i

UNIVERSITY OF RWANDA
COLLEGE OF BUSINESS AND ECONOMICS
SCHOOL OF ECONOMICS
ACADEMIC YEAR: 2017-2018
Level III ECONOMICS

COURSE:MICROECONOMICS II

Prepared by Mr. HABYARIMANA Cyprien

Kigali October 2017

TABLE OF CONTENT
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CHAPTER ONE: INTRODUCTION AND REVIEW...................................................................1

1.1 Introduction............................................................................................................................1
1.2 Common Properties of Production Sets.................................................................................1
1.3 The Marginal Rate of Technical Substitution........................................................................2
1.4 The Elasticity of Substitution.................................................................................................3
CHAPTER TWO: MARKET POWER...........................................................................................6
2.1 Introduction............................................................................................................................6
2.2 Monopoly...............................................................................................................................6
2.2.1 Profit Maximization Problem of Monopolist..................................................................7
2.2.2 Inefficiency of Monopoly................................................................................................9
2.3 Oligopoly.............................................................................................................................17
2.3.1 Choosing a strategy.......................................................................................................17
2.3.2 Quantity Leadership......................................................................................................18
2.3.2.1The Follower’s problem..............................................................................................18
2.3.2.2 The Leader’s problem................................................................................................20
2.3.2.3 Price leadership..........................................................................................................20
2.3.2.4 Simultaneous Quantity setting....................................................................................22
2.3.2.5 Simultaneous price setting..........................................................................................25
2.3.2.6 Collusion....................................................................................................................26
CHAPTER THREE: GAME THEORY........................................................................................30
3.1 Introduction..........................................................................................................................30
3.2 Definition.............................................................................................................................30
3.3 History and impact of game theory......................................................................................30
3.4 The Payoffmatrix of the game.............................................................................................31
3.5 Nash Equilibrium.................................................................................................................32
3.6 Mixed Strategies..................................................................................................................33
3.7 The Prisoner’s Dilemma......................................................................................................34
3.8 Repeated games....................................................................................................................35
3.9 Sequential game...................................................................................................................36
CHAPTER FOUR: APPLIED COMPETITIVE ANALYSIS AND EXTERNALITY...............38
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4.1 General overview.................................................................................................................38

4.2 Definition.............................................................................................................................38
4.3 Efficiency between production and consumption................................................................39
4.4 Social welfare maximization................................................................................................40
4.5 Pareto efficiency..................................................................................................................41
4.6 Externalities.........................................................................................................................42
4.6.1 Definition.......................................................................................................................42
4.6.2 Types of externalities....................................................................................................42
4.6.3 Production and externalities..........................................................................................46
4.6.4 Coase and production externalities................................................................................49
4.6.5 Solutions of externalities...............................................................................................51
CHAPTER V: SLUTSKY EQUATION.......................................................................................53
5.1 Introduction..........................................................................................................................53
5.2 The Substitution effect.........................................................................................................53
5.3 The Income effect................................................................................................................54
5.4 The Total change in demand................................................................................................55
5.5 Rates of change....................................................................................................................56
CHAPTER SIX: UNCERTAINTY...............................................................................................59
6.1 Definition.............................................................................................................................59
6.2 Contingent consumption......................................................................................................59
6.3 Utility Functions and Probabilities......................................................................................59
6.4 Expected utility....................................................................................................................60
6.5 Reasonability of Expected utility.........................................................................................60
6.6 Risk aversion........................................................................................................................61
CHAPTER SEVEN: RISK ASSETS.............................................................................................63
7.1 Mean variance utility...........................................................................................................63
CHAPTER EIGHT: INTERTEMPORAL CHOICE.....................................................................64
8.1 Definition.............................................................................................................................64
8.2 Intertemporal Choice by Irving Fisher.................................................................................64
8.3 Franco Modigliani and life-cycle hypothesis.......................................................................68
8.4 Inflation................................................................................................................................69
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8.5 Present value........................................................................................................................69

8.6 Bonds...................................................................................................................................70
CHAPTER NINE: ASSET MARKET..........................................................................................72
9.1 Definition.............................................................................................................................72
9.2 Rates of Return.....................................................................................................................72
9.3 Asset with consumption returns...........................................................................................73
9.4 Application...........................................................................................................................74
INDICATED BOOKS...................................................................................................................77
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CHAPTER ONE: INTRODUCTION AND REVIEW

1.1 Introduction

Economic activity not only involves consumption but also production and trade. Production
should be interpreted very broadly, however, to include production of both physical goods- such
as rice or automobiles, and services- such as medical care or financial services.

