IMPORTANT PORTIONS - 2007

IMPORTANT PORTIONS FOR THE EXAM: The portions to be listed out will have to be located using the syllabus copy. Please note one should be at least familiar with the other portions as well.

Secondly I do not have time to post notes for the balance three topics. They are Stackleberg models, Marginal Productivity Theory - Clark's and Marshall - Hicks versions and Factor Share. They are to be part of self study.

Important Portions:

1. Module 2 : fully except elasticity topics, Bandwagon & Veblen effect and Consumer's Surplus.
2. Module 3 : fully.
3. Module 4 : fully. In fact do not gamble in any topic in this module.
4. Module 6 : fully. Do not gamble in any topic in this module.
5. Modules 1, 5 and 7 : try to be familiar.
6. Study stackelburg models and Product exhaustion theorem (Euleur's Theorem) from the Mathematics course.

OLIGOPOLY - 4

OLIGOPOLY – 4

SWEEZY’S KINKED DEMAND CURVE MODEL

INTRODUCTION:

In many oligopolistic industries prices remain sticky and inflexible. There is no tendency on the part of firms to change price of the commodity. The Kinked Demand Curve hypothesis helps to explain this situation and explain price as well as output determination in differentiated oligopoly. The kink in the demand curve of this model and the difference in elasticity above as well as below the kink portray a particular competitive reaction pattern assumed in an oligopoly market.

KINKED DEMAND CURVE HYPOTHESIS:

Each oligopolist believes that if he lowers the price below the prevailing level, his competitors will follow him and will accordingly lower their prices, whereas if he raises the price above the prevailing level, his competitors will not follow his increase in price. This type of reaction creates a relatively elastic portion above the kink and a relatively inelastic portion below the kink in the demand curve. (Figure 39.1, page - 774, Advanced Economic Theory - Microeconomic Analysis, H L Ahuja, 15th edition, 2006)

a) Price Reduction: If the oligopolist reduces the price below the prevailing price level, competitors will quickly match the price cut to retain their customers. So the increase in sales of the firm will be a proportionate share of the increase in the total quantity demanded. Hence the demand curve is inelastic below the prevailing price.

b) Price Increase: If an oligopolist raises price, customers will crossover to competitors because the latter will have motivation to match the price increase. So the demand curve for the increase in price above the prevailing one is highly elastic.

PRICE RIGIDITY & EQUILIBRIUM OF FIRM:

Under a rigid pattern of competitive behavior of firm in an oligopoly market will have to attain profit maximizing equilibrium at the point of the kink and under the same conditions: (a) MC = MR & (b) ∂²MC / ∂Q < ∂²MR / ∂²MR / ∂Q.

The MR curve corresponding to the kinked demand curve will be a discontinuous line with a broken vertical portion. Greater the difference in the two elasticity of the kinked demand curve, greater the length of the discontinuity. In fact when the relative elasticity of the upper segment increases, the discontinuous gap in the MR curve also increases. The oligopolist firm will be maximizing profits when the MC equals MR in the discontinuous portion of the MR curve depending on the operational relative cost condition. This happens at the prevailing market price and so there will be no incentive to change the price. In fact even when the marginal cost curve shifts upward due to rise in costs, the equilibrium price and output remain unchanged as the new marginal cost curve passes through the discontinuous portion of the MR curve. (Figure 39.2, page - 775)


CHANGE IN DEMAND & PRICE RIGIDITY:

The kinked demand curve model also shows that even when the demand conditions change the price may remain stable. (Figure: 39.3, page: 775 - KINKED DEMAND CURVE: CHANGE IN DEMAND & PRICE RIGIDITY


INCONSISTENCY OF PRICE RIGIDITY:

Price need not always remain rigid even when costs and demand conditions undergo a change. It is rigid for a decline in costs and decrease in demand because the curve becomes less obtuse. The degree of elasticity and inelasticity increases leading to an increase in the gap of the discontinuous portion of the MR curve. As a result MC = MR in the gap and so at the prevailing price itself. Conversely price is instable for an increase in cost and an increase in demand because the curve becomes more obtuse. The degree of elasticity and inelasticity decreases leading to decrease in the gap of the discontinuous portion of the MR curve. As a result MC = MR in a higher point and price fails to remain sticky or rigid.

CRITICAL APPRAISAL:

1. There is nothing in the kinked demand theory which explains how the prevailing price is determined. It only explains why the price is rigid or stable. However Hall’s & Hitch’s version tries to correct this defect by claiming that firms in oligopoly mostly seek normal profits. (Figure: 39.4, page: 777 – FULL COST PRICING AND KINKED DEMAND CURVE)

2. It does not apply to collusive oligopoly where there is joint behavior about price changes and so there is no kink in the demand curve.

3. It applies only to cases of decrease in demand or cost conditions but not in the case of increase in cost or demand.

4. It applies only to demand conditions in a period of depression while in times of boom or inflation demand is likely to increase and the price is also likely to increase rather remain sticky or rigid. The kind of kink observable in times of boom or inflation. (Figure: 39.5, page: 778 – KINKED DEMAND CURVE DURING BOOM AND INFLATIONARY CONDITIONS)

In the above diagram, the upper segment of the curve dc is less elastic and the lower segment is more elastic. The reason is in times of boom, consumption demand is quite high because all sectors are doing well and everyone is earning appreciable income. So firms expect rivals to follow suit in the case of an increase in price but do not expect the same with respect to decrease in prices. Due to this reversal in the elasticity of the curve the MR curve goes through the following:
· The first segment of the MR curve becomes steeper because the AR curve above the kink has become less elastic.
· The second segment of the MR curve becomes more flat because the AR curve below the kink has become more elastic.
· The discontinuity in the MR curve also reverses with the upper steeper segment being below the lower flatter segment.

