j qoj 1 Figure-2 Economists go back one step back and look for reasons as to why consumers decide to buy more when there is discount. Their argument is based on the Law of Diminishing Marginal Utility, which says that as you consume an additional amount of orange juice, you do not derive as much utility or satisfaction from it as you did from the previous unit. You open the refrigerator thirsty as hell. The first gulp gives you a lot of pleasure; the second too but not as much as the first; the third gulp feels great too but not as great as the second, and so on. Similarly the first pack of orange juice gives you a certain amount of pleasure, the second too but not as much as the first. To induce you to buy the second pack of orange juice, the store had to reduce its price. The supply curve is similarly derived. Students don't instinctively understand why supply is positively sloped. Why should it take higher prices to call forth greater quantity? If the market price provides a profit, why isn't an unlimited supply of the good available at the market price? Here is one more example that will help you to see the intuition behind the law of supply. Now supply of orange juice will depend on several factors; in general: qoj = S(poj , paj , wage rate, technology, )
Ex-3: Assume tha t you are the proprietor of a juice shop (firm). You have one worker and one juicer. You cannot c hange this immediately. You have to pay your worker Rs.10/- per hour (tha ts fixed too). Suppose the worker, as he works through the day, gets progressi vely tired and to chu rn out an additional pack of juice takes hi m (progressively) more time. How would the following table look? Quantity 1st 2nd 3rd 4th 5th
1 2

P oj 80
Doj

qoj 2 3 3 6

Qoj

Time taken for worker 1 ho u r 2 ho u rs 3 ho u rs 4 ho u rs 5 ho u rs

Price that propri etor expec ts Rs.20

At each price (say Rs.60/-), we add your consumption of 1 unit and my consumption of (say) 2 units, to arrive at a market demand (Qoj ) of 1 + 2 = 3 units.

Now assume that orange juice is being made and packed in a rudimentary juice factory ( a firm) with one worker and one manually operated juicer. The worker can squeeze out (1 liter) juice and pack it in, say, 1 hour. The owner is willing to supply the first pack of juice at Rs.20. The worker begins to work on the second pack, but is already a little tired. To churn out the juice for the second pack it takes him (say) 2 hours so the owner is willing to supply more juice only at a higher price of (say) Rs.30, because the wage he pays to the worker per hour is fixed 2. It might have helped if he could get another worker or a juicer, but this would take him time, which he cannot do now. The third pack takes the worker even more time, say, 3 hours. So the owner is willing to supply additiona l quantities at an even higher price than the second. The upward sloping supply curve is based on the Law of Diminishing Marginal Returns , i.e. an additional unit of variable input (labour) added to a fixed capita l (juicer) will yield a smaller amount of output than the previous unit of variable input did. The supply curve of a firm is upward sloping as shown in Figure 3. The market supply curve is the horizonta l summation of all individua l firm supply curves as in Figure 4. P oj soj 80

60

1 Figure 3 P oj
1

qoj

P oj soj2

P oj Soj 80 60

80 60

80 60

1 2

qoj

qoj

Qoj

Figure 4

This is an important assumption to make.

There is another way of understanding why the supply curve is upward sloping. This is because of differences in the opportunity cost of scarce resources. Opportunity cost is nothing but the cost of the best foregone opportunity. When you do X-job, you have to give up doing Y-job. Would you then do X-job if Y-job gives you more income or benefit? Consider the following example.
Ex-4: Illustrating the Law of Supply Would you mind earning some extra money this Sunday afternoon? I have a 20-page paper to be typed out. I will pay Rs.100/- for the job (pick up and drop at your residence is on me). How many are willing to work for that fee? I now offer to pay Rs.500/- for the sa me work. How many are willing to work for tha t fee? I now offer to pay Rs.1000/- for the same work. How many are willing to work for tha t fee? And so on. I would get many more students willing to do the work at a higher fee. Develop a table tha t contains fee and the quantity supplied at each wage. Then plot the numbers, and you easily see how the law of supply is realistic and relevant. Why does this happen? At the higher fee you are willing to forego the nex t best opportunity. If you are doing nothing (opportunity cost = 0), then you would be willing to work for Rs.100/-. If you were planning to sleep and its worth Rs.200/- to you, then you would not take up the job at Rs.100/-. The opportunity cost of Rs.200/- > Fee of Rs.100/-.

We are now ready to see how buyers and sellers interact in the market. There is only one price poj * that will satisfy both the sellers and buyers, where demand and supply intersect, point e in Figure 5. The market system automatically takes us to this price through a process called price discovery. If the price is not poj *, say poj , then at this price there exists an excess demand for orange juice (Qd -Qs ). Orange juice sellers would like to put more juice on the she lves but they will only at higher prices. Or one can think of the consumers bidding for the orange juice just like buying tickets from a black marketer outside a cinema hall. As the price increases, quantity demanded decreases and quantity supplied increases till we reach poj *. This is the market clearing or equilibrium3 price. Economists believe that a freely functioning market system will eventually take us to this market clearing price; a price at which societys (buyers and sellers) wish-list is met . simultaneously. P oj Soj

P*

P Doj Qoj Figure 5

3

Q*

Equilibriu m price because there is no tendency to move fro m it unless of some external perturbation. Its like a ball at rest at the bottom of a curved bowl.

Equilibrium is a set of forces which result in a "state of rest", "a position to which you are forced to go" or "a position from which there is no impetus to move". Consider an ordinary mixing bowl and a ping-pong ball. Drop the ball into the bowl, and watch it come to rest. This means that it has reached its equilibrium. Now slap the ball gently. It will roll around the bowl, but will eventually come to rest in the same spot as before, namely, the bottom of the bowl. Thus, the original equilibrium was stable . Now turn the bowl upside-down, and balance it on top of the bowl. The ba ll will be at rest, so it is at equilibrium. Tap the bowl gently and cause the ball to roll down the side of the bowl. It will be obvious to all that it will not come to rest at the same spot as before. Hence, the position at the top of the upside-down bowl was an unstable equilibrium. At the equilibrium price (p*) and quantity (Q*) there is no excess demand or excess supply, all those who are willing and able to buy orange juice at that price find suppliers who are willing and able to supply it at that price. This is how the market decides how much resources must be allocated for orange juice and similarly for apple juice and cars . and so on. Shifts in Demand and Supply: In the derivation of demand and supply curves, we saw how change in poj affects qoj (and Qoj ) for both consumers and firms respectively. That is, the demand curve and supply curve show the relationship between prices (of a good) and the quantities demanded (of that good) everything else held constant (ceteris paribus). When we say change in quantity demanded (or supplied) it refers to the change in quantity at a different price this is a movement along a given demand curve. Consider, for example, the demand curve for orange juice. What happens if all of a sudden the weather changes and temperature increases by 10o C? At a given price, say, Rs.60/- your quantity demanded may go up now to 3 instead of 2 units. Similarly if you were willing to buy 4 packs at a price of Rs.40/- you may now want to buy 6, and so on. There is a now shift in the demand curve we call this shift as a change in demand or increase in demand. See Figure 6. P oj P oj soj soj

doj do j qoj Figure 6 Figure 7 qoj

Similarly we have a change in quantity supplied (movement along a supply curve) and change in supply (shift in the supply curve). A change in supply could be due to change in technology (a more efficient juicer or a change in wage rate paid to the worker). In Figure 7, the supply curve shifts.

How does the market system work when we demand and/or supply curves shift? Suppose there is a shift in demand due to an increase in consumer incomes. Then in Figure 8, at the original equilibrium price p0 (where D0 intersects S0 ), the quantity demanded (with new demand curve D1 ) is Q1 . There is an excess demand of Q1 Q0 . Prices will increase and there will be a change in quantity demanded (along D1 ) till we reach price, p1 . P oj Soj Excess demand p0 p0 p1 p1 Doj Doj Q0 Figure 8 Q1 Qoj Figure 9 Q0 Q1 Qoj
Excess supply

P oj Soj Soj

In Figure 9, we show the effect of a change in supply, say, due to a more efficient juicer. At the original equilibrium price p0 (where D0 intersects S0 ), the quantity demanded (with new supply curve S1 ) is Q1 . There is an excess supply of Q1 Q0 . Prices will fall and there will be a change in quantity supplied (along S1 ) till we reach price, p1 . Possible reasons for shifts in demand curve: Change in income Change in price of complements or substitute goods Change in consumer tastes Impact of advertisements on consumers Possible reasons for shifts in supply curve: Change in price of inputs Change in technology Change in tax rates imposed on companies Impact of better human resource management and worker efficiency

SESSION-3 How Well Does the Market System Work? In this session we will discuss the following: Consumer surplus Producer surplus Social welfare How does the market create value through exchange? Distortion in market system through price controls How well does the market system work? To answer this question, economists must first define the term well. To do that, we introduce two important concepts: consumer surplus and producer surplus.
Ex-1: We carry out a si mple exercise in class. Suppose the price of an 24 LCD-TV is Rs.25,000/-. I ha ve now introduced a 24 LCD-TV with 3-D i mages. How much would you be willing to pay for this TV? Wri te down in a slip of paper and derive the demand curve. Fix supply and show consumer surplus.

In a market exchange, there exists only one price at which the exchange takes place between all buyers and all sellers equilibrium price. At this price, there is difference between what consumers are willing to pay (spend) and what they actually pay (spend). In Figure 1 below, the area(aep*) is the consumer surplus. This can be thought of the value created for consumers through exchange and it happens because the market system brings many buyers and many sellers together. P A P* e D d Q Figure 1 Figure 2 Q S P* e D P S

What about producer surplus? It is the difference between what producers actually earn (revenue) and what they are willing to earn. In Figure 2, producers are willing to supply the first unit at a price p1 , the second unit at p2 , and so on. The shaded area is what they are willing to supply quantity Q* at; area (dep*) is the producer surplus. But does the market system lead to the best possible outcome for society? Economists have a reason to say that this is indeed the case. At a price poj * and quantity Qoj *, welfare is maximized, where welfare is defined as the sum of producer and cons umer surplus . Economists argue that at the equilibrium price poj *, producer surplus plus consumer surplus is maximized, or in other words Pareto Optimal as in Figure 3. It is also referred to as the allocative efficiency of

the market system; in this situation the welfare of any individual can be increased only by reducing that of another. In other words, any intervention in the market would mean that consumer can gain only at the expense of sellers, or vice-versa. P S e P*

Figure 3

Q*

Suppose the government imposes a price floor of p f a shown in Figure 4(a). Such price floors are usually fixed for agricultural products as price support to farmers1 . Producer surplus is now sfd pf, consumer surplus is reduced to dfd p f. Moreover, the government must incur a cost of QD fd fsQS by purchasing the unsold stock from farmers. Producers have benefited at the cost of consumers and tax payers. If the government does not want the problem of dealing with unsold stocks it may set target prices and subsidize the price differential directly to farmers (p 1 p2 ) as in Figure 4(b).

PW SW fd fs

PW SW

Pf

P1 P2

a Cost to government b

s QD Figure 4(a) QS

DW QW Figure 4(b) Q0

DW QW

Food subsidies are perhaps one of the biggest economic issues in the world today. It will be dealt with later in this course.

Similarly we can see in Figure 5 what happens when the government introduces a price ceiling (like rent controls) in the housing market. At price ceiling (rent control) p c, quantity supplied decreases to QS and unmet demand is QS-QD . Consumer surplus is area dccpc and producer surplus area scpc. Deadweight loss to society (as compared to a free market allocation) is area cec. However, landlords will know that people are willing to pay a rent of up to p b for the available housing (QS). Black market rents rice to pb , consumer surplus falls to dpb c and producer surplus increases to sccpb . Deadweight loss to society as a whole remains unchanged. The free market solution is always the best one for society as a whole. P S Pb

c
e

Pc D

QS Figure 5

QD

These distortions introduced by state intervention in markets show the welfare loss to society when such interventions take place. We have answered two questions of central importance to an economist: how the market system works and how well it works.
Ex-2: Floors and non-price competi tion - Price floors prevent firms from competing with each other through lower prices, encouraging th em to engage in non-price competi tion. One fun exa mple is the way banks competed und er Regulation Q, which prevented them from paying interest on c hecking accounts and li mi ted the interest they could pay on savings accounts. Some banks tried to a ttrac t customers by giving away free gif ts for opening up an account: clocks, radios, and the like. When the government forbade this prac tice as a violation of Regula tion Q, banks began offering the f ree gift to the friend of a person opening up a new account. In a case reported by the Wall Street Journal , a bank offered to send a friend of yours a free color TV if you would do business with them. One can also use this exa mple to highlight the inefficiency of non-price competi tion. Wha t if you (and perhaps your friend) didn't want a new color TV and would have much preferred higher interest ra tes on your deposi ts?

Ex-3: Suppose a maximum price of Rs.5/- a loaf is imposed on bread. Then, by directed questioning of the class, lead them to see what sorts of specific effects a price ceiling on bread could be expected to have. Nex t, for each specific effect (or set of specific effects), ask the class to identify the general nature of the effec t involved (e.g., a smaller loaf is one way to reduce quality). Finally, tell them tha t such a general effect is to be expec ted from any effective price ceiling or price floor (whichever is then being discussed), and reinforce this by showing how those general effects have shown up in several different markets. QUESTION 1: What would happen to the size of a loaf of bread? ANSWER: If producers were allowed to, they would reduce the size of a loaf. If you can't rai se the price per loaf, you can raise the price per ounc e by reducing the size of a loaf (you could get a muffin sized loaf of bread, sandwich sliced, for Rs.5/ -). QUESTION 2: What would happen to the quality of the bread' s ingredients? ANSWER: If producers were allowed to, they would lower the quali ty of the ingredients. Not only would types of bread like milk bread disappear in favor of the cheaper plain white, but even those ingredients would be allowed to fall in quality (maybe a little sawdust would be added) GENERALIZATION: One effec t of a price ceiling below the equilibrium price is tha t the quali ty of the good will be lowered in whatever dimensions a re possible. EXAMPLES: The disappearance of normal quality, the appearance of cash only policies and reduced hours a t service sta ti ons during petrol sho rtages; the reduction in maintenance and service ex pendi tures (e.g., painting, fixing problems) under rent control. QUESTION 3: Would those who enacted the controls want to allow quality to fall, since that evades the intent of the controls? ANSWER: No, so tha t a bread control board of some sort would be set up to regula te, investiga te and enforce standards for sizes and ingredients, and to adjudicate any alleged viola tions. GENERALIZATION: Price ceilings tend to lead to the establishment of regula tory bodies to prevent quality from deteriora ting in whatever manner can be legisla ted (although there are always ways tha t can't be ei ther detec ted or enforc ed), and these bodies consume scarce resources tha t wouldn't be necessary in the absence of price controls (repeat business and reputa ti on give firms sufficient incenti ves, absent the controls). EXAMPLES: Bombay rent control board; regulation of fees, etc. in sta tes with usury laws setting maxi mum allowable interest ra tes. QUESTION 4: If you could give bread a new name or form to escape the controls, would you? ANSWER: Of course. You might ex pec t the emergence of jumbo bagels or sandwich style muffins, as well as a resurgence of frozen bread dough, all as ways to sell bread and avoid price controls.

GENERALIZATION: If there is any way to rena me a good or alter it so as to avoid price controls, it will be tried. EXAMPLES: Under steel price controls during the Korean war the price of seconds (with "imperfec tions") rose dra ma tically, far above the controlled price of standard steel, and the percentage of seconds produced also rose d rama tically; condo conversions, since ownership or mortgage payments were uncontrolled, while rents were controlled under rent control laws. QUESTION 5: Might I try to capture some of the tru e value of the bread by tying its purchase at the controlled price to purchase of other goods not controlled? ANSWER: Certainly. A superma rket may offer (real) bread a t Rs.2/-, provided you buy Rs.500/ - or more in groceries or provided you buy a particular type and size of ja m (at an appropria te price), or a bakery may requi re the purc hase of doughnuts a s well. GENERALIZATION: Attempts will be made to tie purc hases of price controlled goods to purcha ses of some non-price controlled good so tha t the owner to capture the value of the price controlled good. QUESTION 6: If you could change a price controlled market tran saction to one that avoided direct money payment (and hence the controls) might you try it? ANSWER: Yes. There would be an increase in barter, e.g., butc hers and bakers may trade beef for bread. There would also be an incentive for intensive bread u se rs (who ha ve trouble buying under price controls) to ei ther buy a bakery (avoiding markets for bread) or become self-sufficient in bread production (the sa me is true for households, even though this would otherwise be less efficient). GENERALIZATION: People will try to avoid market transac tions: ba rter, vertical integra tion, and self-sufficiency will expand. EXAMPLE: In the US, Johnny Rogers bought a San Diego service sta tion under gas price controls to assure gas for hi mself and his friends. QUESTION 7: What would happen to the amount of bread available for purchase under a price ceiling? ANSWER: Unable to capture the value of the bread to consumers, the quanti ty of bread available will fall, as some bakeries and bakers go out of business and others shif t into alterna tive baked goods. GENERALIZATION: A price ceiling reduces both the price received by the seller and the quanti ties of a good provided by suppliers. EXAMPLES: Explosion of condo and office conversions under rent controls; ga s sta tions closing or cutting their hours of opera tion under gas price controls; the capping of "old" natural gas wells under natural gas regula tion. QUESTION 8: What would happen to the costs of finding bread under price controls? ANSWER: Because there is less bread available at the lower price (i.e., there is a shortage) and because the "market" price no longer provides accurate information

about cost and availability of bread, the costs of searc h and acquiring information about bread availability will rise. GENERALIZATION: Since price controls mean tha t price no longer allocates the scarce goods in question, some other allocative device must be c hosen. This eliminates the market's ability to transmit very low cost information about availability and prices, raising the costs of searc h and acquiring informa tion. EXAMPLES: The difficulties of finding a rent-controlled apartment. QUESTION 9: Will there be more or less discrimination against Pygmy Eskimos (a seemingly safe discriminated against group) under price controls? ANSWER: More. Wi thout controls, if I refuse to sell to someone, i t lowers my profits and so costs me so m et hin g -- dis c rimination is costly. Under controls, the cost of such discri mina tion is zero, as lo ts of more desirable (to the discri mina tor) groups are more than willing to buy as well at the controlled price. GENERALIZATION: Since price controls prevent prices from ra tioning scarce resources, some other way of discrimina ting a mong demanders must ta ke i ts place. By lowering the cost of discri minating, price control s increa se di scri mination. EXAMPLES: Di scri mina tion against fa milies with kid s or pets, lower income families (higher risk of payment), more people per unit (usually poorer, or disliked racial groups) under rent control; discri mina tion against smaller and riskier borrowers under usury laws; discrimina tion in favor of bigger customers and owned subsidiaries under steel price controls; disc ri mina tion in favor of your own family members under rent control. QUESTION 10: As a price control was left on over time, what would happen to the severity of the shortages? ANSWER: Since over time, more and more bakeries will be due for replacement or renova tion, but the profi t incentive for production is weak, the quanti ty of bakeries and the availability of bread will both tend to decline progressively and the shortage will worsen. GENERALIZATION: Price controls reduce the financial incentives to supply a good reducing maintenance of existing supply sources and reducing incenti ves for new sources to enter, which leads to a progressi ve reduc tion over time in the quanti ty of a good available. EXAMPLES: Deteriora tion of the housing stock over time under rent control s; deteriora tion in the a vailable supply of "old" natural gas under price controls; reduced farm output in Third World countries when price controls hold down crop prices. QUESTION 11: Who gains from price ceilings? ANSWER: Those who get to allocate those resources (in their own interests) when the market is prevented from doing so (usually some governmental body) and those who actually acquire the good s more cheaply than otherwise. GENERALIZATION: Price controls transfer power f rom market forces (individual preferences) into political forces, benefi ting the political establishment and those best able to manipulate i t.

EXAMPLES: Schools in the Northeast which get preferential na tural gas ra tes; rent control bodies; subsidized consumption of elec trici ty and water.

SESSION-4 Elasticity of Demand and Supply In this session we will discuss the following: Elasticity of Demand (price, cross-price, income) Elasticity of Supply Applications
Ex-1: Suppose you own a thea tre and there are no controls on pricing for the stage shows. Your tickets are currently priced a t Rs.100/- per sea t. At thi s price, you ha ve been able to get only 50% capacity filled of a total of, say, 500 sea ts. You appoint a new manager to increase the inflow of view ers. She suggests you cut the pric e to Rs.50/- per seat. Do you think it will fill up the thea tre? How many more tickets can be sold at the lower price? Will the quantity demanded rise by a lot or a little? The idea of using percentage changes springs naturally from this. What is the effect on total revenue generated by the different price/quantity combinations?

Elasticity: Elasticity is a measure of responsiveness. The responsiveness of behavior measured by variable Z to a change in environment variable Y is the change in Z observed in response to a change in Y. Specifically, this approximation is common: Elasticity = (% change in Z) / (% change in Y) Price Elasticity of Demand: The Price Elasticity of Demand (commonly known as just price elasticity) measures the rate of response of quantity demanded due to a price change. The formula for the Price Elasticity of Demand (Ep ) is: Ep = (% change in quantity demanded) / (% change in price) Calculating the Price Elasticity of Demand You may be asked the question "Given the following data, calculate the price elasticity of demand when the price changes from Rs.9.00 to Rs.10.00".
Price Rs.7 Rs.8 Rs.9 Rs.10 Rs.11 Quantity Demanded 200 180 150 110 60 Quantity Supplied 50 90 150 210 250

First we'll need to find the data we need. We know that the original price is Rs.9 and the new price is Rs.10, so we have P 0 =Rs.9 and P 1 =Rs.10. F rom the chart we see that the quantity demanded when the price is Rs.9 is 150 and when the price is Rs.10 is 110. Since we're going from Rs.9 to Rs.10, we have Q0 =150 and Q1 =110. So we have: P 0 =9 P 1 =10 Q0 =150 Q1 =110 To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded The formula used to calculate the percentage change in quantity demanded is: [Q1 - Q0 ] / Q0 By filling in the values we wrote down, we get: [110 - 150] / 150 = (-40/150) = -0.2667 We note that % Change in Quantity Demanded = -0.2667 (We leave this in decima l terms. In percentage terms this would be -26.67%). Now we need to calculate the percentage change in price. Calculating the Percentage Change in Price Similar to before, the formula used to calculate the percentage change in price is: [P 1 - P 0] / P 0 By filling in the values we wrote down, we get: [10 - 9] / 9 = (1/9) = 0.1111 We have both the percentage change in quantity demand and the percentage change in price, so we can calculate the price elasticity of demand.