1.2 Common Properties of Production Sets

 Free Disposal or Monotonicity:

Free disposal implies that commodities (either inputs or outputs) can be thrown away. This
property means that if y ∈ Y, then Y includes all vectors in the negative orthant translated to y,
i.e. there are only inputs, but no outputs. A weaker requirement is that we only assume that the
input requirement is monotonic.

If x is in V (y) and x’ ¿ x, then x’ is in V (y). Monotonicity of V (y) means that, if x is a feasible

way to produce y units of output and x’is an input vector with at least as much of each input, then
x’should be a feasible way to produce y.

 Irreversibility

Irreversibility means a production plan is not reversible unless it is a non-action plan.

 Convexity

Y is convex if whenever y and y’ are in Y, the weighted average ty+(1 - t)y is also in Y for any t

with 0 ¿ t ¿ 1.
Convexity of Y means that, if all goods are divisible, it is often reasonable to assume that two
production plans y and y’ can be scaled downward and combined. However, it should be noted
that the convexity of the production set is a strong hypothesis. For example, convexity of the
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production set rules out “startup costs" and other sorts of returns to scale. This will be discussed
in greater detail shortly.

 Strict Convexity: y is strictly convex if y ∈ Yand y’ ∈ Y, then ty+(1¡t)y’ ∈ intYfor all

0 < t <1, where intYdenotes the interior points of Y .
As we will show, the strict convexity of Y can guarantee the profit maximizing production plan is
unique provided it exists.
A weak and more reasonable requirement is to assume that V(y) is a convex set for all outputs yo:
 Convexity of Input Requirement Set: If x and x’ are in V (y), then tx + (1- t)x’ is in V

(y) for all 0 ¿ t ¿ 1. That is, V (y) is a convex set.

Convexity of V (y) means that, if x and x’ both can produce y units of output, then any weighted
average tx+ (1- t) x’can also produce y units of output. We describe a few of the relationships
between the convexity of V (y), the curvature of the production function, and the convexity of Y.

 Convex Production Set Implies Convex Input Requirement Set

If the production set Y is a convex set, then the associated input requirement set, V (y),is a
convex set.Proof. If Y is a convex set then it follows that for any x and x’such that (y,-x) and (y,-

x’) are in Y for 0 ¿ t ¿ 1, we must have (ty + (1-t)y, tx-(1- t)x’) in Y . This is simply
requiring that (y, (tx + (1 -t)x’)) is in Y. It follows that if x and x’ are in V (y), tx + (1- t)x’is in V
(y) which shows that V (y) is convex.

V (y) is a convex set if and only if the production function f(x) is a quasi-concave function.
Proof V (y) = {x: f(x) ¿ y}, which is just the upper contour set of f(x). But a function is quasi-
concave if and only if it has a convex upper contour set.

1.3 The Marginal Rate of Technical Substitution

Suppose that technology is summarized by a smooth production function and that we are
producing at a particular point. Suppose that we want to increase a small amount of input 1 and
decrease some amount of input 2 so as to maintain a constant level of output. How can we
determine this marginal rate of technical substitution (MRTS) between these two factors? The
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way is the same as for deriving the marginal rate of substitution of an indifference curve.
Differentiating production function when output keeps constant, we have;

∂f ∂f
0= dx 1 + dx
∂ x1 ∂ x2 2
Which can be solved for
dx 2 ∂ f /∂ x 1 MP x1
=− =
dx 1 ∂ f /∂ x 2 MP x
2

This gives us an explicit expression for the marginal rate technical substitution, which is the rate
of marginal production of x1 and marginal production of x2.

Example (MRTS for a Cobb-Douglas Technology)