The above observations mean that prices in the oligopolist industry will not be sticky or rigid as the MC curve in the diagram cuts the MR curve at two points E and F with a lower profit maximizing output or sale of ON and a higher equilibrium profit maximizing output or sale of OT. It is to be observed that opting for ON market share is compensating volume losses through higher prices i.e. prices higher than OP. Similarly opting for OT market share is compensating price losses I.e. prices lower than OP through volume gains. Although it is difficult to predict which option the oligopolist firms will take up, it is certain that price will not remain sticky or rigid at the kind i.e. at OP prices.

STIGLER’S CRITIQUE OF KINKED DEMAND CURVE MODEL:

George J. Stigler rejects the kinked demand curve hypothesis of oligopoly based on his empirical study which showed that oligopolists do not follow one another’s price rises in inflationary periods. But supports of this model argue there is a conceptual distinction between the kink in the demand and the phenomenon of price rigidity. Here they claim that while the former lacks empirical proof, there is substantial empirical evidence for the latter. This means the oligopolistic firm’s expectation of competitors reaction pattern is a real phenomenon with the exception of collusive oligopoly. They further argue that the kinked demand curve model does not explain how a price balance settles into an oligopolistic industry but once it is settled the model quite validly explains how it will remain stable or sticky or rigid. ( Figure: 39.6 – STIGLER’S CRITIQUE OF KINKED DEMAND CURVE MODEL)


CONCLUSION:

Therefore it can be concluded that kinked demand curve model, be it of Sweezy or Hall & Hitch, does not point at what price there is price rigidity but rather at an industry settled price, wherever it is and which surely would have gone through a process of fluctuations, there is price rigidity – i.e. at the kink of the demand or AR curve.

OLIGOPOLY - 3

OLIGOPOLY – 3

PRICING AND OUTPUT UNDER PRICE LEADERSHIP

Introduction:

Price leadership is an important form of collusive oligopoly. One firm sets the price and others follow it. Who will be the price leader is set either formally or tacitly as an informal understanding between oligopolists.

Types of price leadership:

1. Price Leadership by a low cost firm: Low cost firms set the price. Often it is lower than the profit maximizing price of a high cost firms. So high cost firms will not be able to sell their products at a higher price.
2. Price leadership by the dominant firm: Here the price leader is the firm that has the largest market share in the industry. The other firms are small and so incapable of making any impact on the market. Sot eh dominant firm fixes a price that maximizes its own profits and the followers accordingly adjust their output.
3. Barometric price leadership: Here the price leader is an old, experienced and maybe the largest firm in the market. This firm assesses changes in market conditions and modifies price to the best interest of all firms in the industry.
4. Exploitative or aggressive price leadership: Here a very large or dominant firm establishes its leadership through aggressive price leaders that compel others to follow. Such a firm’s market behavior contains the threat of ejecting out other firms in the industry if they do not follow suit.



Price output determination under low cost price leadership:

The following assumptions are made to simplify the analysis:

(a) There are two firms A and B. Firm A has a lower cost of production than B.
(b) The product produced by the two firms is homogenous. So consumers have no preference between them.
(c) Each firm has an equal share in the market and so demand curve facing each firm is the same.

Illustration and explanation:

(See figure 37.2, page 752, Advanced Economic Theory: Microeconomic Analysis by H L Ahuja)

· d = firm’s demand curve. Half of the total market demand curve D.
· MR = marginal revenue of each of the two firms.
· ACA, MCA, ACB & MCB = Average costs and marginal costs of firms A and B respectively. As per assumption (1), the above cost curves of firm A lies below the cost curves of firm B.
· OM & OP = profit maximizing output price of firm A at a point where MCA = MR.
· ON & OH = profit maximizing output and price of firm B at a point where MCB = MR.

As profit maximizing price OP of firm A is lower than that of firm B, in a price war firm A will succeed over firm B. Due to this possibility firm A will emerge as price leader and firm B as price follower. At this juncture firm B being a price follower will also charge OP price and sell OM quantity of output. The total output of industry will OM + OM = OQ. Firm A will be maximizing its profits while firm B will not be making maximum profits. This is because at OP price and OM output, MC = MR for firm A while it is not the case for firm B. In case the products of the price leader and price followers are differentiated then the prices between them will be different. However the difference will be less and have a definite pattern that will be followed by the firms.

Price leadership by the dominant firm:

This situation is a case of one firm being the dominant one as a result of its large market share with followers being smaller firms with a small share of the market. In order to analyze price leadership of this kind the following assumptions are made about the dominant firms:

(a) The dominant firm knows the total market demand curve for the product.
(b) The dominant firm knows the MC curves of smaller firms. Its lateral summation is the total supply curve at various prices.