Final Step of Calculating the Price Elasticity of Demand We go back to our formula of: Ep = (% change in quantity demanded) / (% change in price) We can now fill in the two percentages in this equation using the figures we calculated earlier. Ep = (-0.2667)/(0.1111) = -2.4005 When we analyze price elasticities we're concerned with their absolute value, so we ignore the negative value. We conclude that the price elasticity of demand when the price increases from Rs.9 to Rs.10 is 2.4005. How Do We Interpret the Price Elasticity of Demand? A good economist is not just interested in calculating numbers. The number is a means to an end; in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are to price changes. High price elasticity suggests that when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes down, consumers will buy a great deal more. Low price elasticity implies just the opposite, that changes in price have little influence on demand. Often an assignment or a test will ask you a follow up question such as "Is the commodity price elastic or inelastic between Rs.9 and Rs.10". To answer that question, you use the following rule of thumb: If Ep > 1 then Demand is Price Elastic (Demand is sensitive to price changes) If Ep = 1 then Demand is Unit Elastic If Ep < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes) Recall that we always ignore the negative sign when analyzing price elasticity, so Ep is always positive. In the case of our good, we calculated the price elasticity of demand to be 2.4005, so our good is price elastic and thus demand is very sensitive to price changes.

The Income Elasticity of Demand EI measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income. The formula for the Income Elasticity of Demand (EI) is given by: EI = (% change in quantity demanded) / (% change in income)

Calculating the Income Elasticity of Demand On an assignment or a test, you might be asked "Given the following data, calculate the income elasticity of demand when a consumer's income changes from Rs.40,000 to Rs.50,000". Income Rs.20,000 Rs.30,000 Rs.40,000 Rs.50,000 Rs.60,000 Quantity Demanded 60 110 150 180 200

The first thing we'll do is find the data we need. We know that the original income is Rs.40,000 and the new price is Rs.50,000 so we have I0 =Rs.40,000 and I1 =Rs.50,000. From the chart we see that the quantity demanded when income is Rs.40,000 is 150 and when the price is Rs.50,000 is 180. Since we're going from Rs.40,000 to Rs.50,000 we have Q0 =150 and Q1 =180. So you should have these four figures written down: I0 =40,000 I1 =50,000 Q0 =150 Q1 =180 To calculate the income elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in income is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded The formula used to calculate the percentage change in quantity demanded is: [Q1 - Q0 ] / Q0 By filling in the values we wrote down, we get: [180 - 150] / 150 = (30/150) = 0.2 So we note that % Change in Quantity Demanded = 0.2 (We leave this in decima l terms. In percentage terms this would be 20%) and we save this figure for later. Now we need to calculate the percentage change in price. Calculating the Percentage Change in Income Similar to before, the formula used to calculate the percentage change in income is: [I1 - I0 ] / I0

By filling in the values we wrote down, we get: [50,000 - 40,000] / 40,000 = (10,000/40,000) = 0.25 We have both the percentage change in quantity demand and the percentage change in income, so we can calculate the income elasticity of demand. Final Step of Calculating the Income Elasticity of Demand We go back to our formula of: EI = (% change in quantity demanded) / (% change in income) We can now fill in the two percentages in this equation using the figures we calculated earlier. EI = (0.20)/(0.25) = 0.8 Unlike price elasticities, we do care about negative values, so do not drop the negative sign if you get one. Here we have a positive price elasticity, and we conclude that the income elasticity of demand when income increases from Rs.40,000 to Rs.50,000 is 0.8. How Do We Interpret the Income Elasticity of Demand? Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. High income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. Low price elasticity implies just the opposite, that a change in a consumers income has little influence on demand. Often an assignment or a test will ask you the follow up question "Is the good a luxury good, a normal good, or an inferior good between the income range of Rs.40,000 and Rs.50,000?" To answer this, use the following rule of thumb: If EI > 1 then the good is a Luxury Good and Income Elastic If 0 < EI < 1 then the good is a Normal Good and Income Inelastic If EI < 0 then the good is an Inferior Good and Negative Income Inelastic In our case, we calculated the income elasticity of demand to be 0.8 so our good is income inelastic and a normal good and thus demand is not very sensitive to income changes. The Cross Price Elasticity of Demand The Cross-Price Elasticity of Demand (Ec) measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if

the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. The common formula for the Cross-Price Elasticity of Demand (Ec) is given by: Ec = (% change in quantity demand for Good X) / (% change in price for good Y) Calculating the Cross-Price Elasticity of Demand You're given the question: "With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from Rs.9.00 to Rs.10.00." We know that the original price of Y is Rs.9 and the new price of Y is Rs.10, so we have P0 =Rs.9 and P 1 =Rs.10. Suppose the quantity demanded of X when the price of Y is Rs.9 is 150 and when the price is Rs.10 is 190. Since we're going from Rs.9 to Rs.10, we have Q0 =150 and Q1 =190. You should have these four figures written down: P 0 =9 P 1 =10 Q0 =150 Q1 =190 To calculate the cross-price elasticity, we need to calculate the percentage change in quantity demanded and the percentage change in price. We'll calculate these one at a time. Calculating the Percentage Change in Quantity Demanded of Good X The formula used to calculate the percentage change in quantity demanded is: [Q1 - Q0 ] / Q0 By filling in the values we wrote down, we get: [190 - 150] / 150 = (40/150) = 0.2667 So we note that % change in quantity demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%). Calculating the Percentage Change in Price of Good Y The formula used to calculate the percentage change in price is: [P 1 - P 0] / P 0 We fill in the values and get:

[10 - 9] / 9 = (1/9) = 0.1111 We have our percentage changes, so we can complete the final step of calculating the cross-price elasticity of demand. Final Step of Calculating the Cross-Price Elasticity of Demand We go back to our formula of: Ec = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y) We can now get this value by using the figures we calculated earlier. Ec = (0.2667)/(0.1111) = 2.4005 We conclude that the cross-price elasticity of demand for X when the price of Y increases from Rs.9 to Rs.10 is 2.4005. How Do We Interpret the Cross-Price Elasticity of Demand? The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. A high pos itive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes?". To answer that question, you use the following rule of thumb: If Ec > 0 then the two goods are substitutes If Ec =0 then the two goods are independent (no relationship between the two goods If Ec < 0 then the two goods are complements In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between Rs.9 and Rs.10.

Price Elasticity of Supply: The Price Elasticity of Supply measures the rate of response of quantity demand due to a price change. We calculate the Price Elasticity of Supply by the formula: Es = (% change in quantity supplied) / (% change in price)

Calculating the Price Elasticity of Supply You may be asked "Given the following data, calculate the price elasticity of supply when the price changes from Rs.9.00 to Rs.10.00" Using the chart below we can calculate Es Price Rs.7 Rs.8 Rs.9 Rs.10 Rs.11 Quantity Demanded 200 180 150 110 60 Quantity Supplied 50 90 150 210 250

First we need to find the data we need. We know that the original price is Rs.9 and the new price is Rs.10, so we have P 0 =Rs.9 and P1 =Rs.10. From the chart we see that the quantity supplied (make sure to look at the supply data, not the demand data) when the price is Rs.9 is 150 and when the price is Rs.10 is 110. Since we're going from Rs.9 to Rs.10, we have Q0 =150 and Q1 =210. P 0 =9 P 1 =10 Q0 =150 Q1 =210 To calculate the price elasticity, we need to know what the percentage change in quantity supply is and what the percentage change in price is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Supply The formula used to calculate the percentage change in quantity supplied is: [Q1 - Q0 ] / Q0 By filling in the values we wrote down, we get: [210 - 150] / 150 = (60/150) = 0.4 So we note that % Change in Quantity Supplied = 0.4 (This is in decima l terms. In percentage terms it would be 40%). Now we need to calculate the percentage change in price. Calculating the Percentage Change in Price Similar to before, the formula used to calculate the percentage change in price is: [P 1 - P 0] / P 0

By filling in the values we wrote down, we get: [10 - 9] / 9 = (1/9) = 0.1111 We have both the percentage change in quantity supplied and the percentage change in price, so we can calculate the price elasticity of supply. Final Step of Calculating the Price Elasticity of Supply We go back to our formula of: Es = (% change in quantity supplied) / (% change in price) We now fill in the two percentages in this equation using the figures we calculated. Es = (0.4)/(0.1111) = 3.6 When we analyze price elasticities we're concerned with the absolute value, but here that is not an issue since we have a positive value. We conclude that the price elasticity of supply when the price increases from Rs.9 to Rs.10 is 3.6. How Do We Interpret the Price Elasticity of Supply? The price elasticity of supply is used to see how sensitive the supply of a good is to a price change. The higher the price elasticity, the more sensitive producers and sellers are to price changes. A very high price elasticity suggests that when the price of a good goes up, sellers will supply a great deal less of the good and when the price of that good goes down, sellers will supply a great deal more. A very low price elasticity implies just the opposite, that changes in price have little influence on supply. Often you'll have the follow up question "Is the good price elastic or inelastic between Rs.9 and Rs.10". To answer that, use the following rule of thumb: If Es > 1 then Supply is Price Elastic (Supply is sensitive to price changes) If Es = 1 then Supply is Unit Elastic If Es < 1 then Supply is Price Inelastic (Supply is not sensitive to price changes) Recall that we always ignore the negative sign when ana lyzing price elasticity, so Es is always positive. In our case, we calculated the price elasticity of supply to be 3.6, so our good is price elastic and thus supply is very sensitive to price changes. (Ref: http://economics.about.com/cs/micfrohelp)

Elasticity and Total Revenue along a Linear Demand Curve The slope of a linear demand curve is constant, but the elasticity is not. At points with a low price (% change will be relatively high) and a high quantity (% change will be relatively low), demand is inelastic. At points with a high price (% change will be relatively low) and a low quantity (% change will be relatively high), demand is elastic.
P TR = P.Q = aQ bQ2

e>1 e=1

e>1

P = a - bQ

MR = dTR/dQ
Q

a/2b Figure 1(a) Rs.

a/b

a/b Figure 1(b)

10

Ex-1: The marginal consumer approach provides intuition to presenta tions on price elasticity of demand by asking students to identify and analyze two distinct groups of buyers of a product. There are both marginal consumers who quickly respond to any price change and loyal consumers who tend to buy regardless of price. The marginal consumer approach contrasts the total revenues received from these groups, and can be simplified by assuming that: Each consumer will purchase only one unit of commodity. Movements along the demand curve represent consumers entering or leaving the market. The relative contributions to total revenue made by marginal and loyal consumers can be expressed graphically. For example, a price decline from Rs.6 to Rs.5 results in a Rs.1 loss in total revenue from the loyal consumers and a Rs.4 gain in total revenue from marginal consumers for a net increase in total revenue of Rs.3. Likewise, a price decline from Rs.2 to Rs.1 results in a Rs.4 loss in total revenue from loyal consumers and a Rs.1 gain in total revenue from marginal consumers, for a net loss in total revenue of Rs.3. The total revenue impacts of a price change depend upon the relative sizes and contributions of these consumer groups. Segmenting and labeling the total revenue areas under the demand schedule in this fashion incorporates some real world people into the concept of elasticity and can be used to supplement conventional graphical or mathema tical presenta tions on the subject. a. b.

Figure

11

Applications : In matters concerning policy an important factor is that of elasticity. Figure 2(a) and 2(b) show elastic and inelastic demand and supply curves respectively. Making assumptions about the elasticity of demand, for instance, could be invaluable for policy-makers in understanding what the effect of a tax could be in terms of who bears the burden: the consumer or producer? In Fig 3(a), a Re.1 per unit tax is imposed on cigarettes, whose demand we consider as fairly inelastic. The tax is passed on to the consumer to a substantia l extent with price increasing from p0 to p1 . If demand was elastic as in Figure 3(b), then the tax is absorbed by the seller. This would be the case for, say, garments.

PX Inelastic demand P0 P1

PY elastic demand P0 P1 DY

DX q0 q1 QX q0 q1 QY

Figure 2(a) and 2(b) Pc Sc=Sc + t Pc Sc=Sc+t Sc

tax

Sc

P0 P1
tax

P1
Tax

P0

Qc Figure 3(a) and 3(b)

Qc

12

Elasticity of demand is also useful to know how price fluctuations will affect total revenues from sales. If demand is inelastic, then an increase in supply of tomatoes (from a good harvest) would cause a sharp fall in price without a compensating increase in quantity. Total revenue earned by the farmer would decline substantially. See Figure 4. Pt St St

P0 P1

e0 e1 Dt Qt

Figure 4 Using a similar argument we can understand why clothing markets, especially readymade garments, usually resort to sales. We must assume that demand is highly elastic and a price cut would increase quantity demanded substantially and thereby total revenue as shown in Figure 5. Pg

P0 P0 20% Dg

Q0 Figure 5

Q1

Qg

Another interesting use of elasticities is on Government policy on drugs. Will a war on drugs be more effective than an awareness programme? The former may increase the incidence of drug related crime on the short-run because of increased spending on drugs. However, an awareness programme may mean a long-term incentive for young (new) drug users to try out drugs due to lower prices. See Figures 6(a) and 6(b). Ref. Mankiw.

13

Pd Sd Sd

Pd Sd

Dd Dd Dd Qd Figure 6(a) Figure 6(b) Qd

14

SESSION-5 Theory of Cons umer Behaviour In this session we will discuss the following: The equimarginal principle of utility maximization Indifference curves Derivation of demand curve based on the optimizing behaviour of rational consumers Substitution and Income Effects Application 1 & 2 The Equimarginal Principle The question we are trying to answer is how do consumers allocate their resources (budgets) amongst various goods, such that they are able to maximize the utility or satisfaction they receive from consumption of these goods. Let us suppose that utility is measurable in units called utils.

Benefits Measured in Utils (from last section)

Amount 1 2 3 4 5 Utils from Clothing 1100 2000 2700 3100 3200 Utils from Food 80 150 210 260 300

The table below contains columns showing the marginal utility of clothing and the marginal utility of food. These marginal utilities are obtained from the table above which shows the total utility of one piece of clothing, two pieces of clothing, etc. Marginal utility is the utility of the first piece of clothing, the second piece of clothing, etc. Thus, the utility of the fourth hamburger is found by subtracting the utility of four units of food from the utility of three units of food. Notice that the marginal utility of each good declines as more of it is used. This is a case of diminishing returns that has the special title of "the law of diminishing marginal utility. " It is based on everyday observation and introspection. After four units of orange juice, a fifth gives less pleasure than the fourth, a third hamburger gives less satisfaction than the second, etc. The Equimarginal Principle, or How to Spend Your Last Dollar Number Marginal Utility of Clothing First Third Fourth Fifth 1100 700 400 100 Second 900 Marginal Utility of Food 80 70 60 50 40

Suppose we are given price of clothing (pc) at Rs.100/- per unit and price of food (p f) at Rs.10/per unit. Also, assume that consumers budget for these two goods is Rs.500/-. How would the consumer allocate her resources (Rs.340/-) between c and f? The principle that a rational consumer would (implicitly) follow is called the equimarginal principle which states that: Maximization of utility occurs when the marginal utility on the last rupee spent is the same in all areas. In terms of a formula, a person wants (Marginal utility of A)/(Price of A) = (Marginal utility of B)/(Price of B) . (1) The consumer would first pick up two units because per rupee, clothing gives her more utils than food. She would then buy 1 unit of food, followed by 1 more unit of clothing and food. Given her budget of Rs.340, the consumer buys 3 units of clothing and 2 units of food. Equation (1) holds good. This is the basic idea of the equimarginal principle . The effect of a change in price of (say) clothing on quantity of clothing can be ascertained. An increase in pc , implies a fall in (MUc/p c), and obviously a substitution of food in place of clothing. This gives rise to a downward sloping demand curve; the relationship between Qc and pc, everything else held constant (budget, p f, etc.). The Equimarginal Principle Number Marginal Utility of Clothing MUc Marginal pc Food First Third Fifth 1100 700 100 11 9 7 4 1 80 70 60 50 40 Second 900 Fourth 400 Utility of MUf pf 8 7 6 5 4

Indifference Curves A serious problem with the equimarginal principle is the need to consider utility as measurable (utils). To overcome this problem, economists developed an ordina l theory (instead of cardinal) wherein we begin by constructing a utility map. A line will connect all possible combinations of good A and good B that show the same level of utility. This line is called an isoutility (iso is Greek and means "the same" or "equal") line or, more commonly, an indiffere nce curve.

Figure 1 One does not need to measure utility in order to draw a graph such as that in the graph above. All one needs is the ability to order different levels of utility; that is, to say that bundle A is preferred to bundle B , or that bundle B is preferred to bundle A, or that the chooser is indifferent between the two bundles. Indifference curves assume that individuals are consistent. If a consumer prefers option A to option B , and if she also prefers option B to option C, then she should prefer option A to option C. People with inconsistent behavior will not attain their goals as well as they could, and if behavior is too inconsistent, their behavior may show little regularity or predictable patterns. Properties of Indifference Curves: 1. A consumer has many indifference curves, not just one. This is called an indifference map (Figure 2) 2. Every indifference curve must slope downward and to the right, so long as a consumer prefers more of each good to less (Figure 3). 3. Figure 4(a) and 4(b) represents indifference curves for perfect complements and perfect substitutes 4. Indifference curves cannot intersect. Figure 5 shows inconsistency that arises when indifference curves intersect. Consumer is indifferent between bundles A1 and B1 and A1 and C1. However, C1 is strictly preferable to B1. This is a contradiction. 5. The slope of the indifference curve is defined as the marginal rate of substitution (MRS) and is given as: MRScf = MUc/MUf

Y
U=U2 U=U1

Consumer remains
on U = U1 U=U1

Figure 2

Figure 3

Left shoe

Rs.10 note

U=U2

2
1

U=U1

1 Figure 4(a)

Right shoe Figure 4(b)

Rs. 5 Notes

Y0

C D E U=U2

Y1 U=U1 Figure 5 X0 X1 X2 X

The Budget Line and Consumer Choice

To show what the consumer should do to maximize utility, a budget line must be added to the preferences shown in the indifference curves. Figure 6 below adds one. The equation of a budget line is given as: I = pc.C + pf.F Therefore, F = I/pf + pc/pf.C .. (2)

Point a is not attainable because it lies to the right of the bud get line. The consumer is indifferent between points b and d because they lie on the same indifference curve, but point d is cheaper than b because d lies below the bud get line. The consumer wants to get on the highest indifference curve affordable, and this will lead him to point c.

Figure 6 At equilibrium, the ind ifference curve is tangent to the budget line. Therefore, slopes are equal or MUc/MUf = pc/pf MUc/pc = MUf/pf or .. (3)

Equation (2) is the equimarginal principle derived above in (1). The effect of a rise in the price of good A is shown on the graph below (Figure 7). A higher price of A means that less of A can be purchased, and hence the budget line moves to the left, intersecting the vertical axis at a lower point. Point c is no longer possible and the consumer must move to a new position, whic h, assuming utility maximization, will be point b. Unless the indifference curves are peculiar, point b will represent less of good A than will point c, which is what the law of demand says will happen.

Figure 7 Looking at two different prices has produced two different points on an individual's demand curve. By varying the price of good A, other points could be found and an entire demand curve for one individual consumer constructed. The market demand curve is then obtained by adding up the demand curves of all individuals. The theory of consumer choice that the indifference curves embody is an elegant construction with which economists frame problems. One of its weaknesses is that a great many outcomes are consistent with it--though a downward-sloping demand curve can be derived from it, so too can an upward sloping demand curve. Further, in recent years there has been a realization among economists that pictures such as those above may not be a good description of the decision- making process when people must make decisions with partial information, with fuzzy goals, under conditions of risk and uncertainty, and when options are difficult to compare.
Income and Substitution Effects: When the pc falls the budget line shifts from B-B to B-B. There are two effects that arise on account of this fall in pc. 1. Price effect: clothing becomes cheaper relative to food and consumers would tend to buy more of clothing to food. 2. The real income of the consumer increases and she would consequently buy more of clothing (normal good) or less of it (inferior good or sometimes even a Giffen good). Example of norma l good is clothing. Inferior good could be public transport and finally Giffen good is potatoes in Ireland. Figure 8(a), 8(b) and 8(c) shows how we isolate the substitution and income effect for normal, inferior and Giffen goods respectively.

Figure 8(a)

Figure 8(b)

Figure 8(c)

The price effect and the Demand Curve : Figures 9 (a) and 9(b) below shows how the demand curve can be derived from the study of consumer decision making based on indifference curve analysis. Y PX

P0 P1 I1 I0 X0 Figure 9(a) I/P0 X1 I/P1 X X0 Figure 9(b) X1 DX X

Application of Indifference Curve Analysis Source: http://bcjournal.org/2006/the-case- for-cash/ Ex-1: The Case for Cash: Delivering Aid Through Direct Pay ments to the Poor Fatima B. Kassam While it is quite common in the West to provide monetary assistance to people in emergency situations, the practice is highly underutilized in developing countries. Under certain conditions, giving cash is one of the most cost-efficient methods of delivering assistance to a high number of people in a short amount of time while engendering future economic growth. This paper counters the arguments of skeptics and calls on key figures in the industry to reflect upon the paternalism and inefficiency that they may continue to foster through their institutions. While it is quite common in the West as a part of relief action or through insurance companies to provide monetary assistance to people in emergency situations, the practice is highly underutilized in developing countries. When appropriate, a cash-based approach allows beneficiaries of aid to exercise more choice; is usually more cost-efficient for both providers of assistance and recipients; and can have positive short- and long-term effects on the economy of the affected area. However, donor agencies list a myriad of reasons why this approach cannot work in the developing world. Inflationary and security risks, while they have not been thoroughly explored, pose real concerns for both providers of aid and affected populations. Critics also cite the lack of control over where the money is spent and reservations about how the social structure of a community will affect the distribution and control of currency. These challenges affect the plausibility of expanding the scale of cash-based interventions - but they are surmountable. Though not perfect, the cash-based approach is becoming a popular alternative to providing not only food assistance but al so other forms of relief, particularly in places where NGOs overlap in the services they offer. Under certain conditions, giving cash is one of the most cost-efficient methods of delivering assistance to a high number of people in places that have experienced either man-made conflicts or natural disasters while engendering future economic growth. This paper will examine the effects of

10

the infusion of cash by taking a closer look at the cases of Afghanistan1 and Mozambique and the conditions necessary for successful cash-based approaches to relief elsewhere in the world.