α 1−α
Given that f(x1, x2) =
x1 x2 , we can take the derivatives to find

∂f (x ) α−1 1−α
=αx1 x 2
∂ x1

∂f ( x)
=1−αx1α x 1−α−1
2 =1−αx1α x−α
2
∂ x2

It follows that

∂ x2( x1) ∂ f /∂ x 1 α x2
=− =−
∂ x1 ∂ f /∂ x 2 1−α x 1

1.4 The Elasticity of Substitution

The marginal rate of technical substitution measures the slope of an isoquant. The elasticity of
substitution measures the curvature of an isoquant. More specifically, the elasticity of
substitution measures the percentage change in the factor ratio divided by the percentage change
Δ ( x2 / x1 )
in the MRTS, with output being held fixed. If we let be the change in the factor ratio
and ∆MRTS be the change in the technical rate of substitution, we can express this as
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Δ( x 2 / x 1 ) Δ MRTS
σ= /
x 2/ x 1 MRTS
This is a relatively natural measure of curvature: it asks how the ratio of factor inputs changes as
the slope of the isoquant changes. If a small change in slope gives us a large change in the factor
input ratio, the isoquant is relatively °at which means that the elasticity of substitution is large.
In practice we think of the percent change as being very small and take the limit of this

expression as ∆ goes to zero. Hence, the expression for σ becomes:

MRTSd ( x 2 / x 1 ) d ln ( x 2 / x 1 )
σ= =
( x 2 / x 1 )dMRTS d ln MRTS

Example –Cobb-Douglas Production Function.

We have seen above that
α x2
MRTS=- 1−α x 1

Or
x2 1−α
=− MRTS
x1 α
It follows that

x2 1−α
ln =ln +ln MRTS
x1 α
This in turn implies
d ln ( x 2 / x 1 )
σ= =1
d ln MRTS

Example: The CES Production Function

The constant elasticity of substitution (CES) production function has the form
1

y=[ a1 x ρ1 +a2 x 2ρ ] ρ

It is easy to verify that the CES function exhibits constant returns to scale. It will probably not
surprise you to discover that the CES production function has a constant elasticity of
substitution. To verify this, note that the marginal rate of technical substitution is given by
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ρ−1
x1

MRTS =
−
x2 ()
So that
x2 1

=[ MRTS ] 1−ρ
x1
Taking logs, we see that

x2 1
ln = ln MRTS
x 1 1− ρ
Applying the definition of using the logarithmic derivative,
d ln x 2 /x 1
1
σ= =
d ln MRTS 1− ρ
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CHAPTER TWO: MARKET POWER

2.1 Introduction

A market power refers to how markets are organized, and is observed in different structures of
the markets.

2.2 Monopoly

At the opposite pole from pure competition we have the case of pure monopoly. Here instead of
a large number of independent sellers of some uniform product, we have only one seller.

It is a market structure in which there is only one producer of some product that has no close
substitutes. Technically this condition means that the cross elasticity of demand between the
monopoly product and any other product is approximately zero. That is the price of other
products hardly affects the demand of the monopoly product. As the only producer of the
product, the monopolist need not be concerned with the possibilities of that other firms may
under-cut its price. In effect the monopoly is the industry, since it is the only producer in the
market.As a result, the demand curve confronting the monopoly is also the total market demand
curve for the product, and that curve, like all markets demand curves, slopes downward. This
firm may choose to produce at any point on the demand curve.

Also a monopolist has significant market powers whereby a monopolist can influence the market
price. Though a monopolist has no direct competitors, the monopolist can face indirect
competition from other firms/producers in the economy. This indirect competition is based on
the fact that all commodities are rivals for the consumer’s limited income. That is why the
monopolist at times is engaged in advertisement.
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2.2.1 Profit Maximization Problem of Monopolist

A monopolistic firm must make two sorts of decisions: how much output it should produce, and

at what price it should sell this output. In order to maximize Π s, a monopoly will choose to
produce that output level for which MR = MC. Since the monopoly, in contrast to a perfectly
competitive firm, faces a negatively sloped market demand curve, MR will be less than price.
To sell an additional unit, the monopoly must lower its price on all units to be sold if it is to
generate the extra demand necessary to absorb this marginal unit. Of course, it cannot make
these decisions unilaterally. The amount of output that the firm is able to sell will depend on the
price that it sets.

We summarize this relationship between demand and price in a market demand function for
output, y(p). The market demand function tells how much output consumers will demand as a
function of the price that the monopolist charges. It is often more convenient to consider the
inverse demand function p(y); which indicates the price that consumers are willing to pay for y
amount of output. The revenue that the firm receives will depend on the amount of output it
chooses to supply. The cost function of the firm also depends on the amount of output produced.