(See figure 37.3,page – 753, Advanced Economic Theory: Microeconomic Analysis by H L Ahuja)

· DD = Market demand curve for the product.
· At P1 = small firms supply the full quantity demanded. So demand for leader’s product is zero.
· At P2 = P2C is small firms supply and CT market demand is price leader’s demand.
· DL = Demand curve of price leader.
· P2Z = CT of panel A.
· P3 = price at which small firms’ supply is zero and full market demand P3U covered by price leader.
· MR1 = marginal revenue curve of price leader corresponding to demand curve dL.
· OQ (PH) = profit maximizing output of dominant price leader.
· OP = price charged by small firms who are price followers and together produce PB quantity.

In order to maximize profits, the dominant firm not only has to ensure followers charge the profit maximizing price OP, but also has to ensure they produce and sell PB amount of the produce. Otherwise the price leader will have to cover the deficit due to undersupply by price followers and incur additional cost or have excess finished good inventory if followers produce more than their share. This means dominant price leadership would prevail only if there is a definite market sharing agreement among the firms in the industry.

Difficulties of price leadership:

Self and independent study by students. (Advanced Economic Theory: Microeconomic Analysis, by H L Ahuja).

OLIGOPOLY - 2

OLIGOPOLY – 2

Introduction:

Usually there exists some form of tacit or formal understanding among firms of a particular industry in an oligopoly market. Firms choose to follow a uniform price-output policy among them to avoid the uncertainty arising out of interdependence and to avoid price wars as well as cut throat competition. When firms enter into such collusive agreements either formally or tacitly (secretly), collusive oligopoly comes into existence.

Market collusions:

There are two types of market collusions among firms in oligopoly. They are cartels and price leadership. In a cartel, firms jointly fix a price and output policy through agreements. In the case of price leadership one firm sets the price called as ‘price leader’ and others follow it called as ‘followers’. Follower firms follow the price leader even it means deviating from its own profit maximizing objective because it is believed to be in one’s advantage not to compete with the price leader.

Cartels:

It basically refers to a common sales agency that undertakes selling operations for all the firms that are party to the agreement. Now-a-days it takes on various formal or tacit agreements. Due to its competition restraining character their formation is treated as illegal in many countries.

Formal collusion agreements maybe of various forms. One of it is called “Perfect Cartel”. In this case members firms completely surrender their rights of price and output determination to a central administrative agency. The goal of this authority is to achieve maximum joint profits for the member firms. On account of its competition restraining character cartels have been treated as illegal in several countries.

In a perfect cartel, the output quota of each member is decided by the central administrative agency. The goal is to keep total cost of total ouput by the industry minimum. This objective can be achieved when various firms in the cartel produce their outputs at equal marginal costs.

Illustration and explanation:

It is already understood that the objective of the cartel is to maximize joint profits of its members. Given this the process of price output determination maybe analyzed in the following paragraphs by assuming the cartel to consists of two firms.

First the cartel will estimate the aggregate demand curve for the industry. As an aggregation of the industry consumers’ demand it will be a downward sloping curve. The Marginal Revenue curve showing the cartel’s additional revenue of its additional output and sale will be below the demand curve DD. The Cartel’s Marginal Cost curve MCC is the horizontal addition of marginal cost of the two firms i.e. MCA + MCB = MCC.

The cartel maximizes joint profits at industry output level where MR = MCC i.e. OQ output at price level QL (or) OP. (See figure 37.1, page – 750, Advanced Economic Theory: Microeconomic Analysis, H L Ahuja). Given this total output OQ fixed by the cartel, it will now allot this output to firms A and B in such a way that both the firms have the same (equal) Marginal Cost. This is done by extending point R horizontally to the two firms. Also the two firms take the cartel’s decided price as given and manages its marginal cost as well as its average cost in a such a manner that MC is same for both firms and th respective average cost will indicate the profit or loss faced by the firms. In the figure it is:

OQ1 = equilibrium output of firm A.
OQ2 = equilibrium output of firm B.
PFTK = supernormal profits of firm A.
PEGH = supernormal profits of firm B.

However in a perfect cartel arrangement division of profits among the firms depends on ‘relative bargaining strengths’ of firms within the cartel. It is not necessarily proportionate to the individual output of each firm. In fact output quota allocation is on the basis of minimizing costs and not on the basis of determining profit distribution.

Market sharing cartels:

Perfect cartels are quite rare in the real world. The more prevalent one is loose cartels in which there is market sharing by firms. There are two methods of market sharing: (a) Non – price Competition and (b) Quotas.

Market sharing by non-price competition: In this arrangement a uniform price is agreed upon by the cartel. Usually it will be a price that will ensure some profits even to high cost firms. With each firm in the industry taking the uniform cartel price as given, they are free to produce their won profit maximizing output and also engage in non-rice competitive market strategies like advertising to promote their sales. However these cartels are quite unstable because low cost firms are heavily tempted to try price cutting strategies. They engage in it tacitly by providing secret price concessions to their buyers. But eventually this gets exposed, price war follows and the cartel breaks down.

Market sharing quota: Here firms agree to an output quota arrangement that each firm would produce and sell at an agreed price. In case of homogenous products and equality of costs among firms, a monopoly solution emerges. If there are cost differences, output shares agreed upon are also different between the firms. Although ratio of output sharing should be fixed according to each firm’s past sales and productive capacity it ultimately depends on each firm’s bargaining power and skill, because the two criteria can be manipulated by firms. Region wise market division arrangement is also present in cartels. Whatever the arrangement followed in a cartel, cost difference between firm’s and free entry of new players into the oligopolistic industry create instability in the carte.