The Economists Basis for Cash

With only a simple grap h, economists have long helped aid workers to justify the shipment at a moments notice of millions of tons of provisions and other materials into post-disaster or post-conflict areas. The argument follows that food aid results in a better-fed population that enjoys a higher level of utility.2 As shown in Figure 1, given that an individual has a limited amount of disposable income to spend, one can construct a line exhibiting this budget constraint. If he spends all of it on food, he arrives at the intercept of the x-axis. Likewise, if he spends all of it on other goods, he arrives at the intercept of the y-axis. Food relief shifts the budget line to the right, parallel to the original. After the shift, the individual can obtain more food on the same budget and redirect savings to consumption of other goods. With food aid, an individual consumes more of everything and can move to a higher indifference curve, and therefore a higher utility.

If the goal of delivering assistance is a higher nutritional intake of the affected populations, this approach makes sense. However, despite the improvement in the situation, this is not always the most effective use of aid monies. If the goal is to efficiently spend resources available in a way that will maximize the utility of the recipient - that is, in a way that satisfies as many of his needs as possible - then cash is a better alternative. The fungibility of cash allows the new budget line to extend upwards (see Figure 2). With food aid alone, the highest indifference curve achievable is

11

I2. Clearly, the recipient is better off with aid than without it, consuming higher levels of both food and other goods. However, with cash, utility can be maxi mized on the curve I3. As exhibited in Figure 2, at the intersection of I3 and the new budget line, the optimal point of consumption for a beneficiary, it is possible that he consumes less food (point F3) than with food aid (point F2), but more of other goods.

With what goods might beneficiaries replace food? This is a point of controversy. Those in the humanitarian aid industry who are unfamiliar with evaluations of cash-based interventions often, in an effort to err on the side of caution, err instead on the side of paternalism. Interviews with aid workers have revealed that many of them worry that adequate dietary intake for a family may be sacrificed by male heads of household for alcohol consumption or dowries for new wives.3 Later sections of the paper will show that such notions have been negated with empirical evidence from both Afghanistan and Mozambique.

The Practitioners Basis for Cash

Thoughts on food insecurity have evolved throughout the past few decades. In the 1970s, the focus was on global and national supply shortfalls, while in the 1980s it became clear that the fundamental problem was not food scarcity, but food distribution. Availability at the national level did not necessarily translate to access at the household level. Amartya Sen explained this disconnect by introducing the concept of food entitlementin a 1981 publication. Entitlement refers to the set of income and resource bundles available (e.g. assets, commodities) over which households can establish control and secure their livelihoods.4 This new understanding of

12

food-security allowed for consideration of a number of socio-economic factors not previously given as much attention. Research throughout the 1990s focused on the relationship between malnutrition and poverty. More specifically, practitioners observed how the poor absorb various risks and found that food is only one of a whole range of factors that determine why people in desperate situations make certain choices. Balancing competing interests in order to prolong subsistence in both the short- and long-term was found to be more complex than previously thought. Many leading organizations have adopted this latest view that food security is a fundamental need but not independent of a broader number of factors. CARE USA calls this household livelihood securityand defines it as: Adequate and sustainable access to income and resources to meet basic needs (including adequate access to food, potable water, health facilities, educational opportunities, housing, time for community participation and social integration) therefore livelihoods are secure when households have secure ownership of, or access to, resources and income earning activities, including reserves and assets, to offset risks, ease shocks and meet contingencies.5 Both food aid and cash can prevent or delay risk-absorption methods that might be detrimental to livelihoods, like the sale of assets to cope with hunger. However, cash allows recipients more flexibility, and in turn a higher level of household livelihood security.

A Cash Famine in Afghanistan

On behalf of the people of Afghanistan, we would like to make an appeal The humanitarian transition must be marked by an emphatic shift from kindness in-kindto opportunities in cash. -Minister of rural reconstruction and development in Afghanistan In post-Taliban Afghanistan, severe drought over a three- to four-year period in some regions has exacerbated the economic effects of the US-led invasion of the country and the subsequent change in government. In spite of the security risks posed by protracted warfare in some regions, cash-based

13

approaches have not only worked well, but are preferred by many of the international agencies currently operating in the country and the beneficiaries of their programs. The findings of a Tufts University report prepared in 2002 for USAID found what the authors described as a cash faminein Afghanistan. A number of factors contributed to this phenomenon: loss of crops and livestock after the drought; depression of wages in a labor market flooded with new social groups, such as women, now being allowed to work and refugees returning from neighboring countries; and the stress on credit institutions from non-performing loans and failing currency markets. The report states: More people need access to markets to achieve food security than ever before yet fewer people have the cash resources necessary to buy goods in the market Throughout Afghanistan, there are crises of purchasing power, production and credit that continue to directly threaten household food security.6 Though the combination of events leading to the widespread loss of disposable income in Afghanistan may be particular to that country, seizure of land and livestock, forced migration, and stress on traditional financial institutions is not uncommon to conflict zones more generally and can bring about the same negative effect. Though well-intentioned, agencies delivering food aid can actually hurt local producers and traders. It is true that food aid has saved lives, deterred families from migrating out of desperation, and even protected them from falling further into debt. This is the case for particularly vulnerable households with no surplus labor to contribute to Cash-for-Work programs and other such forms of assistance. However, sales of commodities distributed by relief organizations are widespread.7 This monetization not only indicates a preference for cash or goods other than those distributed, but also depresses prices of goods that can be produced and supplied locally. Wheat prices in Nangahar, for example, fell by 15 to 20 percent as a direct result of the World Food Programs presence in the area. It was confirmed through focus groups that this price depression served as a disincentive for farmers who would normally try to cultivate surplus wheat for sal e.8 The non-distortionary nature of cash would guard against this change in both producer and consumer behavior. Inefficiently targeted food aid, in this

14

case, could potentially set back replenishment of household livelihood security.

Beyond Basic Needs in Mozambique

One year prior to the bombing campaign in Afghanistan, devastating floods hit the southern African country of Mozambique, causing 700 deaths and displacing approximately half a million people in the Limpopo, Save, and Zambezi valleys. Having examined the market conditions and the availability of food supply, USAID Mozambique created the Resettlement Grant Program (RGP), which provided 1,500,000 meticais (about $92) in cash to each of a little more than 106,000 rural families. Due to Congressional inertia, approval and appropriation of funds to USAID Mozambique was delayed until well after the flooding took place.9 By the time monies were made available, other NGOs had already been able to meet most peoples basic needs for everyday survival. In conjunction with millions of dollars allotted to other projects aimed at increasing local production, USAID also launched the Resettlement Grant Program (RGP). The scale of the RGP is negligible compared to that of any other programs in the country. Nevertheless, the thorough evaluation of the endeavor provides practitioners with excellent insight into what recipients consumed in place of food. As program designers envisioned, grants were spent predominantly in local villages on items not available through other programs. Though purchases of food were high, most of the money was spent on household goods, clothes, and livestock. Expenditures on seeds and construction materials were also substantial, indicating an investment in future livelihoods. Interviews reveal ed that some of the in-kind donations from other programs, such as zinc roofing, was often re-sold in order to purchase different building materials. Again, this monetization suggests that cash would have been more efficient for both providers and recipients of aid.10 One of the most important findings of an impact evaluation performed by Abt Associates is that grant monies almost exactly reflect the normal spending patterns of households, proving the theory that cash-based interventions are non-distortionary.11

The Secret to Success

The economic, social, geographic, and political landscapes of a post-conflict or post-disaster region are all important elements to consider when deciding 15

whether a cash-based approach is appropriate and optimal. Though there has not been much published on what conditions are necessary for a successful venture, this paper pulls from current working papers on the subject and the realities of relief efforts in Afghanistan and Mozambique. First, a thorough understanding of formal and informal market systems as well as geographical distances are key to determining whether cash will be useful. Local markets must be able to provide essentials at reasonable prices, accommodate additional demand for certain goods, and be competitive and accessible. These facts often relate to how much time has passed since the height of the emergency. Markets are often disrupted in the very short term (four to six weeks) but can be functioning well not long thereafter. An assessment of market indicators is not as complex as it may sound. Price monitoring for key commodities is already a part of most earlywarning systems; interviews with traders and shopkeepers are simple and can be conducted quickly. With the increase between 2002 and 2004 of cash-based projects in Afghanistan, some organizations there have developed their own list of indicators. Knowing the following has helped even the government make more informed choices regarding how to deliver assistance: whether bartering is an important form of exchange, the time and cost of accessing the nearest market center clinic or school, the number of months during the winter when market access is restricted, community views on cash versus food programming as a response, and so on. In a recent report published by the Humanitarian Policy Group, Harvey urges that: Better analysis of markets is arguably something that aid agencies should be doing anyway, in order to better understand how people are surviving and how best they can be supported. As Lautze argues, village markets are a critical arena [sic] for information, political exchange and socialising; monitoring markets should be one of the fundamentals of a livelihoods strategy.

Despite recent progress, cash-based approaches have yet to be considered seriously in the range of options available to organizations. It is imperative that the industry change the current focus on resource-driven needs assessments and fold indicators, like those mentioned above, into their routine vulnerability mapping.

16

Social patterns in a community have bearing on targeting decisions for an organization, who will make spending decisions for a household and how the money will be spent. In Mozambique, program managers targeted families that had not experienced a second harvest, indicating that their assets were more depleted than others. Beyond thi s, and based solely on intuition, grants were dispersed only to female heads-of-household, under the assumption that they would have more incentive to spend on children and to buy items that would benefit the entire household.13 In evaluating the program, Abt Associates found this hypothesis to be true - for the most part. There were a small number of cases in which a wife simply gave the money to her husband and thus was not able to report on what it was spent. At least one case of domestic abuse was reported, indicating that the cash placed the women at a disadvantage, as opposed to food, which their husbands perceived gave them less power. Perhaps to the dismay of veterans in the industry, almost none of the money was spent on alcohol.14 In Afghanistan, much of the money went towards paying off debts, a grave social burden which many families bore and which had resulted in forced, premature marriage of many young girls in efforts to pay back lenders. By 2002, the practice was widespread.15 Cash in Afghanistan then restored a balance of social power that had been lost in the medium term post-conflict. The type and place of an emergency will always influence the decision to administer a cash program. Natural disasters in relatively secure places with developed financial institutions will be far easier for implementation than remote war zones punctuated with treacherous mountain ranges, hidden mines, and sniper fire. Despite the risks, the case of Afghanistan can be seen as proof that cash can work well, and is often preferred, in addressing complex emergencies: Wars distort economies. Patterns of production, employ ment, trade, and services shift to war-related activities and patterns Aid can reinforce market distortions by feeding the war economy and undermining peaceti me production and productivity When aid agencies import goods that can be produced locally and distribute them at no cost, they can undermine peaceti me economic incentives.16 Political power structures and relationships are routinely explored by aid agencies for the benefit of staff safety and logistics concerns. However, the implications of delivering aid in traditional ways is not always as 17

rigorously examined. Aid can al so affect trading patterns that link people. If aid organizations import goods that were previously supplied by one group to another and those two groups are in conflict, aid reinforces the new division.17 Finding the necessary information and information that is reliable, particularly in emergency situations, in order to assess the appropriateness of a cash-based program can be risky and difficult to accomplish in a timely manner. Innovations in the area of needs assessments, however, are the next step that international aid agencies should engage in to better administer their existing programs and better serve their clients in the future.

Security and Corruption

The idea that cash is necessarily more vulnerable to insecurity and corruption than in-kind donations requires further evidence. International aid agencies inevitably find a way to pay staff stationed in remote areas; no one seems to suggest that their salaries be paid to them in-kind. The fact that transport of cash is possible on a smaller scale provides some hope for larger projects. To date, studies of numerous cash-based initiatives have, in fact, shown that the opposite may be true. Although proponents of food aid often argue that the bulky, and highly visible nature of shipments or grain stocks make them difficult to steal, many counter this argument with empirical evidence of attacks of these assets in complex emergencies by armed groups. Mobile assets in smaller amounts can provide far more security to staff especially.18 In order to implement a cash program effectively, it is important for agencies to understand the informal financial institutions that exist. Inhabitants of an area always find ways to transfer currency somewhat safely. In Afghanistan, agencies have made use of the local hawala system.19 Staff from Save the Childrens Cash-for-Work programs in the country stated that these programs were easier to manage than in-kind distribution projects, and that they faced less pressures to redirect funds to local commanders because the bundles of currency were in such small amounts.20 Comparatively, distribution of cash in Mozambique was less straightforward and efforts toward increasing security presented enormous logistical challenges. After the floods, program managers contracted different companies to manage security, transport, communications and financial accounting respectively. Oxfam has generated a list of simple techniques to 18

reduce security risks for agencies, including: limiting knowledge of cash movements, limiting access to bank transactions, decentralizing disbursement responsibility, not scheduling cash transfers to keep them unpredictable, using staff who have been with the organization for a while and are trusted.21 From a high-level survey of evaluations (which should not be viewed as comprehensive), the only major sources of corruption seemed to be within the organizations administering the programs. This should not be surprising given the attraction of cash to everyone, not only those in need. Although precautions can be taken in targeting certain beneficiaries of the program, deciding who handles cash internally can be far more challenging.

For Agencies, Cash is Cost-Effective

The cost-effectiveness of cash is usually stated relative to in-kind distributions. The comparison can be a tricky exercise due to the fact that agencies calculate overhead costs in different ways. Additionally, there are certain costs, post-delivery, that the beneficiary might incur, transport costs for example, which are not counted in overall expense assessments. These variations in accounting methods can account for the wide range in cost-savings reported by different agencies. For projects studied through the Humanitarian Policy Group, cash-based programs were estimated to be between 20 percent and 50 percent l ess expensive for agencies to operate. A significant example can be pulled from a study of food aid in Afghanistan which reported that wheat aid was provided at a cost of $332 per metric ton (MT), whereas local markets could provide it at $112/MT to $167/MT.22 Cash was not only more cost-efficient for the agency, but probably contributed to the strengthening of local markets. It has been suggested that a portion of such cost savings be directed to enhanced security and financial monitoring to ensure proper disbursement and expenditure.

For Recipients, Cash Preserves Dignity Through Choice

While economists laud cash for its ability to deliver a greater level of utility and practitioners point to a higher level of household livelihood security and cost-efficiency, beneficiaries cite dignity, self-esteem and choice as the most beneficial aspects of cash-based programs. Sen summarizes the significance of this agency aspect of the individual:

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The success of a society is to be evaluated, in this view, primarily by the substantive freedoms that the members of that society enjoy Greater freedom enha nces the ability of people to help themselves and also to influence the world, and these matters are central to the process of development.23 Through the optic of a relief-development continuum, the notion that relief, rehabilitation/ mitigation and development interventions are a continuum of related activities, not separate and discrete initiatives,24 the idea of preserving self-worth and individual agency has profound implications for how quickly an area will emerge from crisis. Understanding what might inhibit the cultivation of individual agency should be examined. The philosopher Margalit argues for the decent society in which institutions exhibit respect, or non-humiliation through their actions, not only in their theoretical origins: Social institutions can be described in two ways: abstractly, by their rules or laws, or concretely by their actual behavior. Analogously, one can think of institutional humiliation by law, as manifested by the Nuremberg laws or those of apartheid, in contrast to concrete actions of institutional humiliation, such as the Los Angeles police officers treatment of the black motorist, Rodney King. In the concrete description of institutions the distinction between a non-civilized and a non-decent society is blurred.25 He further posits that NGOs operating in what he calls a welfare society can be compared to public institutions in a welfare state.26 Paternalistic views that recipients do not know what they need, that they will squander money on alcohol or drugs such as qat and hashish, have been institutionalized through the concrete behavior of an industry that gives little credence to cash-based approaches. Harvey states that these attitudes of paternalism and superiority remain an important factor in humanitarian response despite the professed commitment to greater participation on the part of affected populations, and that some of the reluctance to use cash is linked to these prejudices.27 It is imperative that leading agencies engage in introspection and examine the internal structures preventing a necessary paradigm shift in both the aid and development industry.

20

Ex-2: From Mankiw (pp. 400-401). The effect of an increa se in interest rates on quantum of household savings depends on the strength of income effect. The figures below show different outcomes on account of an increase in interest rates.

21

SESSION-6, 7 Theory of the Firm: Production and Costs In this session we will discuss the following: Production function Short-run cost curves Long-run cost curves Economies of scale and economies of scope Break-even analysis We have already explained intuitively the reason why the supply curve of a firm is positively sloped; the basis lay in the Law of Diminishing Marginal Returns. However, it is the pursuit of (maximum possible) profit which actually drives firms to offer different quantities of a good at different prices. The firm in neoclassical economic theory1 is a black box, which converts inputs into an output. The organization of the firm could be a proprietorship, partnership, joint-stock company that is privately or publicly owned, a cooperative or even a state-owned enterprise. What matters is that the firm has one objective: to maximize profits. We assume that this objective is pursued even in firms where management and ownership are not common. In such a situation, the management too pursues this objective and no other. The relationship between inputs and outputs is specified by a production function. This is a technical and physical2 relationship, depending on the state of technology. In reality there are hundreds of inputs that go into the manufacture of a product. If you consider a modern automobile plant inputs would include thousands of raw materials from steel to plastic parts, shafts to fasteners, different categories of workers, plant and machines, and so on. For sake of simplicity, let us assume that these inputs can be divided into two: capita l and labour. The production function can then be expressed as: q = f(K,L) We can study firm behaviour in three time-periods: The short-run in which only the quantity of labour can be varied (capital is fixed) The long-run in which all inputs can be varied, i.e. both capital and labour The very long-run in which technology changes so that the production function itself changes to, say, q = g(K,L) This categorization of time-periods is not fixed across industries like accounting periods. For instance, the long-run for a street food seller maybe three days (i.e. the time it takes him to vary capital the size of his cart or the number of utensils he uses) whereas for a automobile plant it maybe three years (the time it takes them to install a new assembly line). Given the production function, firms can determine output that can be produced by varying the quantities of labour. Whatever may be the actual figures, economists assume that production
1

There are other ways of viewing a firm; neoclassical theory is only one of these. We will return to some others to study the important imp lications that can be derived fro m these theories. 2 The production function relates quantities of inputs to output and not in terms of Rupees.

functions will usually exhibit one common feature: the law of diminishing returns. This law states that keeping one factor of production fixed (capital), varying the quantity of the other input will give us increasing amounts of output but eventually at a diminishing rate. A simple example might make this relationship clear. The street food seller begins with a cart, one gas cylinder, one stove and a few utensils (this is his capital). He can sell any number of food plates that he can produce (prepare). Initially he is alone and produces 100 plates of food a day. He decides to employ a worker to help him with the cleaning. This saves the owner a lot of time and with the same capital stock, they are able to increase the total number of food plates to 250. The additional output from this additional worker is 150 food plates. This is called the marginal product. On average they produce 125 food plates. The owner now decides to employ one more worker to do the chopping. Tota l output increases to, say, 350 plates. The marginal product of this additional worker is 100 plates. The average product of the three workers is ~116 plates. Table 1 below continues the story of what happens when our owner goes on employing more workers without adding anything to his capital stock. The diagrams [Figure 1(a) and 1(b)] illustrate the numerical example. One feature which is particularly important is the one between the average and marginal curves3 . Table 1 K 1 1 1 1 1 1 q=TP L TP L L 0 1 2 3 4 5 TPL= q 0 100 250 350 400 425 APL = TPL/L 0 100 125 116 100 85 MPL = dTPL/dL 0 100 150 100 50 25 APL , MP L

AP L MP L

L Figure 1(a)
3

L Figure 1(b)

In general, when average is increasing, marg inal > average; when average is decreasing, marginal < average; and when average is constant (Maximu m or min imu m point), margina l = average. As an examp le, consider a batsman with an average of 50 runs/innings. If his average must increase (decrease) then in this (marg inal) innings he must make more (less) than his existing average of 50. If his average must remain at 50, then this innings he must make the same, marg inal = average = 50.

Let us now assume that the wage the owner must pay to each worker is Rs.100 per day. We also assume that the food sellers total capital stock (1 unit) is worth Rs.100. From Table 1 we can compute the different cost functions as shown in Table 2; these cost functions relate costs (in Rupee terms) to the number of units of output. When calculating costs, economists calculate opportunity costs. In our example, the owner himself works as the cook. He may not pay himself but we must take what he would earn in the next best possible job. Suppose his only alternative is to be employed by another street vendor on the next street at a wage of Rs.100 a day, then this is his opportunity cost. This is why we have taken his wage to also be the same as the other workers. The same logic is used to calculate the cost of his capital stock. If he could sell off his equipment for Rs.75 then this is his opportunity cost. But suppose he could hire out his equipment to the food seller on the next street at Rs.100, this must be taken as the opportunity cost of capital (as we have done). It also does not matter how much he actually purchased the equipment for. Table 2 K 1 1 1 1 1 1 L 0 1 2 3 4 5 q 0 100 250 350 400 425 TFC 100 100 100 100 100 100 TVC 0 100 200 300 400 500 TC 100 200 300 400 500 600 AFC --1 0.4 0.28 0.25 0.20 AVC 0 1 0.8 0.86 1 1.18 AC --2 1.2 1.15 1.25 1.38 MC 0 1 0.67 1 2 4

pK = Rs.100/unit; TFC = pK .K; AFC = TFC/q

pL = Rs.100/unit; TVC = pL .L AVC = TVC/q

TC = TFC + TVC AC = AFC + AVC

MC = dTC/dq

In general, cost curves indicate certain interesting relationships amongst themselves the most important for all our subsequent analysis are shown in Figure 2 & 3. The U-shaped average costs curves and the rise in marginal costs are the essence of economic cost analysis. Also note that the marginal cuts the average cost curves at their minimum points4 . Rs. TC Rs. MC TVC AVC TFC AFC q Figure 2
4

ATC

q Figure 3

See footnote 3.