The profit maximization problem of the firm can then be written as:
MaxR(y) = max p(y)y - c(y)

The first-order conditions for profit maximization are that marginal revenue equals marginal

∆r ∆c
cost, MR=MC or = orp(y*) + p’(y*)y* = c’(y*). The intuition behind this condition is
∆y ∆y
fairly clear. If the monopolist decides to increase its output by Δy, there are two effects on
revenues: First, it sells more output and receives a revenue of pΔy from that. But second, the
monopolist pushes the price down by Δp and it gets this lower on all the output it has been
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selling. Thus the total effect on revenues of changing output by Δy will be Δr = pΔy + yΔp; and

∆r ∆p
MR= = p+ y.
∆y ∆y

In other words, if the monopolist considers producing one extra unit of output he will increase
his revenue by p(y*) dollars in the first instance. But this increased level of output will force the
price down by p’(y*), and he will lose this much revenue on unit of output sold. The sum of
these two effects gives the marginal revenue. If the marginal revenue exceeds the marginal cost
of production the monopolist will expand output. The expansion stops when the marginal
revenue and the marginal cost balance out.
The first-order conditions for profit maximization can be expressed in a slightly different manner
through the use of the price elasticity of demand, as we have done in chapter three.

It becomes as follows:
dTR d ( PQ )
MR  
dQ dQ
dP
 PQ
dQ
 Q dP 
 P 1  . 
 P dQ 
 1
MR  P 1  
  p 

Graphical illustration of the profit maximization condition for monopoly:

Suppose for simplicity that we have a linear inverse demand curve: p(y) = a-by. Then the
revenue function isR(y) = ay - by2, and the marginal revenue function is just R’(y) = a- 2by.
The marginal revenue curve has the same vertical intercept as the demand curve but is twice as
steep.
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The optimal level of output is located where the marginal revenue and the marginal cost curves
intersect. This optimal level of output sells at a price P1 so the monopolist gets optimal revenue
of 0P1Q1M. The cost of producing Q1is just Q1times the average cost of production at that level
of output, 0P2Q1N. The difference between these two areas gives us a measure of the
monopolist's profits.

2.2.2 Inefficiency of Monopoly

Social efficiency requires a balancing of the costs and benefits of any action. We create benefits
for people by giving them something they value; the value of something is equal to what people
are willing to pay for it. The demand curve tells us people's marginal willingness to pay. So, the
benefits society receives from consuming a good are represented by the demand curve. The
industry supply curve measures the social costs of producing the good. The industry supply
curve is the same as the marginal cost curve. Therefore, the efficient level of output is given
by the intersection of the demand and marginal cost curves. For levels of output below the
efficient quantity, the benefits society receives from consuming a unit of the good are greater
than the costs of producing a unit of the good; for levels of output greater than the efficient
amount, the costs are greater than the benefits from consuming a unit of the good.
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The monopoly output is where MR=MC. So, the monopoly produces too little output and
charges too high a price compared to the efficient outcome. The deadweight loss is a measure
of the inefficiency of a monopoly. It represents the net social benefits from the lost output from
having a monopoly in the market rather than perfect competition. (Perfect competition results in
efficient outcomes.) The deadweight loss may be overstated because the monopoly fears that
entry or government intervention could occur. It may be understated if monopoly firms tend to
operate inefficiently and devote resources to maintaining their monopoly positions.

2.2.2.1 Deadweight loss of Monopoly

According to the standard model, in which a monopolist sets a single price for all consumers, the
monopolist will sell a lesser quantity of goods at a higher price than would companies by perfect
competition. Because the monopolist ultimately forgoes transactions with consumers who value
the product or service more than its cost, monopoly pricing creates a deadweight loss referring to
potential gains that went neither to the monopolist nor to consumers. Given the presence of this
deadweight loss, the combined surplus (or wealth) for the monopolist and consumers is
necessarily less than the total surplus obtained by consumers by perfect competition. Where
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efficiency is defined by the total gains from trade, the monopoly setting is less efficient than
perfect competition.

It is often argued that monopolies tend to become less efficient and less innovative over time,
becoming "complacent", because they do not have to be efficient or innovative to compete in the
marketplace. Sometimes this very loss of psychological efficiency can increase a potential
competitor's value enough to overcome market entry barriers, or provide incentive for research
and investment into new alternatives. The theory of contestable markets argues that in some
circumstances (private) monopolies are forced to behave as if there were competition because of
the risk of losing their monopoly to new entrants. This is likely to happen when a market's
barriers to entry are low. It might also be because of the availability in the longer term of
substitutes in other markets.