OLIGOPOLY - 1

OLIGOPOLY – 1

Introduction:

Oligopoly is the most important form of imperfect competition and also the most prominent of market relations seen in the real world. It is defined as a market made up of a few but not many sellers. Its basic form is duopoly. It is of two kinds namely (a) Pure oligopoly where sellers deal in homogenous products and (b) Differentiated oligopoly where seller deals with differentiated but close substitute products.

Characteristics:

Unlike other market forms, oligopoly is a unique market structure. Its most important characteristics are as follows:

1. Interdependence: It is the most important feature and is the result of the presence of a few competitors. Each firm has to consider the product’s market demand along with competitors’ reaction to one’s market strategy.
2. Advertising and selling costs: High market rivalry due to strong interdependence, forces firms to engage in different shades of aggressive as well as defensive market strategy. This is done to gain or prevent fall in one’s market share.
3. Group behavior: There is a concerted form of competition (or) rivalry among firms in oligopoly. The demand curve is neither the result of mass seller behavior nor individual seller behavior. So traditional profit maximizing goal is not necessarily a satisfactory dimension of equilibrium for firms in this market.
4. Indeterminate demand curve: Due to interdependence between firms, no single firm can assume that rivals will not react to one’s market strategy behavior. Every firm will react to another’s price changes and so the demand curve is never stable but keeps shifting.

Fluidity of price & output:

A definite theory of price-output determination is difficult to evolve because of interdependence between competing firm’s market behavior and so an uncertain pattern of rival’s reactions. Different market behavior patterns are possible. It ranges from co-operative behavior (collusive oligopoly) between firms to cut throat competition among them (non-collusive oligopoly). Hence there is an indeterminateness of a theoretical framework of oligopoly price-output determination.

Interdependence between firm’s behavior is the most important reason for indeterminateness as to a theoretical framework of oligopoly. Rival’s reaction to each other’s market strategies is most evident as price reaction. There is also uncertainty about direction and intensity of rivals’ reaction. As a result market demand curve deeps shifting and cannot be easily determined. There is an “interplay of anticipated strategies and counter strategies which is tangled beyond hope of direct analysis.” (William J. Baumol, Economic Theory & Operational Analysis, 3rd edition).

In other words it is difficult to locate a definite shape of the AR and MR curves for a firm in an oligopolistic market. There is an infinite range of market situations. The equilibrium logic of the MC = MR and the slope of the MC being greater than slope of MR curve, cannot be applied to an individual oligopolistic firm without making additional qualifying assumptions. This is true be it collusive or non-collusive oligopoly.

A second reason for the lack of clarity with respect to a theory of oligopoly market is the uncertainty about the firm’s goals. The possibilities are reasonable stable profits over a long time (or) sales maximization or merely ‘satisficing’ market behavior. There is no single determinate solution of the oligopoly problem. The data available permits two or more or perhaps an infinite number of answers to price and output determination by firms in an oligopoly market. Hence economists claim ‘indertminacy’ about a theory of the firm in an oligopoly market.

Putting in another way, there are a number of determinate solutions depending on different assumptions that have been adopted. Four approaches emerge according to four fundamental assumptions adopted in the models. The first perspective is a model that ignores interdependence among competing firms’. Each firm operates on the belief of constant output and price policy with respect to its competitors. This automatically makes the demand curve of a firm determinate. Classical models of duopoly of Cournot, Edgeworth and Bertrand fall in this category.

The second perspective is a model assuming an oligopolistic firm’s ability to predict the reaction patterns and counter moves of rivals. Chamberlain’s model and Sweezy’s kinked demand curve model fall in this category. The third perspective is models that assume tacit or formal collusive behavior related to price or supply and price leadership behavior by a firm, both of which are consequent to the characteristic of ‘interdependence’ in an oligopoly market. The fourth perspective is a model adopting the theory of game. Here the firm does not assume anything about the competitors’ reaction pattern. Rather it calculates and speculates the optimal moves by rival firms. Accordingly a firm adopts its strategies. Neumann and Morgenstern model fall in this category.

MODULE 6 - WELFARE ECONOMICS

WELFARE ECONOMICS

INTRODUCTION:

Ø Positive microeconomics attempts to explain determination of product & factor prices & on this basis resources allocation being made in a private sector economy.

Ø Welfare Economics brings in Economic Efficiency into this process.

Ø An attempt to establish criteria to evaluate alternative economic states and help policy formulation to achieve economic efficiency i.e. maximize social welfare.

Ø Establishes criteria to meet the social rationality of economic activity.

Ø Social rationality: activity ensuring optimum allocation of resources and therefore guaranteeing maximum social welfare.

Ø Welfare economics considers interrelationship or interdependence between various parts of the economy such that changes in resource allocation in one part of the economy affect all other parts of it.

Ø Greatest challenge is to objectively measure social welfare because interpersonal comparison of utilities or welfare is very subjective.


OVERVIEW OF THEORIES OF WELFARE ECONOMICS

PARETO OPTIMALITY:

Ø Any change that makes at least on individual better off without making any other worse off is an improvement of social welfare.