In the long-run capital is no longer constant, it can be varied. Plant size must now be chosen by the firm. The long-run cost curves can be constructed from the short-run cost curves for each plant size. We begin in Figure 4 by considering the average costs of two plants, L1 and L2 . If the firm intends to produce an output q1 , it chooses plant L1 because for this output SATC1 < SATC2 . If output were to be q2 , then it would choose plant L2 because SATC1 > SATC2. Imagine the possibility to choose from an infinite number of plant sizes. The long-run average cost (LRAC) curve will then be the envelope of the short-run average cost (SRAC) curves. Rs. SATC1 SATC2

Figure 4

q1

q2

The downward sloping part of the LRAC indicates increasing returns to scale and the upward sloping part decre asing returns to scale . The minimum point of the LRAC curve is called minimum efficient scale. Increasing returns to scale can occur for several reasons; for instance, when research and development expenditure is spread over a large output or from sheer geometry. If a container to hold 1 m3 of liquid was required we would need 6 pieces of steel, each of 1m2 , totaling to 6 m2 . Now to hold a container of 8m3 , we would need 6 pieces of steel, each of 2 m2 , so that the total steel requirement increases to 24 m2 , i.e. by 4 times, whereas the output increases by 8 times. LRAC curves of different firms can exhibit a wide range of shapes. In the electricity industry, minimum efficient scale some years ago was reached with generators of 1000 MW. Today, the minimum efficient scale can be reached with a plant size of just 100 MW. Diseconomies of scale (or increasing returns to scale) are usually attributed to problems which arise in management, coordination and supervision of very large enterprises. Distribution of output from a centralized plant may also face diseconomies of scale.

Rs.

MES LRAC

q Figure 5 The Importance of Flexibility Figures 6 and 7 shows how firms are often faced with decisions regarding not only scale but also type of plants depending on the probability distribution of demand. It is evident that in case the probability distribution of demand is of type D, plant type 2 must be chosen. Rs. Type 1 Rs.

Type 2 Distribution C Distribution D

Figure 6

Figure 7

Some interesting cases for analysis (from William Boyes, The New Managerial Economics) Mrs. Fields Cookies was a cookie distribution chain with a centralized dough manufacturing unit in Utah, USA. The company grew rapidly in the 1980s and reached a network of more than a 1000 stores in 8 countries by 1990. However, losses were reported at ~$9 million with sales of $130 million. The company was sold to creditors and Mrs. Fields had to resign. Costs had increased due to diseconomies of scale. Figure 7 explains what may have happened to the company.

Rs. LRAC

Figure 8

Q1990

In 1955 Akio Morita (founder of SONY Corp.) came to the USA with a small transistor radio his company had developed. He received an order for 100,000 radios/year. He declined saying that he would be able to supply only 10,000 units/year; this was his plant capacity. However, Marito was faced with a long-run planning decision to make. Should he build a larger plant size of 100,000 units/year? What would happen if demand fell to 30,000 units a couple of years later? Figure 8 throws some light on the problem facing SONY. Rs. SRAC1 A C SRAC2 LRAC

Figure 8

5000

30000

100,000

Estimation of LRAC curves for the Electric Power Industry and Steel Ingot Industry (US). Figures 9 and 10 show the above respectively based on studies by L. Christenson and W. Greene (1976) and George Stigler. Rs. Rs.

LRAC (1995) LRAC LRAC (1970) Figure 9 Q Figure 10 Q

Economies of scope Economies of scope arise from cost advantages that accrue from the production of more than one product, or TCA+B < TCA + TCB For example, petroleum companies may also produce a variety of chemical products. Diseconomies of scope may also arise when adding on new products to the companys product list actually increase costs disproportionately. Some examples of industries where economies of scope are common: FMCG (soaps, shampoo, etc.) Advertisement agencies (TV, print, radio, outdoor, direct response ads, non-media, etc.) Break-Even Analysis The break-even point is the output level (q) that firms must reach in order to avoid losses, i.e. q: TR = TC In Figure 11 below, break-even point is at q = qv Rs. TR Profit TC

Loss

Figure 11

6000

Break-even analysis and operating leverage: operating leverage (OL) is a measure of the sensitivity of profits to a change in sales volume. This could be an important consideration in choosing the type of plant, i.e. whether it is more capital intensive or labour intensive. Degree of OL = dOL = (%change in profit)/(% change in q sold) = (d? /dq).(q/? ) The Tables below give three plant types, from capital intensive (high fixed cost) to less capital intensive (low fixed cost).

Type I plant q 10000 20000 30000 40000 50000 Type 2 plant q 10000 20000 30000 40000 50000 Type 3 plant q 10000 20000 30000 40000 50000 TR 50000 100000 150000 200000 250000 TC 65000 105000 145000 185000 225000 ? - 15000 - 5000 5000 15000 25000 TR 50000 100000 150000 200000 250000 TC 90000 120000 150000 180000 210000 ? - 40000 - 20000 0 20000 40000 TR 50000 100000 150000 200000 250000 TC 120000 140000 160000 180000 200000 ? - 70000 - 40000 - 10000 20000 50000

dOL (1) = [(50000 - 20000)/10000].[40000/20000] = 6 dOL (2) = [(40000 - 20000)/10000].[40000/20000] = 4 dOL (3) = [(25000 - 15000)/10000].[40000/15000] = 2.67 The above shows that in case of Type 1 plant, a 1% change in sales would lead to a 6% in profits, for type 2 plant it is 4% and type 3 only 2.67%. Therefore, type 1 plant profits is the most sensitive to changes in sales. This can help the firm in its decision-making.

SESSION-8, 9 Market Structures I: Pe rfect Competition In this session we will discuss the following: Market structures Perfect competition Short-run profit-maximization, firm supply curve, market supply Long-run equilibrium Allocative and productive efficiency under perfect competition Equipped with the short-run and long-run cost1 curve of firms, we are now ready to understand how firms make price and output decisions. This, however, depends on the structure of the market in which they operate. A wheat farmer faces a different market structure as compared to Kellogg Wheat Flakes. Broadly speaking, economists categorize market structure on the basis of several factors. Table 1 below summarizes the characteristics of each market structure. Table 1
Market Characteristic Numbe r & size of firms Perfect Large nu mber; Small size Standardized Monopolistic Large nu mber; Small size Differentiated Oligopoly Small nu mber; Large size Standardized/ Differentiated Difficult Possible/ Difficult Lo w to high Monopoly One

Type of product

Unique

Market entry & exit Non-price co mpetition

Very easy Impossible

Easy Possible

Impossible Not necessary

Market power Long-run econo mic profit

None None

Lo w to high None

High

Lo w to high; High; Subject to Subject to mutual regulation interdependence

Allocative & Productive Efficiency of Perfectly Competitive Markets The objective of a firm is maximization of profit, not cost minimization. However, under conditions of perfect competition we will see that in the pursuit of maximizing profits, firms reach the minimum efficient scale of production in the long-run. This makes perfect competition an ideal market structure in economic theory a benchmark against which other market structures are compared and contrasted.

The very long-run is characterized by technological change and development. This will entail a shift in the SRAC and LRA C curves downwards.

Profits are defined as total revenue minus tota l costs, where total costs are calculated on the basis of opportunity costs and total revenue is price times quantity sold. Firms seeking to maximize profits need information on costs as well as revenues. In the short-run a perfectly competitive firm faces a horizonta l demand curve at a price corresponding to the price at which the market demand and supply curves intersect. Consider a wheat farmer. He may produce an output of 100 tons, but can he affect the price of wheat in India? On the other hand, if the market price of wheat is Rs.15/kg, this farmer will be able to sell his entire output2 at that price. Even if his output increases (decreases) to 200 (50) tons, the market price of wheat will not change. Each firms demand curve is also its marginal revenue (MR) and average revenue (AR) curve. When a firm se lls an additional unit of wheat, the additional revenue that it would earn will be the price (Rs.15). Figure 1 illustrates the market price and the demand curve facing an individual firm. p Sw p

Pw

Pw

d=MR=AR

Figure 1 We can now show (as in Figure 2) how this firm will decide on quantity to be produced, given the market price. The firm will choose an output where MR = MC, and where MC is increasing. Equilibrium output of the firm is q* and its profits are the area (p*eac) which is the distance between total revenue (p*.q*) = area (Oq*ep*) and tota l costs (q*.ATC) = area (Oq*ac). Intuitively, we can explain the MR = MC rule as follows: so long as an additional unit of output adds more to TR than to TC (MR > MC) it should produce that unit of output. If, on the other hand, the production of an additional unit of output adds more to TC than TR (MC > MR) then that unit should not be produced. Therefore, firms will produce up to the point where MR = MC.
Analogy: "Take one step forward--I pay you Rs.5 and you pay me Rs.4." Ask students if they would step forward. Yes, for a net gain of Rs.1: MB > MC. Would you move i mmediately after hearing "I pay you Rs.5"? No, we can't make a good decision based only on benefi ts or costs. I might ha ve said "You pay me Rs.6." Then, we would have made a bad decision and wound up with Rs.1 less in our pockets. Would you move if I said "I pay you Rs.4.10 and you pay me Rs.4"? Sure, we could pocket 10p. Si mon pays Rs.4.01 and you pay Rs.4?

Entire could mean any quantity, even if 1 million tons. In such a situation the farme r can influence price. However, by definition, individual firms (farmers) are too small to influence price in a pe rf e ctly c o mp et itive market.

The figure below also tells us output levels that will not be produced by this firm. If the firm cannot cover even its variable costs in the short-run, it shuts down. If it is able to earn some amount over and above its variable costs it will always choose to produce an output because this earning can be used to offset its fixed costs, at least partially.

MC

P* a

e c

d=AR=MR

q* Figure 2

qw

Finally, in Figure 3 we derive the supply curve of this firm. For each price level, the firm chooses an output where MR = MC. This means that the MC curve above the minimum point of the AVC curve is the supply curve of the firm. As we have seen, if the price were to fall below the minimum point of AVC curve, the firm shuts down.

Rs.

MC ATC AVC d0 d1 d2

P0 P1 P2 e2 e1

e0

q Figure 3

Firms in a perfectly competitive industry can make short-term supe r-normal profits , i.e. they can earn a profit which is higher than what the owners could earn if the resources were to be used in their next best alternatives. Returning to the food sellers, he earns a profit of more than Rs.100 which would be his wage if he were to work as a worker with the food seller in the next street. A horizontal summation of each firms supply curve would yield the industry supply curve. Given the all-India demand and supply of wheat, the equilibrium price of wheat would be determined in the market, which is then taken by each farmer as given. Rs. MC1 = s1 Rs. MC2 =s2 P* Min AVC Min.AVC PS q Figure 4 The short-run ana lysis shows us that a firm in a perfectly competitive market makes a decision based only on variable cost. The firms fixed cost is essentially sunk costs, whose opportunity cost in the short-run is zero (because it cannot be sold and opportunity cost realized thru sale). For instance, during a drought, a farmer in the short-run could simply not produce an output by hiring no labour, but his land is fixed and would not be sold. In Figure 4 when we add up each firms supply curve, it is likely that the market supply curve would come close the Y-axis and in the limit (or thru estimation) we could extend it right up to the Y-axis. Now the producer surplus is nothing but the area abp* in Figure 4. It is the area above the MC curve. The area below the MC curve is the TVC (integral) and fixed costs are not considered. The producer surplus is therefore the difference between willingness to supply at different price levels and the actual market determined price level, p*. However, if firms do earn a super-normal profit, new firms will be attracted into the industry. Existing firms also have an incentive to increase output by installing bigger plants3 . With this market supply increases and industry price falls.
Analogy: When we drop some cookie crumbs on the floor, what do they attract? Ants, of course. In competitive markets, the "ants" are the firms and the crumbs are the excess profits. Ants will come to the place until all the crumbs are gone. Firms will enter the industry until all excess profits are zero. This is possible because competition prevails. When there are no more crumbs, no more ants will come--when there are no excess profits, the entry of firms will stop.

Rs. SMC = S

In Figure 5 profits would increase by area (abgf) keep ing output same but installing a larger plant. However the firm would increase output to maximize profits with new p lant.

Long-run equilibrium will achieved only when price is equal to the minimum efficient scale of production and firms earn only normal profits . This is called productive efficiency and is illustrated in Figure 5. In Figure 5 the long-run supply curve of the firm is horizontal.

Rs. S0 P0 P1 P2 LS S1 S2

Rs. LMC p0 p1 p2 e0 e1 e2 LRAC d0 d1 d2

Q Figure 5

By maximizing the sum of consumer and producer surplus, perfectly competitive firm achieve allocative efficiency with the intersection of the market demand and supply curves (as we have already seen in the previous session).

Rs. CS

P*

LS D PS=0 (normal profit) Q* Q

Figure 6

Ex-1: A Case Study In Perf ect Competition: The U.S. Bicycle Industry Submitted by Jay on Sun, 2006-07-16 22:27. I had an epiphany, as in a sudden insight into reality, in May at a meeting where a long time friend in the industry offered the opinion tha t the U.S. bicycle industry is in a classic sta te of perfect competition. My i mmediate response was "...tha t sound s like a good thing!" My friend, who went back to gradua te sc hool af ter working in a bike shop, for a major component manufac turer and prominent bicycle brand quickly responded with "...no, you don't understand." He went on to explain tha t when he studied economics in gradua te school he beca me aware of perfect competition which i s a term of art in economics for the most competi tive ma rket imaginable - one where the companies and businesses realize the bare mini mum profi t necessary to keep them in business. At the time we were in a meeting together with six other people from the bicycle industry and the room went silent for a time. As the group sta rted to discuss the notion of perfect competition it became apparent tha t no one strongly disagreed, and in fact there seemed to be more agreement than not tha t our industry was indeed in perfect competition. We ended our meeting, and went our separa te ways, but the concept of perfect competition stayed with me, kind of like the dull pain of a toothac he. When I got back to my office I did a searc h on the web and found quite a lot about thi s subjec t. Here is a summa ry of wha t I learned.

Perfect competition[1], according to economists, is the most competi ti ve market

imaginable. In the real world, it is ra re, and there are even some economists tha t f eel it may not even exist in i ts purest (I take this as worst) form. The example of a market in perfect competition tha t i s referenced by those economi sts tha t believe i t does exist - is agriculture. Competi tion i s ... competi tion, so what ma kes perfect competition different from all other forms or kinds of competi tion? According to economists - because it is so competi ti ve tha t any individual buyer or seller ha s a negligible impac t on the market price. Products a re homogeneous, or composed of parts tha t are all of the sa me kind. Product and pricing informa tion is also perfect in tha t everyone, including the ul tima te purchaser knows everything about the products, including the best prices available in the market. In a market in perfect competition everybody is a price taker, producing and selling essentially identical products and each seller has li ttle or no effec t on market price, and is unable to sell any output a t a price grea ter than the market price. Firms ea rn only normal profit, or the bare mini mum profi t necessa ry to keep them in business. If firms do earn more than normal profit, which is called excess profi t, the absence of barriers to entry mean tha t other firms will enter the market and drive the price level down

until there are only normal profits to be made. Manufac turing output will be maxi mized and price mini mized. This sounds very fa miliar to me - and I a m sure you can also rela te to real world examples of the U.S. bicycle industry as you read through this explana tion o f perfect competition. Component manufac turers sc ramble to get the la test designs and functionali ty to market in a timely fashion. Bicycle suppliers struggle mightily to craf t and specify bicycle products tha t have more value than the competi tion and sweat over the ti ming and dealer programs to introduce them. Bicycle retailers loose sleep over how much to commit for and what to bring to market - and whether to become a concept store or remain independent, and which suppliers to do business with. And with all this ac ti vi ty, no buyer or seller has a negligible impac t on the market price, and everybody in the channel of trade is a price taker, earning the bare minimum profi t necessary to stay in business. Last year and thi s season are good exa mples. In 2005 we had our best yea r ever for the sale of high-end road 700c bicycles selling above Rs.1,000. And in 2005 the typical bike shop lost 5 ma rgin points on the sale of new bicycles, continuing an unfortuna te trend of loosing money on the sale of new bicycles tha t ha s plagued our c hannel of trade for over a decade[2]. High-profi t bike shops, while they performed much better than the typical shop, also ca me in just below their cost of doing business on the sale of new bicycles in 2005, the first actual loss for high-profi t shop on the sale of new bicycles in a decade[3]. Despi te the continuing, and apparently growing losses on the sale of new bicycle, the U.S. bicycle industry posted one of i ts best years for apparent ma rket consumption in 2005 second only to the record set in 2000. 2006 sta rted off well enough, but now as we enter the 3 rd quarter of the year, some bicycle brands are reporting overstocks from last season, and retailers are reporting some 2006 model s already are out of stock as the brands introduce and sta rt to deliver 2007 models. History does ma tter, and in economics, pa th dependence refers to the way in which apparently insignificant events and c hoices can ha ve huge consequences for the development of a market or an economy. In the case of the specialty bicycle retail c hannel of trade, the collective choice not to adopt Uniform Product Codes, or UPC's has come back to blind the industry again, and again over the last twenty five to thirty years. The seemingly insignificant, competi tive based choice of not adopting UPC's ha s made bar coding tec hnology, and the full power of i ts inventory and sales tracking efficiency uniformly unavailable across all level s of our c hannel of trade, making real channel efficiency impossible. Si mply sta ted - brands and manufactures don't know what i s selling at retail and retailers ha ve little or no input or influence on what is reordered and manufac tured to refill the supply pipeline. As most economi sts will tell you...where we ha ve been in the past

determines where we are now, and where we can go in the future. This, in turn, leads to the importance of information. Economic and channel efficiency is likely to be grea test when informa tion is comprehensive, accurate, and readily and cheaply available. As evidenced by the specialty bicycle retail channels recurring pattern of having too much or not enough, many of the problems facing economies and ma rkets a rise from making d ecisions without all the informa tion tha t is needed. Currently our channel of trade opera tes on the premi se tha t if a brand or company can acquire or gather more informa tion than i ts competi tors it is a good thing. However, economists will tell you tha t asymmetric information, when one c hannel player knows more than the other c hannel players, can be a serious source of inefficiency and market failure. Uncertainty can also impose large economic costs. The power of the Internet has grea tly increased the availability of certain information. However, even with all its informa tion power, there are special ty bicycle retail channel inefficiencies, like not knowing what is actually selling a t retail, tha t the Internet will not be able to solve. Accordingly, uncertainty - li terally not knowing, will remain a huge source of special ty bicycle retail channel inefficiency. And this inefficiency makes our c hannels blindness compl ete. Potentially the most useful informa tion, about wha t will happen in the future...or the a bility to more accura tely forecast future demand, replenishment, inventory and sales will simply never be available under our channels current sta te of perfect competition. The best example of perfec t competi tion tha t I ha ve heard recently i s in my own backyard...Madison Wiscon sin, one of the best specialty bicycle retail markets in the country. As most of the industry knows there are two Trek company stores in Madison, and one of them, loca ted on the East side ha s been identified as the companies flagship store. Erik's Bike Shop is a successful multi -store retailer headquartered in the Minneapoli s-St. Paul Minnesota market. Erik's established a store in Madison several sea sons ago, and carries Specialized, as wha t I understand i s i ts marquee brand. Several weeks ago, according to the buzz a mong bicycle dealers, Specialized announced to its dealers in Madison tha t Erik's will open a second store, reportedly direc tly across the street from the Trek flagship store on the ci ties East side. By the way, both the Trek flagship and the new Erik's tha t will carry Specialized are both in direc t competi tion with an established bicycle dealer tha t has carried both the Trek and Specialized brands for many years - and is just one-mile away! To make this ma rket si tua tion even more "perfec t," the Trek flagship and new Erik's store are located al most within sight of a large new Dick's Sporting Goods tha t opened last yea r. This is, I suggest to you, much more than just two brand competi tors going head -to-head in one of the best specialty bicycle markets in the country. It is also a clear exa mple

of perfect competition at its best, or should I say worst. The most comp eti tive market imaginable...where output will be maximized and price mini mized. Consumers, particularly adult enthusiast cyclists ha ve been and will continue to be the clear beneficiaries of this most competi tive of markets. The retailers, including the two backed by deep pocket bicycle brands, will beat on each other and will become more efficient to survi ve, and as a result prices in the market will be kept surprised. Keep in mind tha t in a sta te of perfect competition a firm tha t earns excess profits will experience other firms entering the market and driving the price level down until there a re only normal profits to be made - the bare mini mum profit nec essary to keep them in business. All of the retailers in thi s scenario, when it comes to full frui tion, including those backed by the big brands, will still only have a negligible impac t on the market, including the ma rket pricing. This all raises the question - a t lea st in my mind, of the big guy tha t was there first, Trek Bicycle, erecting or creating some type of barrier to entry. I a m sure they will think about such a thing - and they may ac tually try several potential barriers to another new store, which might very well also be a brand "concept," entering their geography, and market space. At the end of the day...there is no real barrier to entry tha t can be put in place, or actually exists for tha t ma tter, because the largest brand seller in our channel of trade still doesn't ha ve enough mass or leverage to domina te through a monopoly, and I am not talking about the board ga me. Most ma rkets ex hibi t some form of imperfec t or monopolistic competi tion. There are fewer firms in this i mperfec t competi tion than in a perfec tly comp eti tive market and each can to some degree c reate barriers to entry. Such barriers would allow the existing firms to earn some degree of excess profi ts without a new entrant bei ng able to compete to bring prices down. So far, the consolida tion in the U.S. specialty bicycle retail channel of trade hasn't reached a point where there are a small enough number of brand s and /or manufac turers with enough product differentia tion to allow the c rea ting of barriers to market entry. The number of bike shops has kept falling over the last seven years, but here again, no retail organization ha s grown to the point tha t it can crea te barriers to market entry. And what about the current independent bicycle retailer tha t ha s been in the ma rket the longest? He i s clearly at a dangerous place, but is the only one of the players who can breakaway from the sta te of perfect competition tha t has a strangle hold on the rest of the industry and the specialty bicycle retail c hannel of trade. By the way, thi s retailer was made aware in advance by the brand s, first tha t the Trek flagship store was going in a mile from hi m, and nex t tha t Erik's Bike Shop was going to loca te a new store within about the same distance from hi m. He has reac ted by remodeling the interior of his current location. I ha ve not spoken with thi s pa rticular retailer since the news about the loca tion for the new Erik's store, but I have E-mailed, and when I do talk to hi m, here is wha t I a m going to suggest.