Ø Increase in social welfare: changes that make everyone in the society better.

Ø Decrease in social welfare: changes that make no individual better off while it makes at least one individual worse off.

Ø Pareto optimal economic state: resource allocation wherein a rearrangement to make one better off is impossible without making another worse off.

Ø The basis of welfare economics.


NEW WELFARE ECONOMICS:

Ø Pareto optimality excludes interpersonal comparison of utility.

Ø Does not include changes in economic state where some persons are better off and other worse off.

Ø Compensation principle tries to judge such situations.

SOCIAL WELFARE FUNCTION:

Ø Propositions of welfare economics need to have explicit value judgements.

Ø Otherwise useless.


CONDITIONS OF PARETO OPTIMALITY

ECONOMIC EFFICIENCY:

Ø Neoclassical & earlier versions: social welfare a sum total of cardinally measurable utilities of different members of society.

Ø Pareto’s objections: (a) cardinal utility & its independent additive nature; (b) need to take away welfare economics from interpersonal comparisons of utilities to impute objectivity into it.

Ø Pareto’s maximum social welfare: (a) based on ordinal utility; (b) keep it free from value judgements.

Ø Pareto optimum, merely a necessary condition of maximum social welfare not a sufficient condition.

PARETO CRITERION:

Ø Any reorganization of economic resources that does not harm anybody and makes someone better off, indicates an increase in social welfare.

Ø Can be explained and illustrated using Edgeworth Box and Utility Possibility curve. Explain diagrams 57.1 & 57.2 on page 1074.

Ø Edgeworth box: tangency points of various indifference curves of two individuals of the society are Pareto Optimum points and locus of these points is called, “Contract Curve” or “Conflict Curve”.

Ø Utility possibility curve: locus of various combinations of utilities obtained by two persons from the consumption of a particular bundle of goods. Movements: Q to R – B’s welfare increases, A’s remains same; Q to S – A’s welfare increases, B’s remains same; Q to D – welfare of both increase. Fails to explain movement beyond RS range like from Q to E: B’s welfare increasing & A’s welfare decreasing.

MARGINAL CONDITIONS OF PARETO OPTIMUM

Ø Competition leads society to an optimum position. Has not given mathematical proof or derived marginal conditions to establish it.

Ø Lerner & Hicks derive marginal conditions to attain Pareto Optimum.

Ø Assumptions: see page 1075.

Ø Derived seven marginal conditions. Also can be called necessary conditions of Pareto Optimum.

Condition – 1: Optimum distribution of products among consumers: efficiency of exchange -

Ø MRS between any two goods must be the same for every individual who consumes them both.

Ø MRS: amount of one good necessary to compensate for the loss of a marginal unit of another to maintain a constant level of satisfaction.

Ø Unequal MRS of two goods between two individuals: better to have exchange between them of the goods so that satisfaction of both or one increases without decreasing satisfaction of the other.

Ø Explained use Edgeworth Box in diagram 57.3 on page 1076.

Ø Movement from a point off the contract curve to a point on the relevant segment of it increases social welfare.

Ø All IC tangency points on the contract curve are Pareto optimum points but movement along it increases one person’s welfare at the cost of decreasing the others.

Ø Pareto criterion does not identify the best of the optimum on the contract curve.

Condition – 2: Optimum allocation of factors – efficiency in production –

Ø MRTS between any pair of factors must be the same for any two firms producing two different products and using both the factors to produce the products.

Ø Using factors of production such that it is impossible to increase output of one good without decreasing the output of the other or of increase the output of both by any reallocation of factors of production.

Ø Explain diagram 57.4 on page 1077.

Condition – 3: Optimum direction of production – efficiency in product mix –

Ø Relates technical production conditions and state of consumer’s preferences. Also called overall condition of Pareto Optimality or overall condition of Economic Efficiency.

Ø MRS between any pair of products for any person consuming both must be the same as the marginal rate of transformation (for the community) between them.

Ø Social welfare is maximized when in the product mix produced in society matches what consumers would like to have (consumer preferences as shown in the indifference curve).

Ø Can be explained and illustrated in two ways: (1) match between consumer’s indifference and society’s transformation curve; (2) drawing the Edgeworth Box within the space underneath the chosen point on the transformation curve.

Ø Explain diagrams 57.5, 57.6 & 57.7 on pages 1078 & 1079.

Condition – 4: Optimum degree of specialization –

Ø To determine optimum level of output of every product by every firm.

Ø The Marginal rate of transformation between any two products must be same for any two firms that produce both the products.

Ø Similar MRTXY between goods in two firms implies any reallocation of resources between the two goods would not lead to increase in the combined output of either goods or lead to the increase in the output only with output loss of the other.

Ø Transformation curve: locus of various combinations of two goods which a firm can produce by fully utilizing its given resources. Slope of the curve measures MRT between the two goods.

Condition – 5: Optimum factor product relationship –

Ø The marginal rate of transformation between any facto and any product must be the same for any pair of firms using the factor and producing the product.

Ø MRT of factor into a product: how many units of a product are produced by an additional unit of a factor – it marginal product.

Ø Marginal product of producing a product to be same for all firms producing the product.

Ø Unequal marginal product means transferring inputs across the outputs would increase output of both products and one of it without increase in the quantity of input used.

Ø Explain diagrams 57.9(a) & 57.9(b) on page 1087.

Condition – 6: Optimum allocation of a factor’s time

Ø The marginal rate of substitution between ‘leisure and work for money income’ by the factor should be equal to the marginal rate of transformation between factor’s time and the product.

Ø Greater MRS between leisure and income of the factor compared to MRT between factor’s time and product, increase in individual satisfaction by transferring a factor unit’s time from work to leisure.

Ø Greater rate of exchange between leisure and income vs. lesser rate of exchange between factor’s time and producing output – better to move away from work to leisure.

Ø Greater value attached to leisure than productive work.

Ø Explain diagram 57.10 on page 1083.

Condition – 7: Inter temporal optimum allocation of money assets –

Ø Relates to lender and borrowers of capital or money assets.

Ø Rate of interest at which lender is willing to lend should be equal to the marginal productivity of the financial to the borrowers.

Ø Technically stated it is equality of the marginal rate of substitution between money funds at any pair of times (present vs. future income and consumption) must be the same for any two individuals (one maybe the lending firm and the other maybe the individual borrower).

Ø The comparative value of present income or consumption to future income or consumption must be the same for both the individuals – both borrower and lender.

Ø Explain diagram 57.11 on page 1084.

Second order & total conditions

Ø All indifference curves are convex to the origin.
Ø All transformation curves are concave where the marginal conditions are satisfied.

Conclusion:

Ø Pareto optimality assumes given income distribution.

Ø Change in income distribution leads to change in product mix in the production process and change in factor allocation between products.

Ø No criteria by Pareto to judge whether new optimum better or worse than previous optimum.

Note: Critical evaluation of Pareto criterion and Pareto optimality to be independent self study.


NEW WELFARE ECONOMICS: COMPENSATION PRINCIPLE

INTRODUCTION:

Ø Although Pareto laid the foundation of modern welfare economics through optimality concept, he tried to keep it free from a comparison of welfare between individuals and from value judgements.

Ø In terms of the Edgeworth Box technique all points of equal substitutions between individuals are optimum even though one would have an absolutely higher level of welfare by being on a higher indifference curve and the others have an absolutely lower share of welfare by being on a lower indifference curve. (See again the Edgeworth Box diagram 57.1 on page 1074).

Ø Putting in another way Pareto could not explain economic changes specially those resulting from policy which makes some better off and others worse off.

Ø Problem due to his unquestioned acceptance of a given socio-economic structure of income distribution.

Ø Kaldor, Hicks and Scitovsky tried to address this Pareto Indeterminacy by evolving welfare criteria to address economic reorganization which benefits some and harms others.

Ø The criterion is called “Compensation Principle”, as it involves socio-economic bribery of the loser by the beneficiary not to stall the economic reorganization process or the socio-economic bribery of the beneficiary by the losers to stall the economic reorganization that accentuates unequal distribution of welfare changes.

Ø Assumptions: independent individual satisfaction, no externalities from consumption & production, constant individual tastes, production & exchange issues separate from distribution issues & ordinal utility ranking.


KALDOR – HICKS WELFARE CRITERION: COMPENSATION PRINCIPLE


v An economic reorganization or policy change that makes some people better off and others worse off, can increase social welfare if those who gain from the change could compensate the losers and still be better off than before. (Kaldor’s Version)

v Putting it in another way if the losers cannot successfully bribe the gainers not to change from the original situation.

v Explained and illustrated by the ‘Utility Possibility Curve’, diagram 58.1 on page 1097.

v Movement from point Q to T makes B better off and A worse off. It involves interpersonal comparison or difference in the distribution of welfare between A and B. So it cannot be explained by Pareto Optimality Criterion as to whether there is increase or decrease in overall social welfare.

v Compensation Principle: B can compensate A by moving from point T to R, result being A’s utility same as in Q but B’s utility still greater than A’s utility.

v Meaning: Economic reorganization benefits B and harms A. B compensates A and puts him back to original welfare and still gets a bigger share of welfare consequent to the economic or policy reorganization. So the sequence is: policy change – gainers & losers – gainers compensate losers through subsequent income redistribution – losers back to status quo and gainers still gainers.

v Existence of the possibility of compensation is enough. Need not be necessarily be made. Merely a shift to a more efficient position and not necessarily involves overall or absolute increase in output or real income. Only an act of efficient redistribution.

v Illustration: Both A & B could move to a superior position G benefiting both – overall economic development & increase in overall welfare. Then mere redistribution can take B to point T and again through compensation down to point R with A in original welfare position. (Diagram 58.1 on page 1097).

v Compensation principle can also increase social welfare when individuals move from a point on a lower utility possibility curve to a point on a higher utility possibility curve due to economic change.

v Explain diagram 58.2 on page 1098. Movement from point Q to R: B loses & A gains. On compensation A moves to point R which puts B in old utility position as in point Q and still A is still better off.


SCITOVSKY PARADOX:

v Statement: If according to a welfare criterion position B is shown to be revealed preferred to position A, then by the same prince it should also be ensured that position A must never be preferred to position B.

v Explain diagram 58.3 on page 1099. Movement from point C to D and to point F through compensation satisfied Kaldor-Hicks criterion. Also movement from point D to C and to point E through compensation also satisfies Kaldor-Hicks criterion. Since to and fro movements in welfare positions satisfies Kaldor-Hicks criterion, it is a paradox, named as ‘Scitovsly Paradox’.

v Scitovsky paradox occurs when two utility (higher & lower) possibility curves intersect.