1.

Hyper-differentia te your store. This is a term coined by Mike Ba sch, former CEO of YaYa! Bike, and it means differentia te your store totally from any other bike shop or bicycle retailer in your market so tha t you stand out as the brand in your market. It will be important to keep the adult enthusia st cyclists tha t a re now customers - but the key will be crafting and ma rketing f ea tures and benefi ts to retain them as clients for life. The battle between the two big bicycle brands is going to test the "loyalty" of the adult enthusiasts in the market - but their loyalty is a question of personal attac hment, relationships and the deal they got most recently, so there is marketing room for the independ ent to establish client loyalty programs and establish ongoing communica tions so the rela tionship is maintained and strengthened. Items 7, 8 and 9 discussed below become very i mportant here. 2. Market to and really welcome casual cyclists, women, minori ties, baby boomers seniors - everyone tha t is now underserved by all-the-other bike shops and concept stores. Thi s i s a key stra tegy for growth. It involves a product selec tion tha t will give all the non-enthusiast adults a truly enjoyable bicycle riding experience while not forgetting about the kids. Proac tive ma rket outreach in the form of demographics within zip codes and direc t-response is essential, along with a formal referral-marketing progra m to drive word-of-mouth. 3. Focus totally on the consumer. Our channel of trade is now very product focused, and we think everyone tha t walks in the door is also product focused. This i s a false premi se. Shoppers, all shoppers are looking for an enjoyable experience, and tha t experience includes focusing on their wants and needs, while ma ki ng them comfortable in the store. Adul t enthusiast cyclists want and seek out product orienta tion, but also apprecia te a more enjoyable experience. Casual cyclists and non-cyclists, where the growth potential is, are seeking the shopping experience and want to be comfortable with and develop a rela tionship with a consul tant who's expert advise about bicycle products will best meet their wants and needs. 4. Educa te your whole organiza tion to focus totally on shoppers and customers. Because of the current product focus of our c hannel of trade, we don't educate our employees about the vi tal importance of focusing totally on the shopper, and not making any snap judgments about who a cyclist or customer is, or isn't. Hi ring and educating customer service na tural s is way more i mportant than in-depth product knowledge. Educating them to really listen to shoppers and customers wants and needs is vi tal to building lasting, lifetime rela tionships. 5. Make it all about them and an extraordinary shopping experience. There i s no retail selling today - everything a retailer does, everything retail employees do is marketing. The whole store, and the whole a tti tude has to ma ke it all about them from the parking lot to the windows to the front door to the greeting - through making the bicycle buying process easy and fun, and the whole visi t to the store extraordinary. Making it all about them and providing an extraordinary shopping experience is the pa th to increa sed transac tion values and increased close ra tes. 6. Make your store the brand. Work with, stoc k and sell products tha t will provide the features and value your customers want and need, and the margins and inventory turns you need to grow your business. Present a uniform brand image in everything you do and tha t your staff does and says - one outward brand face. And develop and

10

7.

8.

9.

10.

promote formal word-of-mouth customer referral programs to leverage your store brand in the market. Create individual client solu tions. You and your staff - your whole store, your brand and the shopping experience you provide are for one purpose. To crea te individual solutions for your customers wants and need s. In doing so you will create clients for life. Become an efficient da tabase manager. Educate your staff to the i mportance to your business of utilizing all the fea tures built into to your computerized point of sale system and any other retail shopping systems you incorpora te into your retail process and shopping experience. The uniform entry of shopper, customer and client information is as i mportant to your business a s a uniform and consistent new bicycle assembly process and check list. Become an efficient di rec t-response ma rketer. Staying connec ted to prospec ts, shoppers, customers and clients utilizing a regular direc t-response marketing plan is essential to growing the number of transac tions genera ted by the business, and it is reliant upon a clean and current database. Follow the Phillips Rule of never ever selling anything in your retail store below your cost of doing business. This will lead to consistently ea rning excess profi ts.

All ten of these suggestions together create the foundation for a new level of specialty bicycle retailing that changes the paradigm and has the potential to take the retailers that follow it out from under the state of perfect competition that the rest of the channel of trade is trapped in.
[1] http://www.investopedia.com/: Economics Ba sics: Monopolies, Oligopolies and Perfec t Competi tion. [2] NBDA Cost of Doing Business for Special ty Bicycle Retailers: 2006-2007 Financial Survey; 1993-2005 NBDA CODB Trending Analysis Report. [3] Tired Of Working So Hard For So Li ttle? by Jay Townley

Jacob R (not verified) Says:

Thu, 2008-10-30 23:34 Townley argues tha t the bicycle retail industry is in perfec t competi tion and tha t thi s market system i s undesirable for retailers. Of course retailers would love for the bicycle market to not be perfec tly competi ti ve because then they could profiteer and provide less bicycles for the society and thereby jack up prices. Having an economic profi t of zero does not force firms out of the industry in the long run and also provides the best prices for consumers; it is the best compromi se for both consumers and producers.

11

It is readily apparent t ha t Townley is not an economist and a t most ha s learned wha t he knows about economics second hand from bicycle retail owners. One indica tor of Townleys inexperience in economics is tha t he equa tes an economic profi t of zero to a firm not making a profit when in fac t this is not the case a s economic profit includes explici t costs such as the costs of production and employing workers a s well as the i mplicit cost or the profi t tha t could have been made investing ones resources in the next best option. In fac t an economic profit of zero is expec ted to occur in any non-monopolistic industry in the long run and si mply means tha t investors a re getting the best deal possible for their resources.

12

Session-10 Market Structures II: Monopoly and Monopolistic Competition In this session we will discuss the following: Profit Maximization Output and Price by a Monopolist Welfare Losses under Monopoly Monopolistic Competition, short-run Monopolistic Competition, long-run Optima l Advertising Expenditure Profit Maximization Output and Price of a Monopolist The obverse of perfect competition is monopoly. When a firm is a monopolist, it is not a pricetaker; it is a price-maker or can set its own price. It is often assumed that a monopolist can charge any price it wishes to. This is not entirely true. It can set a price but only within the confines of the demand curve for the product. In the case of monopoly, the firm and industry demand curves are one and the same. However, the marginal revenue curve, unlike the case of a horizontal demand curve, is no longer the same as the demand curve. For a downward sloping demand curve, marginal revenue will be below price. Intuitively, this is because though the firm increases revenue by selling an additional unit of output, it also loses revenue because all previous units must be sold at this lower price. Suppose the first unit of X sells at Rs.9/- and the 2 units can be sold at Rs.8/- (each). Then MR is 8-1=7 where -1 is because the first unit is now sold at Rs.8/- instead of Rs.9/-. The other way of looking at this is that since average revenue is the price or demand curve (AR = TR/Q = p.Q/Q = p) which is decreasing, marginal revenue must be below price. Figure 1 shows the demand, AR and MR curves facing the monopolist. P

D=AR MR Q Figure 1 The profit maximization rule for the monopolist remains the same as we have discussed above, i.e. MR = MC. Here, however, the monopolist must choose both, price and quantity corresponding to the point where MR = MC. From the demand curve, he will set the price = p* at which the firm sells the output Q*. The firm is able to earn super-normal profits of p*eac as

shown in Figure 2. Note that the monopolist has no supply curve corresponding to the MC curve as the perfectly competitive firm. Rs.

E pm

MC ATC

a D MR Q Figure 2 In the long-run the monopolist continues to earn super-normal profits since entry into the industry is restricted. There is no incentive for the monopolist to increase production to reach the point of minimum efficient scale. A market dominated by a monopoly does not attain productive efficiency. Moreover, the monopolist price and quantity decision is not allocatively efficient, i.e. the sum of consumer and producer surplus is not maximized as in the case of perfectly competitive markets. We can compare monopoly and perfectly competitive market structure as below (Figure 3). Assume a horizontal MC curve (MC = AC) for the monopolist and further that if this industry were to become competitive from a monopoly (break up the monopolist into several small firms), the cost curve remains the same. Then MC becomes the supply curve for a perfectly competitive industry as each additional unit can be supplied at MC. The deadweight loss from the monopolist producing a lesser quantity and charging a higher price is the area (ems) in the Figure 3 below. Rs. A m Pm Pc S e MC=AC

D=AR MR Qm Figure 3 Qc Q

In Figure 4, welfare losses arising from monopoly can be shown if we consider how a social planner would allocate resources. As long as p > MC, output increases would lead to a net benefit to society, since p is nothing but the willingness to pay or the value derived from the consumption of one more unit of the good. The planner would stop production at p c, Qc (instead of pm, Qm), thereby maximizing socia l welfare (or allocative efficiency). P MC

Pm Pc

MB>MC; p>MC Demand curve = MB curve D=AR MR Qm Qc Q

Figure 4 Monopoly is, therefore, considered a case of market failure . When the market structure is dominated by a monopolist, the free market, with no government intervention, does not give us a Pareto optima l solution for societal welfare maximization. Monopolies can be defended when it known that significant economies of scale can be achieved by supplying goods and services on a very large scale. The case for monopoly is illustrated in Figure 5 below. Economies of scale are indicated by lower average costs for the monopolist as compared to a small competitive firm. A monopoly in such a context is called a natural monopoly. A natural monopoly could, therefore, provide potentia l gains in economic welfare for both, producer and consumer. Rs.

Pc pm

ACc = MCc D=AR ACm=MCm MR

Figure 5

Economies of scale usually exist for industries that are subject to increasing returns, if large capital investments must be made prior to production, long gestation periods are needed before actual production commences, and where the marginal cost of producing additional unit or providing a service to additional customers is very low (as compared to the marginal cost of the first unit). Examples of such industries are water and sewerage systems, electricity transmission companies and the telecommunications industry. A serious problem arises in case of industries where even at the level of full market demand for the product, average costs continue to fall. In such a situation, if p = MC rule were followed, the firm would incur a loss. It would be necessary to allow the firm to charge p= AC instead to ensure sustainability of the enterprise in the long-run. See Figure 6. Rs.

Pm

P=AC Pc Qm Figure 6 Qc

AC MC Q

The microeconomic theory of perfect competition and monopoly has opened a debate on the regulation of markets (and monopolies) by governments. It also serves as one of the best examples of applying microeconomic theory to issues of national and perhaps global importance.

Monopolistic Competition Perfect competition and monopoly may be considered as the two extremes in a wide range of market structures. In this chapter we look at two intermediate market structures: monopolistic competition and oligopoly. A monopolistically competitive market has elements of both, perfect competition and monopoly. The products are not homogeneous; product differentiation is an important feature of this market structure. This feature also gives market power to firms or the ability to choose price; rather than be a price-taker (like perfect competition). However, like perfectly competitive markets, and unlike monopoly, this market structure is characterized by free-entry or no barriers to entry. There will be an incentive for new firms to enter the industry when existing firms are making supernormal profits.

A good example of monopolistically competitive markets would be the toilet soap or toothpaste industry. Generally speaking, most FMCG markets can be slotted as monopolistically competitive. In these markets brand differentiation does mean that firms have some degree of market power. However, these markets have no barriers to entry like patents or other intellectual property that restricts new firms to set up shop. What is the outcome from the working of the free market when industries are monopolistically competitive? Does the market system work efficiently in terms of allocative and productive efficiency? Do we reach an efficient outcome like perfectly competitive markets or do we reach an inefficient solution like monopoly? A monopolistically competitive firm like a monopoly will face a downward sloping demand curve. If it raises price, it will lose some of its customers. At the same time it could attract new customers (or increase the demand of existing ones) by lowering prices. Monopolistically competitive firms are not helpless like, say, a wheat farmer. We have seen that in the long-run a monopoly could earn supernorma l profits because of the lack of entry of new firms into the industry. A monopolistically competitive firm too has a possibility to earn supernormal profits in the short-run. However, in the long-run, equilibrium will be attained only when supernormal profits are wiped out by the entry of new firms. This is illustrated in Figure 7 and 8. Rs. Supernorma l profits MC AC P mc

D=AR MR Figure 7 Rs. Normal profits MC LRAC Pm e Q

Excess capacity MR Figure 8 Qmc Q

D=AR Q

This leads us to an interesting result: a monopolistically competitive firm will not produce an output corresponding to the lowest point (minimum efficient scale) of its long-run average cost (LRAC) curve. Productive efficiency is not achieved. The output produced q m and the output corresponding to productive efficiency qc (as in perfectly competitive markets) is called excess capacity or the existence of unexploited scale economies. The existence of excess capacity raised an important question as to whether product differentiation through, for instance, branding is wasteful. Would it not be better for society to have all toilet soaps wrapped in white paper and toothpaste in white plastic tubes? Perhaps not; for as our model of a monopolistically competitive market shows, people are willing to pay a higher price because they may actually value diversity. The label on jeans or the toilet soap wrapping does make a difference to the satisfaction or utility we derive from the consumption of such products, even if we must pay for this.

Session 11 Market Structures III: Oligopoly & Strategic Decision-Making In this session we will discuss the following: Paul Sweezy?s Kinked Dema n d Cur ve M odel Game theory and strategic behaviour Nash equilibrium Some of the different types of games One feature which is of increasing significance in the real-world today and ignored by the market structures studied thus far is strategic behaviour. The market structure we will now turn to is oligopoly (or duopoly) and it takes into account strategic behaviour of firms. Strategic behaviour is nothing but the fact that firms while taking a decision take into account the effect of their decision on a riva l firm and the reaction of the rival to that decision. In fact, a chain of reactions could follow. The behaviour of firms under perfect and monopolistic competition was nonstrategic; firms took decisions on the basis of their own demand and cost curves and ignored how rivals would react to their decisions. Strategic behaviour can be seen in many Indian industries today including the domestic airline industry, aircraft industry, soft drinks, automobiles, digital TV, supermarkets, consumer durables and even detergents. Perhaps the simplest model that can be used to understand the implications of strategic be ha viour on the market system o utco me is with Paul Sweezy?s Kinked Demand Curve ana lysis. This a nalysis assume s that the oligopolists do not collude ; however, each firm will take into account the reaction of the other(s) when it raises or lowers price. If we start at a price p* in Figure 1, then if the firm increases prices others do not react. The firm will lose several of its customers to rivals and this makes its demand curve elastic for prices higher than p*. On the other hand, of the firm decreases price all other firms follow suit and the firm will not able to gain significantly in terms of sales. The demand curve below p* is, therefore, inelastic. Rs. MC MC P*

D MR q q* Figure 1

With demand curve deD, the marginal revenue curve is now discontinuous at r. Given costs, the firm will choose an output q* to maximize profits. For all output levels less than q*, MR > MC and for all output levels higher than q*, MR < MC. Therefore, q* is the profit maximizing output level. Under such circumstances, a change in costs and/or demand may not cause any change in prices. In Figure 2 & 3 prices are sticky and do not respond to the changing market conditions. Recall that price signals were the essential feature of the market system. If price signals are sticky, how will firms respond to the needs and requirements of society? Sweezy?s mo del of oligopoly has important implications on the functioning of the market system in markets characterized by strategic behaviour. Figure 2 Rs.

MC MC P*

D MR Figure 2 Rs. MC q* q

Increase in P

D Figure 3

D q

No change in q

Strategic behaviour is now extensively studied using game theory. It is very tempting for students to believe that mastery over game theory would actually be useful to solve their managerial decision-making problems. This is far from the truth. Let me begin this discussion with a couple of passages from Guerrien (2004):
Ariel Rubinste in, a re cognize d ga me the orist, is a bsolutely right whe n he e x plains tha t ga me the ory is a fascinating and abstract discussion, that is closer to philosophy than to the economic pages of the ne wspa pe rs?. All game theory presentations, advanced or not, have however a common feature: they never give concrete ex a m ple s, with re a l da ta in pla ce of da ta, a re figure d other, m ore or le ss com plica ted stories the se stories (almost) always centre on the same question: is there a rational way to make a decision when gains de pe nd on this de cision, but a lso on othe rs? de cisions? Inde e d, the re a lot of situations whe re the re is no simple answer or no answer at all to this que stion. This is why the re a re so ma ny dile m m as? or pa ra dox e s? a m ong ga me the ory storie s. Ga me the ory doe s not re solve ? proble m s, concre te or not: it highlights the difficulty of characterizing rational beha viour

S o what then is the usefulness of game theory to mana gers? When you ponder strategic decisions, you must explicitly consider what actions others will take. And, your optima l choice may change, depending on what you believe others will do. But that is not all. You must remember that all the others in the game are sitting there thinking of what you and each the others might do. The expectation chain continues There ma y be a lack of an unconditional optimal strategy or no best strategy fo r all situations. Game theory is nothing but a n orga nizational tool it helps you to better understand any strategic decision and to better anticipate the actions and reactions of others, making you a better decision-maker. You ma y not always be able to solve game theory problems and find equilibria but there can be better visual identification and organization of game parameters. There are tow ways of visual representing a game. The first is a matrix and the other a game tree. Consider the matrix below which shows the players, order of play (in this case simultaneous i.e.e each reaches a decision without knowing what the other will do), feasible strategy set (increase or maintain spending), outcomes (in this case four possible outcomes) and payoffs (A,B) of each player. B Spend at Current Level Spend at Current Level A Increase Spending (4, 3) (3, 2) A game tree is like a decision tree except that the latter has no interactive payoffs; payoffs are of a single individual and nature. The extensive form game is essentially a decision road map and gives more details than a matrix. The node represents who the player is; in this case square is B and circle is A. (3, 4) Increase Spending (2, 3)

Current A Current B Increase Current Increase Increase

(3, 4) (4, 3)

(2, 3)

(3, 2)

Let us now try to ascertain market system outcomes under conditions of strategic behaviour. We begin with a situation where firms do not collude or, in other words, the firms are noncooperative . The simplest game is illustrated with the prisoner?s dilemma : this is a story of two partners-in-crime, A and B who are being questioned separately by the police. Each can either lie or confess to the crime and will get sentences; but the actual term of the sentence will depend not only on their own decision to lie or confess, but also on what their partner decides to do: lie or confess. Given in the table below is the payoff (A, B) matrix and outcomes for each strategy chosen by each player. B Lie Lie A Confess (0, -6) (-5, -5) A will look for his best response function. If B lies, then A should confess. If B confesses, then A should confess. Confess is a dominant strategy for A, i.e. whatever B does, it is always better for A to confess. B will also look for his best response function. If A lies, then B should confess. If A confesses, then B should confess. Confess is a dominant strategy for B, i.e. whatever A does, it is always better for B to confess. The dominant strategy for both A and B is to confess; they end up with a sentence of 5 years each. This was the rational thing for both of them to do when it was impossible for them to (-1, -1) Confess (-6, 0)

cooperate or collude. But is their de cision collectively rational? No. If they had both lied they would have escaped with a term of just 1 year each. The prisoners? dilemma is a story without a dilemma. A rational non-coope rative solution for each prisoner actually results in a collectively sub-optima l decision. A real dilemma occu rs when there is no dominant strategy and therefore no solution? to the game. The table below illustrates this possibility. B Low Price Low Price A High Price (0, 60) (100, 100) (20, 20) High Price (60, 0)

As best response function: If B plays low, then A must play low If B plays high, then A must play high No dominant strategy for A Bs best response function: If A plays low, then B must play low If A plays high, then B must play high No dominant strategy for B There are two equilibria: (Low, Low) or (High, High) or: If A (B) plays low, then B (A) must play low. If A (B) plays high, then B (A) must play high. When both a re playing their best move to the other?s best move, no one is going to move. In this case neither player has an interest to move if it finds itself in box (low, low) or (high, high). If it moved, it would find itself worse off. Such outcomes are called NASH EQUILIBRIA. Another example (table below) illustrates the possibility for Nash equilibria to actually be socially inefficient outcomes. Airbus Build Build Boeing Dont Build (-1, 10) (5, 5) (-10, -10) Dont build (10, -1)

Boeings best response function: If Airbus builds, Boeing must not build. If Airbus does not build, Boeing builds. No dominant strategy for Boeing.