SCITOVSKY’S DOUBLE CRITERION OF WELFARE:

v Rules out the possibility of contradictory results in Kaldor-Hicks criterion.

v The double criterions are: (a) gainers of an economic reorganization through compensation persuade losers to accept the change; (b) economic reorganization policy simultaneously does not allow opportunity for losers to persuade gainers to remain in the original situation.

v Explain diagram 58.4 on page 1100.

v Putting it another way in the compensation principle gainers bribe the losers to accept the change and along the policy should not provide an opportunity for the losers do be able to reverse bribe gainers to accept status quo.

v Ideologically ‘Scitovsky’s Double Criterion’ appears dogmatic (dictatorial) with all possibilities for a reversal or review closed. It also assumes that policy makers and policy lobbyist are always committed to some equity in welfare distribution.

v Double criterion fulfilled only when the two utility possibility curves are one above the other and do not intersect each other.

v Critical analysis of compensation principle: self – independent study by students.

SOCIAL WELFARE FUNCTION AND THEORY OF SOCIAL CHOICE


INTRODUCTION

Different welfare theorists have failed to provide a satisfactory solution to the problem of maximization of social welfare. Externalities and market imperfections impede achieving Pareto criterion. Also Pareto Optimality does not explain unequal share of welfare benefits and so actually is not able to address the issue of benefit to one social section along with loss to another. Even the compensation principle addressing this lacuna in Pareto Optimality and simultaneously claiming to be value judgement free could not be amenable to implementation. In fact Kaldor and Hicks did not consider it necessary to actually execute the redistribution but claimed fulfillment of their criterion just by its presence.

Addressing the preceding issues Samuelson and Bergson evolved the Social Welfare Principle of Welfare Economics. They brought out their reasoning by first accepting Lionnel Robbins’ (a staunch positive economist) criticism of the subjectivity of welfare economics because of the need to make interpersonal comparison of utilities (or welfare) which depends on value judgements. But at the same they also asserted that without such value judgements impact of economic policy cannot be evaluated. So Samuelson and Bergson posited welfare economics as a normative study of economics, which can be scientific despite inevitable value judgements.

BERGSON – SAMUELSON SOCIAL WELFARE FUNCTION:

Social Welfare is an ordinal ranking of society’s welfare. It is a function of the utility level of all individuals in society. Its general and basic form is as follows:

W = W (U1, U2, U3, ………… UN) - where W = Social Welfare and U1, U2, U3 ……. UN = ordinal utility indices of different individuals of the society.

Social welfare functions and value judgements: In the social welfare there are explicit value judgements which are actually ethical notions. The form of the social welfare function is decided by the value judgements on which it is based. So when value judgements change social welfare functions also change. There is no standardized or unique welfare function in this model. Further the ethical framework could be obtained outside of economics either through democratic process or dictatorship. Welfare economics has now allowed normative value judgements to be imputed into economic analysis through the back door by both accepting its inevitability for understanding desirableness of welfare distribution of policy and by proposing that these value judgements need not necessarily made by economists. While in a positive sense this makes economic science more interdisciplinary it could free ride on the knowledge accretion of other academic disciplines of knowledge. The convenience available in economics to do this is just to take ethical notions given outside the so called boundaries of economics as given and simply convert them into assumptions.

Social welfare function is individualistic: The Social Welfare function takes evaluation of welfare as dependant on the individual who would be judging it using economic variables. An individual’s ordinal utility level depends on his own consumption of goods and services based on his tastes but not on others. However any value judgement used to build the social welfare function must be consistent and transitive i.e. if situation A > situation B and situation B > situation C, then situation A > situation C.

Explanation & illustration of social welfare function:

Refer figure 61.1 on page 1123. The social welfare function is explained and illustrated using social indifference curves also called welfare frontiers. A social indifference curve or welfare frontier is a collection of combinations of utilities of say two individuals A and B, which give equal level of overall social welfare. Each individual will have different specific levels of utility or welfare but on the whole it sums up to a given level of welfare. The properties of the social indifference curve are similar to indifference curves. So the slope of the slope of the social indifference is the sacrifice of one individual’s utility for a given increase in the other’s utility. Similarly economic progress (growth or development) would push both the individuals to a higher curve resulting in an overall increase of social welfare.

Fairness and equity which are value judgements are seen in the shape of the social indifference curves. For example in the diagram movement from point R to Q means B’s utility increases and A’s utility decreases but the social welfare remains the same because both the points are on the social indifference curve W1. Given that W1 was in the very instance constructed upon a normative model of values, it follows that A’s loss of utility is equal to B’s gain in utility. By being able to make such an interpretation of the points in the curve, social welfare function has now incorporated interpersonal comparison of utility and also value judgements. In the same even movements between the curves can also be normatively rationalized. For example movement from point Q on W1 to point S on W2, means A’s gain in utility is greater than B’s loss of utility and still overall social welfare has moved to a higher level.

Maximum Social Welfare: Point of Constrained Bliss:

On the basis of the social welfare concept, social indifference map and grand utility possibility frontier, a unique point of maximum social welfare can be identified. This ultimately solves the indeterminacy of the Pareto criterion. (The Grand Utility Possibility Frontier is defined as a locus of various physically attainable utility combinations of say two persons when the factor endowment, state of technology and preference of individuals are given). The social indifference map shows the individuals utility combinations society would like to attain while the grand utility possibility curve shows the individuals utility combinations society can attain. When the two are superimposed a unique social welfare point is attained at the point of tangency between the social indifference and the grand utility possibility frontier. Refer diagram 61.2 on page 1125.

· W1, W2, W3 and W4 = social indifference map.
· V V’’ = grand utility possibility frontier.
· Q = point of tangency between W3 & V V ‘. Point of constrained bliss, as it is the optimum welfare attained within factor & technology constraints.
· W4 = social indifference curve unattainable given the present facto and technology constraints.
· R = being on the grand utility possibility is economically efficient when compared to point S which is within O V V ‘space, even though the latter is on a higher individual social indifference curve. This means what socially acceptable is not necessarily economically efficient. It brings out the conflict between efficiency and equity. Sometimes it is in social interest to choose inefficient allocation of resources, if the optimum option is unattainable. That is to say to achieve equitable distribution of welfare i.e. to satisfy the objective of social equity, some inefficiency in resource allocation is accepted.

The following features of Bergson-Samuelson’s social welfare function are to noted:

1) It is based on explicit value judgements and involves interpersonal comparisons of utility in ordinal terms.
2) The maximum social welfare position is completely determined as a result of the introduction of value judgements regarding distribution of welfare among individuals.
3) There is no unique value judgement basis for the function.
4) Once the social welfare function has been decided upon by value judgements, the maximization technique used to obtain the maximum social welfare position at which allocation of resources is Pareto optimum and also the distribution of goods and services is equitable. Thus, both efficiency and equity are achieved so that social welfare may be maximized.
5) Used along with the Pareto optimality analysis the concept of social welfare function enables us to find a unique solution generally called the point of bliss and which combines economic efficiency with distributive justice.

Note: The critical evaluation of the function is independent study by the students.


ARROW’S THEORY OF SOCIAL CHOICE

1) Sources of and method of inducting value judgements into the social welfare function is unclear.

2) Through reasonable democratic procedures it is difficult to add up each individual’s preference into a social preference. (Arrow).

3) Social ordering does not reflect every individual members ordering. (Arrow).

4) An individual’s preference for a social state depends on: (a) commodities – including those of other; (b) collectives – municipal services, parks etc.

5) So there could be a difference between an individual’s values (value judgements) and his / her tastes.

6) Therefore Arrow claimed that there is a difference between what an individual likes to have and what an individual should have.

7) So every individual’s values itself could have a deep private motive to be accomplished.

Arrow’s condition of Social Choice (Arrow’s Theory of Social Choice):

1) They are reasonably necessary conditions of a social state that reflects and represents preferences of all individuals in society.

2) Sources of Social Choice: (a) Dictator: compulsion (easiest); (b) Traditional Society: custom & tradition; (c) Democracy: voting (most difficult).

3) In a democracy it is very difficult to have social choice that exactly tallies with individual preference ordering of social conditions because: (a) no two individuals are the same; (b) every individual is free to choose his preferred social state.

4) Such an ideal condition could come about only if five necessary conditions are satisfied. (Arrow’s Theory of Social Choice).

5) Such an ideal condition does not get fulfilled in real life. At least one of the five conditions is not fulfilled or is violated. This claim and the validation of this claim is called “Arrow’s Impossibility Theorem”.

Arrow’s Theory of Social Choice:

1) Condition 1 – Transitivity (or) Consistency: Social state A > Social State B; Social State B > Social State C; then Social State A > Social State C; provided Social States A, B & C can be related to each other in terms of preference or indifference (Principle of Connexity).

2) Condition 2 – Responsiveness to individual’s preferences: Social ranking of choices must respond positively to individuals’ ranking of choices including changes taking place in it. A sub-group’s choice of alternative A more intense than before compared to alternative B and no one’s preference for A has diminished, then it should remain that A > B. Discrimination deliberately reduces the social desirability of a social sate even if some individuals’ preference for it increases. Putting it in layman’s terms what the group likes must be similar or representative of what the individual likes. This view implies the idea of consensus (or) popular acceptance, fundamental to a free market economy.

3) Condition 3 – Non imposition: If B is not better than A for no one, and A > B for even a minority, then social choice should be A > B. Choice of A makes some better off but no one worse off. But rejection of A will make some worse off without making anyone better off (Pareto Criterion). Also social choice should not be externally decided.

4) Condition 4 – Non Dictatorship: Social choice to be determined democratically by voting.

5) Condition 5 – Independence of irrelevant alternatives: Social preference between two alternatives determined exclusively by individual’s preference for the alternatives and not affected by alternatives that are not available. If A, B & C are available at one time and A > B > C, so A > C. If C by is unavailable then it should not be B > A. This follows from the consistency (or) transitivity condition by which individuals do not violate or reverse preferences or choices due to an alternative becoming immediately irrelevant.

Note: Arrow's Impossibility Theory is also taught in Public Economics. Hence for this semester it will not repeated as lecture in the Micro Economics course (November 1st, 2007).