Airbuss best response function: If Boeing builds, Airbus must not build. If Boeing does not build, Airbus builds. No dominant strategy for Airbus. Tw o Nash e quilibria exist: (Build, Don?t Build) and (Don?t Build, Build), i.e. If Boeing (Airbus) builds, then Airbus (Boeing) does not build. If Boeing (Airbus) does not build, then Airbus (Boeing) builds. Neither will move if it finds itself in either of the highlighted boxes. However, social welfare is maximized when both Airbus and Boeing do not build new aircraft. Game theory shows us situations where players are rational but outcomes uncertain. As Guerrien puts it, Normally, we should stop here, as game theory is interested in determining rational people?s decisions in intera ction?, and as, in general, assuming a player?s rationa lity is insufficient to make predictions different than: a nything, or almost, ca n ha ppen?. We ha ve seen in our exa mple of the prisoners? dilemma how individual ma ximization need not always lead to a socially optima l allocation of resources. In that example we had ruled out the possibility of cooperation or collusion between the prisoners. If they were allowed to do cooperate , would we reach the social optimum? The example below gives us a situation similar to that of the prisoners? dilemma . A s out put Monopoly 2/3 Monopoly output output B s ou tput Monopoly output (40, 40) (30, 44) (34, 34)

2/3 Monopoly (44, 30) output

In the case both, A and B would choose their dominant strategy, i.e. they would take aggressive posture on market share and end up producing 1.1/3 times of the market requirement. Their profits are 34 each. This is a suboptima l result. If Nash equilibrium is established by strategic reasoning, wherein both parties cooperate, they will in fact be better off. However, if each firm tends to behave rationally, the solution gravitates to a sub-optima l one. This example is close to situations faced by cartels like the OPEC. The above example tells us that if both parties could settle for monopoly output, it would be mutually beneficial. However, the incentive to cheat makes the outcome gravitate towards 2/3 monopoly output. Is it at all possible to reach the optima l outcome? Economists have explored how an optimal strategy may evolve from games played repeatedly (repe ated games); some suggest signaling (announcing a commitment of price level through the press and advertising) whereas others suggest punishment (i.e. if one party cheats the other also follows a tit-for-tat

policy). Whatever may be the strategy, the incentive to cheat in the short-run makes the outcome inherently unstable. Some Other Insights & Applications of Game Theory Strategic Foresight and the Use of Backward Induction: Consider a firm B that must decide to either expand or not expand its current capacity. Given what B does, the follower in the market (A) will decide whether or not to expand. Its decision woul d impact B?s profits. How will B take a decisio n? The game tree shows possible outcome s of B and A?s de cisions.

No expansion A No expansion B Expansion

(80, 80) (60, 120)

Expand

No expansion A Expansion

(150, 60)

(50, 50) Payoff = (B, A) B will begin by supposing it expands. Then A would not expand because its profits = 60 > 50 = profits when A expands. Suppose B does not expand. Then A will expand (profits = 120 > 80). So the choice set is (B expand, A does not) and (B does not expand, A does). The first option wo uld give B a higher profit = 150 > 60 = profit is B does not expand. So B will decide to expand.

The Credibility of Commitments: Should we believe others? Yes, but only if the commitments are credible. A commitment is credible if the costs of falsely sending one are greater than the associated benefits. A company that proclaims its product as the best is not credible: the benefits > costs. A warranty is credible because the cost of commitment > benefit. A kiss on the hand may be quite continental, but diamonds are a girls best friend B makes a threat to drop its price. Is this threat a credible one to A? If A does so, B would maintain price because profits = 30 > 20 = profits if B drops price. But what if A maintains price. B would then have dropped price because profits = 70 > 50 = profits if B maintains price. A would therefore decide to drop price and B would then maintain price. Therefore the threat by B to drop price is not a credible one.

Maintain B Maintain Price A Drop

(30, 50) (20, 70)

Drop

Maintain B Drop

(40, 30)

(15, 20) Payoff= (A, B) Several other kinds of games have been studied: repeated games, incomplete information games, coordination games, sequentia l games, first-mover advantage, etc. Ours was but an introduction into the concept of strategic decision-making. Game theory illustrates the complexity that strategic decision-making brings into common notions of rationality and efficiency.

Session 12 Market Structure and Market Failure: Is There a Need for Regulation? As we have seen in the preceding classes, the market system fails to allocate resources efficiently when the market structure is imperfect. There are other reasons too for market failure (which we examine later in the course). To overcome market failure, the government regulates the market system in many ways. Broadly speaking we divide this into:1. 2. Economic regulation Social regulation (e.g. health, safety, environment)

Economic regulation may be further divided into:a. b. Price control of monopolies, agricultural pricing policies, rent control, etc. Antitrust or competition policy

In this and the next lecture we will study government economic regulation pertaining to market power, i.e. when the market structure is imperfect or not perfectly competitive. We already introduced the concept of natural monopoly. This is the clearest case for government intervention in the market system. Natural monopolies arise when economies to scale are so large that there is room for only firm to operate at the minimum efficient scale. Most natural monopolies also tend to be public utilities, i.e. industries which are provide essential services (for day-to-day life and growth of a region or economy) and there duplication of services is rather wasteful given the investment (falling AC). A case of a natural monopoly is shown in Figure 1. Several options are available to the government:1. Let the firm operate as a monopolist. Here a deadweight loss and a transfer of consumer surplus to the monopolist would accrue (as seen in Lecture-6). 2. Invoke antitrust laws and divide the company into several smaller entities. However, economies of scale would be lost and consumers may actually end up paying more. 3. Set p = MC. However, firms incur a loss and must be compensated with a subsidy. 4. A compromise solution is to let firms charge p = AC. A deadweight loss is incurred this is the cost of the compromise solution. 5. Differential or non-linear pricing. 6. State ownership of companies and adopting the appropriate pricing policy.

Rs.

Pm

P=AC Pc Qm Figure 1 Qc

AC MC Q

We have seen that markets dominated by a monopolist could lead to a long-run market equilibrium characterized by productive and allocative inefficiency. However, it is the existence of allocative inefficiency1 which is the theoretical basis for government intervention into sectors of the economy plagued by market power (William F. Shughart). Neither has productive inefficiency2 nor the redistribution of income between producers and consumers3 been the basis for government intervention. Even if there are grounds to justify the gains in productive efficiency from natural monopolies, allocative efficiency is still not achieved if the monopolist is free to exercise market power. Society will be even better off by having a single producer and then forcing this producer to charge a price where p = MC and produce an output corresponding to this price, rather than a price and output corresponding to the point where MR = MC. However, as we have already seen, where average costs are falling at the level of full market demand, the p = MC rule might force the firm to shutdown in the long-run. One solution that solved these concerns in the regulation of natural monopolies, and adopted by many European nations, is state ownership. Even with falling average cost curves, the sustainability question could be taken care of through allocations from state budgets. In the U.S., however, the emphasis was on regulation of privately owned firms rather than state ownership, though some industries were also state owned in the U.S. These included the first class mail, local public transport systems and municipal services. In Europe, state control was extended over many other sectors of the economy like steel, automobiles, aircraft, civil aviation, oil, mines and minerals, fertilizers, and so on. The European approach to natural monopolies was also followed by India.

1 2

This is the deadweight l oss . The bias in favour of monopolies to utilize econo mies of scale fro m la rge-scale manufacture has meant that this may not be an appropriate argu ment against a monopoly. 3 This area is now part of monopolists (producer) surplus rather than of consumers.

Many concerns have been raised against the idea of regulating markets by governmental authorities. Perhaps the strongest critique of regulation was proposed by George Stigler, an economist at the University of Chicago. It is called the economic theory of regulation. Simply put Stigler argued that regulation is often sought by the very groups that are to be regulated. Why? Because regulation restricts price and choices of not only the regulated but everyone else, including potential competitors. By lobbying political parties, the regulated seek regulation, and eventually capture regulatory authorities to serve their interests. Regulatory agencies are usually managed by bureaucrats who require continued support, financial and otherwise, to survive. As long as the regulated are satisfied with the regulations, the support will come. At the same time, blatant favoritism towards the regulated may mean that the regulatory authority comes under flak and eventually may be challenged by the public. Therefore, the managers of regulatory authorities will have to play a balancing game; they too are optimizing agents with their own objectives and constraints. Once regulations are promulgated, the firms have another advantage over the regulatory authorities; asymmetric information. For the regulatory authority to price optimally it must have full information of costs and demand. But this can only come from the regulated firm. The firm will always have better information about its operating conditions than any outside expert. Firms will exploit this asymmetric information in their favour by securing rates (or prices) that deviate from optimality. A more basic concern has also been raised by many economists as to what constitutes a monopoly. Is it sheer market share? For instance, a companys share in the telephone call market may be very large, but its share in the communications market may not be that significant. Similarly a company like Kellogg may have a large share in the Indian breakfast cereal market, but what about the breakfast market itself? Will not consumers switch to oats and almonds if Kellogg were to exercise monopoly power? This also raises another growing issue; in todays global markets we must not only contend with domestic industry but also internationa l trade. A company may be a monopoly producer in India, but imports could take care of any threat of this firm exercising undue monopoly power. International trade and investment have also brought in need for laws and institutions that actually legitimize market power like copyright and patent laws. Deregulation of important sectors of the economy, privatization of several large state-owned companies, and large-scale production to achieve economies of scale are now seen as important incentives, even necessary conditions, for domestic industry to compete in global markets. Appropriate trade policies that foster competition through trade and investment could be a more effective mechanism to protect consumers from monopoly power than regulation of narrowly defined monopolies. Finally, there is also a growing recognition that in industries where sunk costs (once incurred these costs cannot be recovered) are high, monopoly power is likely to be higher. Examples include electricity transmission lines, airport runaways, gate facilities, highways, etc. Markets where sunk costs are high usually mean that competitors are less likely to enter. The theory of contestable markets focuses on high sunk costs rather than economies of scale as a source of monopoly power and deterrent to free entry. One way to reduce sunk costs and make markets more contestable is for the government to finance and construct facilities and then lease them to private firms. Another way would be to require owners of such facilities to all competitors on an equal basis.

Whatever may be the concerns raised against anti-antitrust and regulation policy the conventional wisdom4 that government intervention in markets serves the interests of the most unorganized of groups consumers still holds sway (Shughart). Although regulation can be used to encompass all such intervention, there is a subtle difference in the usage of the terms regulation and antitrust (or competition) policy. According to Shughart, regulatory policies (including pricing of goods or services) are normally tailored narrowly to apply to specific firms and industries. This makes the identification of interest groups who have a stake in the regulatory outcomes easy. Economic regulation can also take the form of antitrust or competition policy. It makes a broad set of recommendations on fir m behaviour that apply to all economic players generally. It makes identification of winners and losers difficult and complicated, and the special-interest basis of antitrust policy less apparent. Antitrust policies were first introduced in Canada in 1889 and followed by the Sherman Act (Section 1 and 2) in the U.S.A. in 1890. Several other pieces of legislation, like the Section 7 and 7A of the Clayton Act (1914), Section 5 of Federal Trade Commission Act (1914) and the Robinson-Patman Act, extended the scope of the Sherman Act and together they provide the core of U.S. antitrust policy. Put together these legislations check illegal business practices, which mat be categorized as follows: Horizontal agreements among competitors [this includes agreements on price, agreements to restrict output, boycotts, division of markets based on sales territories or customers, agreements to restrict advertising, codes of ethics (restricting the ways professionals may compete), and restraints of other business practices]; vertical agreements among competitors [including resale price maintenance agreements, non-price agreements between manufacturer and dealer, tie-in sales]; maintaining or cre ating monopoly; mergers [horizontal, vertical and potential competition mergers (merging with/acquiring a potential competitor]; and price discrimination5 by charging customers different prices for the same commodity. Competition policy generally prohibits monopolizing, attempting to monopolize and conspiring to monopolize. The legal definition of monopoly differs from the economic definition of the term; in the former, monopoly power implies a high degree of control over price of a good or service rather than a single seller of a good or service. It is obvious that proving that a firm has exercised or abused monopoly power is not straight-forward. High market shares or aboveaverage profits are not a sufficient condition to prove this. Even if they exist these could arise from superior technology or production techniques, manageria l skills, etc. Further, curtailing the monopoly power of a firm may entail efficiency losses and unless remedial measures are found which do not reduce efficiency gains arising from monopoly power, proceedings cannot be initiated. Merger and acquisitions are an increasingly widespread phenomenon and antitrust regulations usually target such M&As. However, regulation is a costly procedure (finding a partner, negotiating a deal, planning the new organization, etc.), the US Department of Justice issued the following guidelines based on the Herfindahl Index (HI). This is only the starting point as to whether or not to challenge a merger, which then proceeds on a case-by-case basis.

4 5

This, as we have seen, is based on conventional mic roeconomic theory. Price d iscrimination will be taken up in a subsequent chapter.

Likelihood of Justice Department challenging the merger: Postmerger HI Increase in HI 0 50 100

m

<1000 Will not Will not Will not

1000-1800 Unlikely Unlikely Likely

>1800 Unlikely Likely Will

The HI is calculated as follows: HI = ? Xi 2

i=1

where m = number of firms, Xi = percentage market share of the ith firm. Antitrust and competition policy also are critically watchful of collusive arrangements amongst oligopolistic firms. We have seen in our earlier (game theory) session, the possible reasons for collusion and the incentive to cheat. In any case, competition policy has curtailed the possibility to collude by imposing severe penalties on the violators. In the US, there have been instances of prosecution of company employees. This has had the desired effect on corporations. Finally, price discrimination may be used by a firm to preempt entry of new firms into an industry and sometimes to weaken existing competition. One example of such pricing is called predatory pricing and usually takes place in industries which are characterized by a large firm and several locally distributed small or medium sized firms. The large firm then cuts prices in one market but effectively makes up the loss incurred in other markets where it continues to earn super-normal profits. Regulation seeks to control such practices. However, in order to do so it first needs to identify parameters which indicate predatory pricing. A simple parameter that is presently used in the US is where price is set below AVC (Figure 3). Economic theory tells us that if p < AVC a firm should shut down. It does not make economic sense for a firm to operate when p < AVC, unless it purpose is to eliminate current and/or potential competition. Rs. MC

ATC AVC P > AVC P < AVC

Figure 3 With this we complete our introduction to the theory of economic regulation. We now look at the how regulation has been put into practice.

Some Interesting Anti-trust Cases from the US and Other Parts of the World: Several interesting cases in the U.S. provide us with an idea of the scope and result of antitrust policy; we will mention a few of them to illustrate how policy based on economic theory is translated into policy and implemented in courts of law. Case 1 : Brown Shoe Co., Inc. v. United States (1961-1962) This case prevented two corporations from consummating a merger by which concentration in the shoe industry, both manufacture and retail, would have resulted in depriving all but the top firms in the industry to compete. It instructed the company not to acquire any further interest in the business, stock or assets of the other corporation and also called for a full divesture of already acquired stocks and assets. Case 2 : Federal Trade Commission v. Superior Court Trial Lawyers Association (SCTLA), et al (1989-1990). A group of lawyers at a meeting of the SCTLA agreed to stop acting as court-appointed counsel for indigent defendants in District of Columbia criminal cases. They boycotted the District government until it agreed to increase their compensation. The government agreed, but after the lawyers returned to work, it filed a case against the SCTLA that it entered into a conspiracy to fix prices and to conduct a boycott that constituted unfair methods of compensation in violation of Section 5 of the FTC Act. The FTC ruled that the boycott was illega l per se and entered an order prohibiting respondents from initiating such boycotts in future. Case 3 : Atlantic Richfield Co. (ARCO) v. USA Petroleum Co. (1989-1990) ARCO, an integrated petroleum company, increased its market share in the retail gasoline market by encouraging its dealers to match the price of USA, an independent petroleum company, which competes with ARCO dealers at the retail level. USA suffered as sales dropped. They filed a case against ARCO for maximum-price fixing with its dealers. The court ruled against ARCO that it had indeed caused a disruption in the market, which should alone determine what goods and services are offered, their prices, and whether particular sellers succeed or fail. Case 4 : Eastman Kodak Co. v. Image Technical Services, Inc., et al (1991-1992) Kodak among other products manufactured and serviced copying and micrographic equipment. When independent service organizations (ISOs) began servicing Kodaks equipment, Kodak adopted policies to limit sales of spare-parts to ISOs, making it more difficult for these ISOs to compete with it in the service market. The court ruled against Kodak that it had used its market power in trying to monopolize the service market. Case 5 : The AT&T Breakup (1974-1982) AT&T was the primary provider of phone services for 70 years. It was alleged that AT&T used profits from its monopoly on local telephone services to suppress competition in the emerging long-distance and telephone equipment industries. AT&T was required to allow competitors to interconnect their phone networks. This meant that competitors could utilize AT&Ts infrastructure and need not build theirs up from scratch. This led to an immediate fall in longdistance telephone rates with companies like MCI taking advantage of this facility. AT&Ts local network was also broken up into 7 smaller companies. Case 6 : United States v. Microsoft (1998) Perhaps one of the most widely publicized antitrust cases in recent history in which Microsoft was alleged to have abused its monopoly power in its bundling of operating system and web

browser sales. Bundling the Windows operating system with the Internet Explorer unfairly restricted sales of competing web browsers like Netscape. In 2000 the judge decided that Microsoft must be broken into two companies, one to produce the operating system and another to produce other software products. But Microsoft appealed the decision. The judges rulings were overturned. In 2001 the U.S. Department of Justice reached an agreement with Microsoft wherein it was decided that Microsoft would share its application programming interfaces with third-party companies and appoint a panel of three people who will have full access to Microsofts source code for five years. Microsoft, however, would then not be prevented from tying other software with Windows in the future. In 2002 the judge accepted the Department of Justice proposal for settlement. The Microsoft case opened up a great amount of debate on antitrust policies in general. It was felt that it was not consumers but competitors who would have benefited from breaking up Microsoft into two companies. Others still maintain that Microsoft abuses its monopoly power and break up as the only solution. European antitrust policy is based on Article 81 and 82 of the Treaty of Rome and attack agreements which restrict competition (like price-fixing and cartels) and also prohibit firms in a dominant position from abusing that position through predatory pricing and so on. Two recent cases further highlight how interventions in markets may be used to increase consumer choice and welfare. Case 1 : The Coca-Cola Case The European Commission has secured commitments until 2010 from Coca-Cola that will benefit consumers by improving competition in the market. These commitments include: no more exclusivity agreements (all outlets can stock any brands of their choice, and Coca-Cola can be sole supplier only in cases when it bags an order through a tendering process); no target or growth rebates; no u sing Coca-Colas strongest brands to sell less popular brands (either through discounts or reservation of shelf space); 20% free space in Coca-Cola coolers for competing carbonated soft drinks. A break of any commitment could mean imposing a fine of up to 10% of Coca-Colas worldwide turnover. Case 2 : The Astra-Zeneca Case Astra-Zeneca pioneered a new generation of medicines to treat stomach ulcers and other acidity problems, for which it received a patent on its drug Losec. However, by giving misleading information to national patent offices it received extended patent protection. Moreover, by selectively deregistering market authorizations for Losec, it prevented import of the generic drug, which requires an existing reference market authorization for the original corresponding product (Losec). Astra-Zeneca was fined Euro 60 million for blocking and delaying market entry for generic competitors to its ulcer drug. These cases will make it easier for students to grasp the nature of antitrust (competition) policy as well as put into perspective the basis for Indias new competition policy. Indias anti-monopoly has its origins in the late 1960s when it was widely believed that Indian industry was controlled by a few industrial families. In 1965 it was found that in 62% of some 1380 products, the top three firms accounted for ~75% of the output in the organized sector. The result of this growing concern was legislation of the Monopolies and Restrictive Trade Practices (MRTP) Act in 1969. Subsequent amendments to the Act were legislated in 1984, 1991 and 2003. The aim of the MRTP Act was to curb monopolies and its objective was pursued through industrial licensing. Overall the MRTP Act has been considered as a failure in curbing monopolies and/or restrictive

trade practices. Not only was it captured by monopolies, but it also was used selectively by the State in targeting specific industries and industrialists. With the 1991 economic reforms in India, it was felt that a shift of focus was essential for rapid economic growth: from curbing monopolies to promoting competition. Ultimately in January 2003, the Competition Act 2002 was enacted. The provision relating to repeal of the MRTP Act has not been notified as yet. Indias recent competition policy are specifically aimed at preventing anti-competitive practices (price-fixing and/or quantity-fixing agreements, bid rigging or collusive bidding, tie-in agreements, refusal to deal, resale price maintenance, etc.) and the abuse of dominance (rather than dominance) by dominant firms practiced through predatory pricing, barriers to entry and applying dissimilar conditions to similar transactions. The Act also includes regulation of combinations (merger/amalgamations and acquisitions) for large corporations. The objectives of the Act are sought to be achieved through the instrumentality of the Competition Commission of India (CCI). The CCI will prohibit anti-competitive agreements and abuse of dominance, and also regulate mergers/amalgamations and acquisitions through a process of enquiry. If a prima facie case can be established it will direct the Director General to conduct an investigation on the basis of which it can pass orders (in case of anti-competitive practices and/or abuse of dominance) including penalties, modify agreements, award compensations and recommend to the Central Government to divide an enterprise. In the case of combinations, the CCI may approve or disapprove of combinations, or it could provide suitable modifications as acceptable to the parties involved. We list below some of the anti-competitive and anti-consumer practices that the Competition Act has to deal with:1. Predatory pricing: weakening or eliminating existing or potential competition 2. Full-line forcing or tie-in sales: forcing customer to buy a full range of products 3. Vertical restraints: forcing customer to buy products from a service provider (eg. mobile phones) 4. Resale price maintenance: setting minimum price and forcing distributors to sell at more than that price. 5. Exclusive dealing: not permitting distributors to deal in other manufacturers products. 6. Collective price fixing 7. Market sharing 8. Manufacturing process control: an agreement between producers not to utilize certain technologies or techniques 9. Limiting technical development 10. Output restriction 11. Veiled quality deterioration: lowering quality of products 12. False representation: misleading actions, giving wrong impressions about price or quality, free gifts, etc. The Competition Act 2002 also deals with mergers, acquisitions and amalgamations and prohibits such actions where they will have detrimental effect on competition. Though forward looking, it remains to be seen how effective the new Competition Act of 2002 performs.

Regulation, as we have seen, has, in a general sense, the same objectives as antitrust (or competition) legislation. However, the term in common parlance is used in an industry-specific context. For instance, we find electricity regulation, telecommunications regulation, insurance regulation, etc. It is common for industries to come under the purview of several regulators at the same time. In addition to regulation of tariffs and quality of services, industries may also be subjected to labour (health and safety) and environmenta l protection regulation. In India, where a strong case for natural monopolies existed, usually utility companies providing water, electricity, telecommunications, transport services, etc., the state ownership route was more common than regulated private monopolies. Rather than maximizing social welfare the outcome of state-owned monopolies in India is now seen as the major cause of Indias poor infrastructure and utility services. The government by taking over the role of provider of services rather than regulator of private industry paid no heed to issues of efficiency, productivity or consumer satisfaction. The result was a complete lack of transparency, no disclosures to the public, financia l mismanagement, lack of private investment in these sectors, lack of competition and complete disregard to consumer interests (Sunder and Sarkar 1999). With economic reforms, however, such policies have undergone change. There is now a positive move towards privatization, commercialization and unbundled organizational models of infrastructure services. The commoditization of infrastructure services brings in the need for regulation of the large-scale enterprises that would be operating in these sectors. We will look at some of the functions of Indian regulation authorities in two sectors; electricity and telecommunications. Electricity sector regulation in India Electricity in India has traditionally been generated, transmitted, and distributed by the stateowned enterprises and State Electricity Boards (SEBs), which were regulated under the Electricity Supply Act 1948 and the India Electricity Act 1910. The utilization of electricity for social and political ends, through subsidies and even free distribution, resulted in heavy losses to these undertakings. Investment suffered and electricity generation has not been able to keep pace with growing demand. Shortages and poor quality of services has plagued this industry. With Indias economic reform focusing on rapid economic growth, electricity will be key factor in meeting these targets. Investment, including private sector participation, can therefore no longer be ignored. To regulate the activities in this sector, the Electricity Regulatory Commissions (ERC) Act 1998 created the Central Electricity Regulatory Commission (CERC). The objectives of the CERC include: Regulation of tariffs of central generating agencies and inter-state transmission of electricity including National Therma l Power Corporation (NTPC), NHPC (National Hydro Power Corporation), POWERGRID, NEEPCO, Neyvile Lignite Corporation, Satluj Jal Vidhyut Nigam, etc. Regulating tariff parameters to encourage competition, efficiency, economical use of resources, good performance, optima l use of resources and safeguarding consumer interests. Licensing of any person for the construction, maintenance and operation of inter-state transmission system. In March 2004 CERC announced that all future projects and new investment in the electricity sector should be structured through a tariff-based transparent competitive bidding process. This would obviate the need for detailed tariff regulation based on the cost plus approach which leads to inefficiencies and lack of incentives for improvement.

Apart from these functions the CERC can also act as an arbitrator and adjudicator for disputes involving generating or transmission companies on matters relating to tariffs. The CERC is also to aid and advise the government on tariff policy as well as policies and procedures for environmental regulation of the power sector. The CERC also prescribes that the State Electricity Regulators be guided by the principles and methodologies prescribed by the CERC. This would lead to greater harmonization, uniformity and certainty in electricity regulation across States. Though a step in the right direction, it is believed that the autonomy and powers of the CERC is limited. Not only does it depend wholly on the government for funding, its recommendatory role is vague. The judicial powers of CERC are also limited; it cannot act as a civil court and can only summarily proceed in the matter of contempt. On the task of regulating qua lity of services, the CERC will receive advice from the Central Advisory Committee (CAC), but what is to be done with this advice is not clear. The ERC Act of 1998 also provided for the creation of state ERCs through an enabling provision. Orissa and Karnataka, for instance, have set up their own legislation. The state-specific legislation (especially Orissa) is more focused and exhaustive. The Orissa Electricity Regulatory Commission (OERC) has assigned the following functions to provide efficient, economical and equitable distribution of electricity: Issue and enforce licenses for generation, transmission and distribution of electricity Determine tariffs and charges Monitor the financial viability of operators Set service standards and monitors compliance Arbitrates in disputes between licensees and between licensees and consumers Aid and advise the government on policies for the power sector Address consumer grievances Promote competition in all sectors of the electricity industry Telecommunications sector regulation in India The Indian telecom industry is perhaps one of the best examples of the benefits of a competitive market for consumers and society as a whole. Up to only a few years ago, getting a telephone connection meant waiting periods of 3 years with a waiting list of more than 3 million applicants. Black market premiums for telephone connections touched thousands of rupees. There was a time when using an official instrument was a fear and even a fax connection required a license. All that has changed; and changed for the better. Telephone connections are available on demand and the range and quality of services is improving by the day companies are in fierce competition for new customers and retaining their existing ones. India is one of the fastest growing telecom markets in the world. In a recently published paper by the Telecommunications Regulatory Authority of India (TRAI), the divergence between the Indian and Chinese telecom markets indicates the vast scope that exists for growth in the telecom industry.

10

Table China Total Revenue from telecom services (US $ billions) Number of subscribers at the end of Mar 2005 (million) Subscriber growth in Basic (% year-on-year) Subscriber growth in Mobile (% year-on-year) HHI Index in Basic service HHI Index in Mobile service 65.3 674.5 15.5 23.0 5800 4000 India 17.78 98.08 8.00 55.00 6700 1600

Prior to reforms, telecom services were provided by the Department of Telecommunications (DoT) under the Indian Telegraphic Act 1885 and the India Wireless Telegraphic Act 1933. Beginning with manufacture of telephone equipment and then value-added services, the telecom industry has gradually been thrown open to private investment. The TRAI has been specially mandated to regulate the telecom sector as a whole. Powers and functions of TRAI can be found on TRAI website. TRAI is considered today as a model regulatory authority in India. Not only has it been allowed to levy fees and charges so as to be independent of government funding, but it has also considered as a civil court and powers to prosecute for contempt of lawful authority of public servants, offences against public justice, and offences relating to documents given as evidence. TRAI tries to ensure transparency in its discharging its functions through public hearings and accessibility of proceedings. This chapter illustrates how a simple economic theory has been put into practice all over the world, including India; for years it served as the raison detre for direct government ownership and management of natural monopolies and now in a liberalized regime it has become the basis for wide ranging economic regulation. The benefits of regulation may justify its role; however, some of the larger issues taken up by economists like Stigler and Posner must not be ignored. The benefits from competition could sometimes be better achieved through competition; regulation sometimes stifling the very competition we seek. Those interested in more information on the Indias competition policy and regulation may visit www.cci.gov.in

11

Session-13 Non-Market Structure Reasons for Market Failure I: Imperfect Information and Adverse Selection In this session we will study: Adverse selection Screening and signaling Separating and pooling equilibrium We have seen that the market system delivers an efficient outcome only under conditions of perfect conditions. The market system fails to automatically deliver such an efficient outcome when the market structure is imperfect (monopoly, monopolistic competition and oligopoly). Competition policy and regulation are seen as a possible way to set right this shortcoming in the market system. There are other reasons for market failure. Microeconomics can help us make sense of two major crises that we face today: the first is the financial crisis and the other is that of climate change and global warming. In the next two lectures, I will give you an introduction to the concepts of asymmetric information and externalities; economic concepts that will shed light on these issues and perhaps even provide possible solutions. Throughout our analysis of the market system this far we have assumed that all parties in a market transaction have access to full information (to prices, quality, availability of substitutes, etc.) free of cost. This condition is rarely met in the real world. The point, however, is that this assumption when not met has a significant impact on the functioning of the market system. It leads to market failure with far reaching (if not, disastrous) consequences. When one party in a transaction has more information about the product than the other party we face a situation of asymmetric information. Sometimes the one who has more information is called the agent and the one with less information is called the principal. This principal-agent problem has been widely studied in microeconomics and examples of it are pervasive; for instance, the market for used cars where the sellers (owner) has more information about the quality of the car than the buyer, in the labour market where the potential employee has more information about herself than the employer, in financial markets where the borrower may know where exactly he will apply the funds and the associated risks than the lender, in corporate organizations where the managers have better knowledge about the companys transactions than the owners (equity shareholders), in insurance markets where the insured has more information about her health than the insurer, and so on. There are two problems that arise from asymmetric information: adverse selection and moral hazard. Adverse selection We take the example of the used car market. Here the seller of a (used) car has a good idea of the quality of the car, whether it had met with accidents, any inherent problems that the car may have, etc. Consider a market with 100 sellers of used cars and 100 buyers. Assume that 50 cars are peaches (i.e. good cars) and 50 cars are lemons (bad cars). The owners know the quality but the buyers dont know whether the cars are peaches or lemons.

Owners are willing to sell a lemon for Rs.10,000/-. Buyers are willing to buy a lemon for Rs.12,000/-. Owners are willing to sell a peach for Rs.20,000/-. Buyers are willing to buy a peach for Rs.24,000/-. Type Lemons Peaches % of Population 50% 50% Value to buyer Rs.12,000 Rs.24,000 Value to Seller Rs.10,000 Rs.20,000

Ideally, a lemon should sell/bought for some price between Rs.10,000/- and Rs.12,000/-. A peach should sell/bought for some price between Rs.20,000/- and Rs.24,000/-. But the buyers cannot observe the quality of the car; they dont know whether the car is a lemon or peach. If (assuming) that the probability of a being a lemon or peach is equal, then a typical buyer would be willing to pay the expected value of a used car, which is: EV = 0.5(24,000) + 0.5(12,000) = Rs.18,000/At this price owners are willing to sell only lemons, not peaches. But if the buyers realize that only lemons are being sold, then the offer price would fall to something between Rs.10,000/- and Rs.12,000/-. Only a market for lemons develops, no peaches get sold in the market in spite of the fact that buyers were willing to pay more than what sellers were expecting. When an individua l tries to sell a bad car on the market, he affects the perception of the average car that the buyers have. This adversely affects the chance for the seller of a peach and in the end results in a situation where peaches are driven out of the market a market failure for peaches. There are two possible ways to correct the problem of adverse selection: screening and signaling leading to two possible solutions (equilibria): a pooling equilibrium or separating equilibrium. Signaling The difference between Screening and Signaling is that screening is a cost imposed by the ignorant party (say, an insurance company) and Signaling (as in the market for used cars) is a cost voluntarily adopted by the knowledgeable party to distinguish types. I. Consider the Lemon model again.

Type Peaches

% of Population 50%

Value to buyer Rs.2,000

Value to Seller Rs.1,500

Cost to Pass Inspe ction Rs.200

Lemons

50%

Rs.1,000

Rs.500

Rs.1,100

In this case, sellers can submit their cars to an inspection agency that will certify that the car is a good car. Owners can sneak lemons past the inspectors, but it costs a great deal of money to prepare the car in order to fool the inspector. EV = 0.5(2000) + 0.5(1000) = 1500 Do we have a pooling and/or separating equilibrium? Clearly, all sellers are willing to sell their cars at the pooling price of Rs.1,500. Owners of lemons have no reason to want to deviate from this, since they benefit from no one being able to distinguish the types of cars. ? p = 1500 1500 = 0 ? l = 1500 500 = 1000

However, owners of good cars have an incentive to deviate from this. If they submit their cars for inspection, they will be able to sell them for Rs.2,000. If they do, the profit from deviating is 2,000 Rs.200 Rs.1,500 = Rs.300. ? p = 2000 200 1500 = 300 ? l = 2000 500 1100 = 400

The profit from not deviating ? p is Rs.1,500 Rs.1,500 = Rs.0. So, peach owners will choose to deviate. But the lemon owners will not choose to pass their cars as peaches; by letting their cars go as lemons they get a profit = 1000 500 = 500 > 400. There is no pooling equilibrium in this case. There is only a separating equilibrium. Profits of owners of lemons if they submit their cars for inspection are: Rs.2,000 Rs.1,100 Rs.500 = Rs.400. Their profits if do not are: Rs.1,000 Rs.500 = Rs.500. So, owners of lemons earn more profits by not deviating. ? p = 1500 1500 = 0 ? p = 2000 1,100 500 = 300 ? l = 1000 500 = 500 ? l = 2000 500 1100 = 400

In this case, the sole equilibrium is a separating equilibrium.

II.

Lets consider a modified example: Type Good cars Lemons % of Population 50% 50% Value to buyer Rs.2,000 Rs.1,000 Value to Seller Rs.1,500 Rs.500 Cost to Pass Inspe ction Rs.600 Rs.1,100

EV = 0.5(2000) + 0.5(1000) = 1500 Pooling equilibrium ? p = 1500 1500 = 0 Separating equilibrium ? p = 2000 1,500 600 = -100 ? l = 2000 1100 500 = 400 ? l = 1500 500 = 1000

In this case, the sole equilibrium will be the pooling equilibrium. Owners of good cars will be unwilling to submit their cars for inspection in either case, so the pooling equilibrium is the only one that exists.

III.

Here is a third case: Type Good cars Lemons % of Population 90% 10% Value to buyer Rs.2,000 Rs.1,000 Value to Seller Rs.1,500 Rs.500 Cost to Pass Inspe ction Rs.100 Rs.1,100

EV = 0.9(2000) + 0.1(1000) = 1900 Pooling equilibrium ? p = 1900 1500 = 400 Separating equilibrium ? p = 2000 1,500 100 = 400 ? l = 2000 1100 500 = 400 < 500 = (1000 500) Note that in this case, both equilibria are possible. In the pooling equilibrium, the common price is sufficiently high that the owners of peaches have no incentive to deviate, and similarly, in the ? l = 1900 500 = 1400

separating equilibrium, the cost for the lemons to pass the inspection is too high for them to deviate. Screening : In the insurance sector, people seek out insurance if they know they are more likely to need it (adverse selection). In this case, there is asymmetric information in that the insurer cannot identify who is a high risk and who is a low risk, but the person seeking insurance does know. Since the insurer can only determine the aggregate risk of all people seeking insurance, it can only charge a single average rate. But since people, in fact, differ in the risks they face, people who face relatively high risks, will be more likely to buy this group insurance, since, for them, it is under priced. Possible Solutions: There are two ways in which the problem of asymmetric information can be at least partially remedied: Screening , and Signaling . These will be mechanisms that allow the ignorant party to obtain information about the market and level out the information asymmetry. Note that since we are assuming free (and competitive) markets, any mechanism must be voluntary. That is, no one has to reveal her type. Therefore, any mechanism must provide at least some of the people an incentive to reveal their type. Example: An illness costs Rs. 100,000 / episode Two types of people, with the following characteristics: Type Healthy People Sick People % of Population 90% 10% Risk of Illness 1/1000 1/100 Willingness to pay Rs.200 Rs.1,500

We calculate the cost to insure each group of people, assuming there is a large population, and the insurance company can spread out the risk. So the average cost to insure healthy people is:

1 1000

Rs.100,000

R s.100 . Similarly, the cost to insure sick people is Rs.1,000. We now

revise our table accordingly: Type Healthy People Sick People % of Population Risk of Illness Cost to Insure 90% 10% 1/1000 1/100 Rs.100 Rs.1,000 Willingness to pay Rs.200 Rs.1,500

Since the insurance company cannot determine who is sick and who is healthy, then it can only

charge one average insurance rate. Since 90% of the population is healthy, the average cost per person to insure the entire population is 0.90Rs.100 + 0.10Rs.1000 = Rs.190. If the insurance company charges exactly its cost to insure, it is said to charge actuarially fair rates. In this case, the actuarially fair rate for the whole population is Rs.190. Normally, we assume that in a competitive market, insurers are constrained by competition to charge rates near to the actuarially fair ones (although we will suspend that assumption in a couple of examples below). Notice that in this case, everyone is willing to pay the proposed rate. The case where everyone can be charged the same rate, even though costs may vary, is called a pooling equilibrium. Consider now a modified example : Type Healthy People Sick People % of Population Risk of Illness Cost to Ins ure 80% 20% 1/1000 1/100 Rs.100 Rs.1,000 Willingness to pay Rs.200 Rs.1,500

Again, if the insurance company cannot determine who is sick and who is healthy, then it can only charge one average insurance rate. Since 80% of the population is healthy, the average cost per person to insure the entire population is 0.80Rs.100 + 0.20Rs.1000 = Rs.280. Now, however, healthy people are unwilling to buy insurance at this rate. In other words, no pooling equilibrium exists. So, in this example, since the insurance company is not going to charge rates at which it will lose money, only sick people will buy insurance. Since the insurance company knows this (or, at least, it will eventually figure it out), and if we assume that the insurance company charges actuarially fair rates, the rate that it will charge is Rs.1,000. Note what is happening. Since the company cannot tell who is healthy and who is sick, it can only charge one average insurance rate. If everyone bought insurance, healthy people would be subsidizing the insurance rates of sick people. Individuals, who know the health risks they face, buy insurance accordingly. Thus, in this case, asymmetric information produces a case where a large majority of the population is uninsured, even though, in a full-information world, insurance companies would be happy to supply them with insurance at a rate they would be willing to pay. Screening Lets revisit our health-insurance model, with a few modifications. In this example, we will assume that an insurance company has enough market power that it can charge rates above actuarially fair rates. Type Healthy People Sick People % of Population 50% 50% Risk of Illness 1/1000 1/500 Cost to Insure Rs.100 Rs.200 Willingness to pay Rs.140 Rs.250 Cost of Physical Rs.40 Rs.150

First, lets see if a pooling equilibrium exists: Average cost to insure the whole population is 0.5Rs.100 + 0.5Rs.200 = Rs.150. But, since healthy people are not willing to pay Rs.150 for insurance, there is no pooling equilibrium. In this case, the insurance company would charge at least Rs.200 and insure only sick people. Now suppose that the insurance company decides to offer two policies. It offers a general insurance policy for Rs.240. Second, it offers an insurance policy for Rs.100 to anyone who can pass a physical. Note that even sick people can pass the physical, but they have to bribe the doctor to be able to do it, and it is very costly to be able to do so. Does this new set of policies form an equilibrium where everyone will be insured? First, consider the healthy people. They are unwilling to buy insurance at Rs.240. However, they are willing to pay the Rs.100 + Rs.40 that would be required to get the new insurance policy. So, they will buy the new policy. Now, consider sick people. Sick people are willing to pay the Rs.240 for the general policy. They would prefer to pay the Rs.100 for the other policy, but it would cost them Rs.100 + Rs.150 = Rs.250 to buy that policy. They are willing to pay Rs.250, but they can get insurance cheaper by just buying the general policy. So, they will stick to the general policy. An equilibrium like this, where different groups are charged different rates is called a separating equilibrium. In this particular case, the insurance company is using a medical test to screen people and determine their types. In general, screening is a cost imposed on the healthy people (here) that is used to distinguish them from the sick people.

Moral Hazard in Finance (Wikipedia) Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well but will be bailed out by the taxpayer if the investment turns out badly. Profit is privatized while risk is socialized. Politicians and regulators representing the taxpayer and voter may regulate financial institutions to lend money to specific voting blocks, special ethnicities, special interests, favored companies, and unionized businesses with favored unions, rather than regulate financia l institutions to lend money in such a fashion as to reduce the risk the taxpayer will have to bail them out, particularly if the bailout is likely to happen after the next election.

Taxpayers, depositors, and other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions. Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default. Securitization of mortgages in America was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the present mortgage securitization system in America, many different debts of many different borrowers are piled together into a great big pool of debt, and then shares in the pool are sold to lots of creditors which means that there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write, that he speaks the language that the papers that he signed were written in, that he was sufficiently sober when he signed them to remember signing them, or even that the paperwork exists and is in good order. Various people suggest that this may have caused 20072008 subprime mortgage financial crisis. In the period 1998-2007 regulators kept and published detailed statistics on the ethnicity and location of those receiving loans, but failed to pay similar attention to their credit worthiness, default rates or vulnerability to a housing downturn. The data that the regulators focused on was more relevant to politically mobilizing voting blocks in particular electorates than to keeping the financial system solvent. Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the 20072008 subprime crisis, however, national credit authorities in the U.S., the Federal Reserve assumed the ultimate risk on behalf of the citizenry at large. Others believe that financial bailouts of lending institutions do not encourage risky lending behavior, since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout will prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financia l Corporation whose valuation plunged during the subprime mortgage crisis. Too big to fail does not protect the shareholders in the too big to fail company against wipeout, but it does protect creditors. AIG shareholders were wiped out, AIG creditors were paid. Too big to fail means that loans to the too big to fail company are risk free, giving it a special privilege to borrow money at easy rates regardless of risk. Consider the following hypothetical situation: Suppose that dangerous loans, lent to borrowers with few assets and an uncertain income, would pay six percent interest, due to risk, whereas

loans made to a too big to fail company would pay two percent interest, since there is little risk. Then the too big to fail company could borrow many times its net worth at low interest, and lend many times its net worth at high interest. Suppose the too big too fail company guarantees, or borrows and lends, one hundred and one times its net worth. Then if all went well, the company would triple its net worth in a year, and if all went badly, its net worth would be wiped out, and the taxpayer would have to pay one hundred times its net worth. Thus the likelihood that a too big to fail company may be wiped out may not provide sufficient threat to deter it from taking excessive risks. Theoretically "good strong regulation" should restrain too big to fail companies from taking excessive risks, but regulators are frequently former senior executives of the firms that they regulate, for example Henry Paulson, and to the extent that regulators come from the political class rather than the business class, for example William H. Donaldson, they may overlook the risks taken by firms that cooperate enthusiastically in treating finance as a distribution of the spoils of political victory between political voting blocks, as Washington Mutual and Fannie Mae were accused of doing.

Session-14 Non-Market Structure Reasons for Market Failure III: Externalities We have seen that the free market system leads to allocative efficiency. What this means is that it is impossible to produce any other bundle of goods where one person can be made better off, without making another worse off. Allocative efficiency implies a Pareto Optimal outcome. Recall our earlier discussion of market equilibrium, where demand = supply. The demand curve is essentially the marginal benefit curve and the supply curve the marginal cost curve. Allocative efficiency occurs when firms produce those goods that are most valued by society. If marginal cost is more than the marginal benefit/satisfaction/utility gained from the consumption then it makes sense to reduce production and release resources for alternative better uses; and viceversa. Identifying Allocative efficiency involves comparing the cost of producing an extra unit with benefit gained from its consumption. In Figure 1, we can make compare three levels of output: Under allocation: when output is 10 units, marginal benefit (MB) = Rs.5, whereas marginal cost (MC) of producing that unit is Rs. 3, so it is worth producing that unit. So long as MB > MC it is worth allocating more resources to this good. Over allocation: when MC > MB. Optima l allocation: when MC = MB = p. Rs. S = MC 5 p 3 D = MB

Figure 1

10

Allocative efficiency requires that price is equal to marginal costs in all lines of production. If this condition is not met, then it is be possible to reallocate resources so that societal welfare can increase. The problem, however, arises with the concept of costs and benefits. Markets take into account only priced costs, i.e. un-priced costs are ignored. In other words, there is a problem when private (priced) costs and benefits are not equal to social (un-priced) costs and benefits. Economists then say that an externality has occurred.

An externality occurs when a decision (to pollute the air or a river) causes costs or benefits to stakeholders other than the person making the decision. I.e. the decision-maker does not bear all the costs or reap all the benefits from his/her action. Figure 2 illustrates externalities that occur in the process of exchange between consumers and firms. Rs. MSC MPC Rs.

MSB MPB Q Figure 2 Examples are plentiful and all around us. For instance, take the case of perfume. When a consumer uses it, there are benefits to those around the user who gain for free. At the same time there may be those located near the firm who bear the brunt of pollution involuntarily. In F igure 2, there is a positive externality at the consumer end, but a negative externality at the firms end. This divergence between private and socia l cost results in a suboptimal allocation of resources as illustrated in Figure 3. Rs. MSC Q

PC MPC PM MPB Q Qs Figure 3 In Figure 3, we have a situation where private costs are not equal to social costs. Take for example the production of steel, wherein the mill dumps hazardous wastes into the river. The full costs of its action may not be accounted for, which means that private costs of producing steel are less than the actual social cost of doing so. Qm

The market system leads to an allocation of resources where MPB = MPC, i.e. (Qm, P m). But from a social point of view this is inefficient, because output and price should be (Q s , P s ). The market system ends up producing too much steel, too cheap. This simple model highlights that pollution is not merely an ethical problem. It is not that firms are inherently greedy, but it is more the fact that social costs are not fully accounted for that causes them to pollute too much. How do we internalize this externality is the key question, i.e. how do we force forms to price the cost of pollution? Perfectly competitive firms have no option but to produce (Qm, P m). If they internalize the cost of pollution (and other do not), they will be forced to exit from the market. This model also throws up more questions: would not a monopoly be better (for the sake of pollution at least) since it would produce less than Q m and at a price higher than P m, i.e. closer to (Qs , P s )? See Figure 4 Rs. MC

MSB MPB Figure 4 Q

Another solution to the externality problem would be to impose a Pigouvian tax on all steel firms so that private costs are raised to the level of actual social costs. Now consider a situation where social benefits > private benefits; an example could be taking a small pox vaccination. Not only do you protect yourself when you take a shot, but it automatically benefits others (since you are less likely to get the disease and pass it on). Figure 5 illustrates this. Rs. MSC

MPC

Figure 5

Too few people end up taking the vaccination. What can be done to correct market failure? The government could step in and subsidize the programme or make it compulsory. In general, the market system tends to overproduce goods with external costs and under-produce goods with external benefits. This is quite the opposite of what will be the best outcome for society as a whole. The problem of externalities becomes severe and critical in the case of public goods. One way that economists classify goods is according to their properties, namely: 1. whether rivalrous, i.e. whether their benefits exhibit consumption scarcity. Once it has been produced, will my consumption be at the cost of yours? 2. whether excludable, i.e. whether ones access can be restricted? Table 1 below gives a classification of goods. Division of goods Excludable Yes Yes Rivalrous No Table 1 Examples of the above include Private: food, clothing, cars, furniture, Common: natural environment Club: private schools, cinemas, clubs, Public : nationa l security eg. army, police, lighthouse, firework displays, street lights, A public good is non-rivalrous and non-excludable. It becomes particularly hard for the market system to produce these goods. The essential problem is that there will be too many free-riders utilizing public goods and not paying for them. The solution is for the state to produce goods like defence services. According to the economist, Ronald Coase, an inefficient allocation of resources of goods with externalities takes place because of a lack of well-defined property rights. If property-rights are well defined, individuals could organize bargains and bring about an efficient outcome by eliminating externalities without government intervention. Coases Theorem is now finding application in the real world as a practical tool for environmental protection. In the U.S. tradable permits have been used to control SO2 emissions. At a global leve l the Kyoto Protocol will introduce tradable pollution rights to nations and compensate third world countries for protecting their natural resources. Club Public Private No Common

It is also important to realize that the issue of externalities should not be reduced to a mere technical one of calculating costs. Rather they reflect ethical views and preferences of an entire population. We need democratic ways of attaching values to costs and benefits. Marxists believe that externalities are not exceptions but are pervasive in a capitalist economy. For one, production is socialized whereas decision-making (and appropriation of income/profits) is privatized. How do we solve this contradiction between socialized production and privatized appropriation of income? A similar problem also occurs with Common Goods or Common Property Resources characterized by non-exclusion but competitive consumption. Important examples include : Logging of forests Over-fishing of oceans Private vehicles jamming public roadways Littering Poaching Noise pollution Collectively, the problem of externalities in the case of common goods has been termed as tragedy of the commons (after Garrett Hardins article in Science 1968). The result is something like the Prisoners Dilemma where individua l pursuing their own self interest may not lead to an optimal social outcome.

Session-15 A Brief Introduction to International Economics I: International Trade Value creation exchange specialization. Exchange between individuals and between regions (including nations). Three ways to service foreign markets: Trade of goods and services Foreign direct investment (production) Contractual Resource Transfers (CRTs) In this introduction to the international market system we focus on trade of goods and services. Benefits of exchange arise when there exists: Absolute advantage Comparative advantage The Law of Absolute Advantage Table below gives the amount of output that can be produced with one unit of labour. Rice Cloth India 10 5 USA 6 10

India has absolute advantage in rice and USA has absolute advantage in cloth. Without there is no trade, India and USA have to produce both, rice and cloth (for their people). With trade, there is no rea son to produce both beca use one can specialize? in what one does best and trade the surplus. When India transfers 1L from cloth to rice, we have (+10R, -5C). When USA transfers 1L from rice to cloth, we have (-6R, +10C). The gains from trade (specialization) are: (+ 4R, + 5C). These can be divided between India and USA so that, theoretically speaking, both are better off. International trade is not about competition (rivalry). It is about how both players can be better off from exchange. The Law of Comparative Advantage The law of comparative advantage articulated by the English economist David Ricardo (17721823) is said to be one of the few ideas in economics that is true without being obvious; it is a remarkable insight that distinguished economists from others. The table below gives the amount of output that can be produced with one unit of labour.

Cloth Wine

USA 6 4

EU 1 2

Now USA is better than EU in producing both, cloth and wine. Will exchange be beneficial to EU? Or will EU be wiped o ut ? This is alwa ys a major concern when we talk about international trade. USA has an absolute advantage in both, cloth and wine, but it has a comparative adva ntage? in cloth. That is, it is more better than EU in manufacturing cloth than wine. Its productivity is 6 times that of EU in cloth (6:1), but only 2 times that of EU in the case of wine (4:2). Similarly, EU is worse? tha n USA in producing both, cloth and wine, but it is less worse than USA in wine than in cloth. We say that USA has a comparative advantage in cloth and EU has a comparative advantage in wine. Now assume that USA is endowed with 4 hours of labour and the EU with 12 hours of labour. The Table below gives below the possible gains from specialization and exchange (trade) as compared to autarky (i.e. no trade), assuming that the labour endowment is divided equally (under autarky) between cloth and wine. Table Under autarky (each country devotes half of its labour endowment to each of the goods). USA (4 labour hours) Cloth Wine 12 8 EU (12 labour hours) 6 12 World Output 18 20

With free trade and specialization according to (against) the law of comparative advantage USA (4 labour hours) Cloth Wine 24 (0) 0 (16) EU (12 labour hours) 0 (12) 24 (0) World Output 24 (12) 24 (16)

It is differences in technology which drives the possible gains from trade in the law of absolute and comparative advantage. It is also pertinent to ask how firms in each of the countries come to specialize in goods according to the law of comparative advantage. The answer is price : prices are related to labour productivity and this will induce firms to gravitate towards the outcome in the above Table. Just a word of caution; the above Table shows possible gains from trade and not the actual outcome.

Comparative advantage and competitiveness It is important that the economic theory of trade does not talk of a win-lose game. Trade makes possible a win-win situation; it is mutually beneficial to (all) trading parties. Sometimes

comparative advantage of countries is confused with the competitiveness of firms. Politicians and the media often speak as if nation-states, just like firms, benefit from competitive advantage and suffer from competitive disadvantage. In the rich countries they complain that they suffer from high wages and cannot compete with poor countries. In poor countries they may compare that due to low labour productivity the race for global competitiveness has been lost. The first point is that when specialization takes place according to the law of comparative advantage some firms (say those producing wine in USA or cloth in the EU) may suffer and even close down. This, however, does not preclude the possibility that the nation as a whole gains. At the same time one must understand that if, for instance, India has a comparative advantage (disadvantage) in software (silk) vis--vis China, a complete closure of silk units may cause a great amount of hardshi p for silk farmers after all they cann ot become software engineers overnight. Firms can close down, countries cannot. That is what the law of comparative advantage tells us. In fact, companies going bankrupt and closing down is actually an indicator that the law of comparative adva ntage may a ctually be working. Isn?t this a possibility with the US auto industry? A competitive firm in another country could actually mean benefit for residents of another country. If Philips (Holland) is becoming competitive it may affect the prospects of Sony (Japan) that doe s not mean that all Japane se consumers are worse off. We are often taken in by arguments against trade in India. Take for instance the import of used cars affecting the local automobile industry. We as consumers can gain from cheaper cars. The automobile industry may lose out, but why should you as a consumer care? And as regards the employment loss, the repair and maintenance of used cars may actually lead to far greater levels of employment in this sector. Specialization according to the law of comparative advantage is also what drives multinational companies to relocate their manufacturing activities in different countries. Low productivity countries need low wages to attract low-skilled labour-intensive activities which ultimately help them raise their level of welfare. Trivia: economists estimate that the American economy is about 1 trillion $ better off because of international trade amounting to an annual gain of approx. $9000 per household. The policy advice derived from trade theory is simple: open up the borders. In this section, we will discuss the following:1. 2. 3. 4. 5. The impact of a tariff on welfare The impact of a quota on welfare Arguments made in favour of protectionism A note on the World Trade Organization The impact of trade agreements on welfare: trade creation and trade diversion

A tariff on imports leads to a definite decrease in welfare in the home country. This can be seen from the table below and Figure 1.

Price Autarky Free Trade Tariff Pd Pw Pt

Demand Qd Q2 Q3

Domestic Supply Qd Q1 Q4

Imports 0 Q1 Q2 Q3 Q4

CS napd nfpw ngpt

PS mapd mbpw mhpt

Income to government from tariff = hgec Deadweight loss = bhc + gef Rs. Sd

Pd h Pt Pw b c d k

a g St e f Sw Dd

Q1

Q2

Qd Imports

Q3

Q4

Figure 1 A quota on imports too leads to a deadweight loss as can be seen from the Table below and Figure 2. Price Autarky Free Trade Tariff Demand Domestic Supply Qd Q1 Q3 Imports 0 Q1 Q2 Q3 Q4 CS PS

Pd Pw Pq

Qd Q2 Q4

napd nfpw ngpq

mapd mbpw mhpq

Income from rents = hcjg Deadweight loss = bhc + gjf

Rs. Sd

Sq Pd h Pq Pw b c d j f Sw Dd k a g

Q1 Figure 2

Q2

Qd Q3 Import Quota

Q4

Some of the common arguments made in favour of protectionism/tariffs include: 1. 2. 3. 4. 5. 6. 7. 8. Government finance Income distribution (domestic producers lose out) Infant industry Employment considerations Strategic trade policy (eg. subsidies to Airbus) Diversification of production growth in skills a n d learning b y d oing?. Risks of over-specialization. National defence, food security, political considerations

The World Trading System There is recognition that free trade benefits all countries but the present system is unequal and the movement to a free trade regime will be a difficult process. However, the only way to move in this direction is through negotiation. Trade Economic Growth Human Development Trade for human development: development does not mean economic development (mere creation of wealth) but to expand the range of choices for every human being. Human development is concerned with enlarging choices and enhancing their outcomes.

Human development therefore means helping people acquire more capabilities, sustainability (choices for future generations), economic growth as a necessary but not sufficient condition, gender equality, participation and human security. We must ask several questions that may not follow from theoretical models alone. 1. Is trade liberalization good for economic growth? No definite evidence exists. Countries like India and China began growing more rapidly in the 80s and 70s respectively. However, trade liberalization followed in each country only a decade later. 2. Does trade liberalization improve gender outcomes? 3. Could trade imply destabilization of political systems? Bottomline: free trade must be seen as a means to an end (human development) rather than an end in itself. Principles of good democratic governance: How and by whom mandates, agendas and forums for discussion and decision-making are chosen and agreed? Who establishes, elaborates and enforces rules? The transparency of the process. The effectiveness of representation. The participation of the weakest numbers. The fairness and consistency of dispute settlement and enforcement processes. These concerns are of crucial importance in the global trade regime. The first round of the General Agreement on Trade and Tariffs (GATT) was held in Geneva in 1947. These were followed by six more rounds: Annecy (1948); Torquay (1950); Geneva (1956); Dhillon (1960-61); Kennedy (1964-67); Tokyo (1973-79) and Uruguay (1986-1994). The first six rounds focused on reducing tariffs. Negotiations were usually bilateral between principal? and substa ntial? suppliers and e xtended to all contracting parties. Till 1964 most developing countries only participated in the negotiations of GATT but few were contracting parties. In 1964 the United Nations Conference on Trade and Development (UNCTAD) was set up to reform the GATT so as to make the system more acceptable to developing countries. The Tokyo Round launched in 1973 agreed upon the application of differentia l and favourable treatment to developing countries, including special mention of the least developed countries. In the Uruguay Round, developing countries urged to agree on bringing trade in services, intellectual property rights and investments into the discussions in return for greater market access for exports of goods. The European Communities and Canada submitted proposals for a new multilateral trade agreement to be administered by a new multilateral trade organization. The idea was to treat goods, services, and intellectual property within a single undertaking and subject to a dispute settlement system and enforcement mechanism.

The World Trade Organization was created in 1995. First, the principles underlying GATT would continue to be respected: 1. Reciprocity and mutual advantage from trade negotiations 2. Non-discrimination: MFN and na tional treatment?, i.e. goods once imported were treated on par with national goods. 3. Tariffs as the only legitimate form of regulating trade. Elimination of non-tariff barriers. 4. Special provisions for developing countries. The WTO is a more intrusive system than GATT in terms of affecting domestic policies. The single undertaking? also make s the agreements broader in scope and less sele ctive. Single unde rtaking? means that member nations ag ree to negotiate and sign all WTO agreements as part of a package deal this incorp orate s the principle of overall reciprocity? rather than on the value of each agreement. The WTO also has stronger compliance measures than GATT. NonCompliance with agr eements ca n be challenged under the W TO?s integrated dispute settlement mechanism and no member can block such actions. As remedial action, WTO can allow retaliation across agreements and sectors. The WTO (formally) is the most democratic of all international institutions. It is a one-country one-vote system (unlike IMF, World Bank and even the UN). Most countries are members (except Russia and some middle eastern countries like Saudi Arabia). Ministerial Conference General Council Councils for trade, services, IP and trade-environment All these entities are made up of official representatives from WTO member states. The last ministeria l conference was held at Doha in 2001 (after the Seattle Conference in 1999). Some Agreements and Issues Agriculture 70% of employment in low income countries, 30% in middle-income and only 4% in developed countries. In some African countries, agriculture also is a major export item and countries are dependent on world prices. Women in Africa account for 80% of food cultivation & production and 60-65% in South and South East Asia. Agriculture is the most hotly contested issue in the WTO. Differential treatment to agriculture is justified by arguments like multifunctionality? (food secu rity, cultural heritage , na tural disaster prevention, la ndscape a n d o pen space amenities, etc.), food se c urity? and food sovereignity?. Examples of 1995 tariff quota rates. Another big problem in agriculture is subsidies. OECD members spend about S1 billion per day in agricultural subsidies. This is more than six times what they spend in aid. Since 1997, meets once in two years. based in Geneva (meets about once a month, trade policy review and dispute settlement body.

subsidies have increased by more than 28%. Half of the OECD spending on agriculture subsidies occurs in the EU, and about 40% by Japan. European Dumping of Milk on Jamaica, and Corn on Mexico and Phillipines. The effect of such protectionism and subsidies has disastrous consequences on human development and poverty in developing countries. Proposals for the future include: Increased market access for developing countries. Reduction of tariff peaks. Elimination of export subsidies by developed countries. Food security and sustainable agricultural development in LDCs (creation of a development box? which recommends greater flexibility in market acce ss for food security crops, protect and enhance production capacity for staple foods, protect agricultura l livelihoods, protect small farmers and rural employment). Commodities 80% of commodity exports from developing countries are agricultural products. 86 out of 144 countries still depend on commodities exports which account more than 50% of their total export earnings. For many countries, export earnings come from just one commodity. For 55 countries, 3 commodities account for more than half their export earnings. Commodities include agricultural primary commodities and minerals (excluding fuel). These include tea, coffee, rubber, tin, sugar, cotton, etc. Demand for commoditie s is more ce ntralized today and sup ply has become more marketized with the abolition of marketing boa rds?. The Europea n Union, China and some newly industrialized countries of S.E. Asia (Malaysia, Indonesia) have been increasing its share in world commodity markets. Between 1972 and 2000, EU share in commodity markets has increased from 28% to 43% and China from 2.4 to 4.3%. Traditiona l commodity exports have been losing importance and prices have been falling. This trend is having a significant impact on human development. Proposals for the future: Bring commodity issue into WTO. Need for diversification and adding value by some developing countries. Control of financing which leads to increased supply and fall in prices. Textiles and Clothing The milestone agreement on textiles and clothing trade was the Multi Fibre Agreement (MFA) signed in 1973 and which was phased out in January 2005. Under the MFA some countries like Bangladesh were able to benefit with exports of ready-made garments increasing from $1 million in 1978 to $4.5 billion in 2001, accounting for more than 75% of Ba ngladesh?s export earnings. It employed over 1.8 million people. The phasing out of MFA is likely to see many winners and losers. The losers may suffer losses in terms of human development, especially on the gender front as the garment industry employs many female workers. Trade-Related Aspects of Intellectual Prope rty Rights (TRIPS) Three areas under TRIPS are:

Member states to provide minimum protection of all intellectual property rights (copyrights, patents, etc.) Broad civil and administrative procedures for enforcement of IPR. Making TRIPS more development friendly and incorporating the need for transitional arrangements, technology transfers and technical cooperation. Example TRIPS and public health. Other Agreements and Issues in WTO The WTO also covers various other agreements and issues like anti-dumping, industrial tariffs, subsidies, Trade-Related Investment Measures (TRIMs), General Agreement on Services (GATS see Annex ), competition policy, standards, transparency in government procurement, and trade and environment policy. WTO and Regional Trading Agreements Perhaps the greatest challenge to a multilateral institution like WTO comes from Regional Trading Agreements. It might seem that RTAs are a step towards global free trade, but in reality they may create several distortions and fail to achieve the objective of global free trade and efficient allocation of resources. An RTA or Trade Bloc could be one of the following:Free Trade Zones (NAFTA, ASEAN Free Trade Area, SAFTA) Customs Unions Single Markets Economic and Monetary Unions Free Trade Zone is an agreement whereby tariffs between members are eliminated, but members are free to levy their own tariffs on non-members. FTAs are politically easy to implement, but administratively complex. Ex. Indirect imports through member states when tariff rates differ. Customs Union is when members agree to a common tariff rate for non-members. It may lead to political difficulties, but administratively easy to manage (ex. banana protocol). The third stage is a single market, with free movement of labour. Finally, we have an economic union with a single currency (European Union). Trade Cre ation and Trade Diversion Suppose cost of production in three counties for apples is as follows: India Apple Cost Tariff (50%) Total Cost 100 0 100 Bangladesh 70 35 105 Australia 50 25 75

Apples are imported from Australia and government earns revenue of 25. Now say an FTA is formed with Bangladesh. No duty on Bangladesh apples. The imports will now from Bangladesh: consumers pay more and no revenue from import tariffs.

India Apple Cost Tariff (50%) Total Cost 100 0 100

Bangladesh 70 0 70

Australia 50 25 75

These are called trade creation and trade diversion effects. The effects of trade creation and trade diversion have also been illustrated in Figure 3 and 4 respectively. We have three countries: the home country, Australia (a), and foreign countries Brazil (b) and China (c). In Figure 3 Brazil is the most efficient supplier of ethanol. Suppose initially Australia has no customs union and imports etha nol from any country with a tariff, t. Then imports take place from Brazil at a price pb + t. Suppose Australia now enters into an agreement with Brazil and decides to do away with all tariffs. It will now import Q 1 Q4 from Brazil at price, pb . Price Tariff CU with B Demand Domestic Supply Q3 Q4 Q2 Q1 Imports CS PS Govt.Rev. gfdc -

pb + t pb

Q2 Q3 Q1 Q4

nf(pb +t) nepb

mg(pb +t) mbpb

Deadweight gain from customs union with Brazil = bhg + fde Price Sd

a Pc + t Pb + t Pc Pb b c d e g f tariff tariff

Q1

Q2
Imports before C U

Q3

Q4

Imports after customs union Figure 3

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In Figure 4 we look at the case where China is the least cost producer of ethanol, but Australia forms a customs union with Brazil and does not levy a tariff on Brazil, but continues to do so from China. In this case, pb < pc + t. Price Tariff CU with B Demand Domestic Supply Q3 Q4 Q2 Q1 Imports CS PS Govt.Rev. fec?b? -

pc + t pb

Q2 Q3 Q1 Q4

ne(pc+t) ndpb

mf(pc+t) mapb

Decrease in producer surplus = pb af(pc + t) Increase in consumer surplus = pb de(pc + t) Gain in CS Loss in PS = Gain of abf + cde = X De crease in government revenue = fec?b? = Y Net gain/loss = X - Y

Price Sd

a Pc + t Pb + t X Pc Pb a b b? f Y e X c c? d tariff tariff

Q1

Q2
Imports before C U

Q3

Q4

Imports after customs union Figure 4

The gains from RTAs need to be carefully evaluated. It would be unfortunate if the world dumps the WTO and believes that a return to bilateral trading agreements would be an automatic substitute to a multilateral agreement.

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