Graphically the deadweight loss it looks like:

Pareto efficiency or Pareto optimality

It refers to the concept in economics with applications in engineering and social sciences. The
term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of
economic efficiency and income distribution.
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Given an initial allocation of goods among a set of individuals, a change to a different allocation
that makes at least one individual better off without making any other individual worse off is
called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal"
when no further Pareto improvements can be made.

Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a socially
desirable distribution of resources, as it makes no statement about equality or the overall well-
being of a society.

 Pareto efficiency in short

An economic system that is not Pareto efficient implies that a certain change in allocation of
goods (for example) may result in some individuals being made "better off" with no individual
being made worse off, and therefore can be made more Pareto efficient through a Pareto
improvement. Here 'better off' is often interpreted as "put in a preferred position." It is commonly
accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto
efficiency is an important criterion for evaluating economic systems and public policies.

If economic allocation in any system is not Pareto efficient, there is potential for a Pareto
improvement an increase in Pareto efficiency: through reallocation, improvements to at least one
participant's well-being can be made without reducing any other participant's well-being.

In the real world ensuring that nobody is disadvantaged by a change aimed at improving
economic efficiency may require compensation of one or more parties. For instance, if a change
in economic policy dictates that a legally protected monopoly ceases to exist and that market
subsequently becomes competitive and more efficient, the monopolist will be made worse off.
However, the loss to the monopolist will be more than offset by the gain in efficiency. This
means the monopolist can be compensated for its loss while still leaving an efficiency gain to be
realized by others in the economy. Thus, the requirement of nobody being made worse off for a
gain to others is met.
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2.2.2.2 Price Discrimination

This exists when the same product is sold at different prices to different buyers for which the
cost of production is either the same or different not as difference in price being changed. The
product is basically the same but it may have slight difference for example different drug of the
same product using soft or hard cover, different location of seats in the stadium etc.

In our analysis we shall concentrate on identical product, produced as the same cost which is
sold at different price depending on the preference of the buyer, their income, location and ease
of availability of substitutes.

It is commonly changed different prices for the same product at different time periods e.g newly
produced products are sold at high prices and subsequently are sold at law prices. These factors
give rise to demand curves with deferent elasticities.

Price discrimination or price differentiation is a pricing strategy where identical or largely

similar goods or services are transacted at different prices by the same provider in different
markets or territories.

Price differentiation is distinguished from product differentiation by the more substantial

difference in production cost for the differently priced products involved in the latter strategy.
Price differentiation essentially relies on the variation in the customers' willingness to pay.

 Types of price discrimination

a. First degree price discrimination

This type of price discrimination requires the monopoly seller of a good or service to know the
absolute maximum price (or reservation price) that every consumer is willing to pay. By
knowing the reservation price, the seller is able to sell the good or service to each consumer at
the maximum price he is willing to pay, and thus transform the consumer surplus into revenues.
So the profit is equal to the sum of consumer surplus and producer surplus. The marginal
consumer is the one whose reservation price equals to the marginal cost of the product. The
seller produces more of his product than he would to achieve monopoly profits with no price
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discrimination, which means that there is no deadweight loss. Examples of where this might be
observed are in markets where consumers bid for tenders, though, in this case, the practice of
collusive tendering could reduce the market efficiency.

In other books is explained as follows: Personalized pricing (or first-degree price

differentiation) selling to each customer at a different price; this is also called one-to-one
marketing.The optimal incarnation of this is called perfect price discrimination and maximizes
the price that each customer is willing to pay, although it is extremely difficult to achieve in
practice because the "brain-scan technology required to determine the precise willingness to pay
of each customer has not yet been developed"

b. Second degree price discrimination

In second degree price discrimination, price varies according to quantity demanded. Larger
quantities are available at a lower unit price. This is particularly widespread in sales to industrial
customers, where bulk buyers enjoy higher discounts.

Additionally to second degree price discrimination, sellers are not able to differentiate between
different types of consumers. Thus, the suppliers will provide incentives for the consumers to
differentiate themselves according to preference. As above, quantity "discounts", or non-linear
pricing, is a means by which suppliers use consumer preference to distinguish classes of
consumers. This allows the supplier to set different prices to the different groups and capture a
larger portion of the total market surplus.

In other books is Product versioningor simply versioning (or second-degree price

differentiation) offering a product lineby creating slightly different products for the purpose of
price differentiation,i.e. a vertical product line. Another name given to versioning is menu
pricing.

In reality, different pricing may apply to differences in product quality as well as quantity. For
example, airlines often offer multiple classes of seats on flights, such as first class and economy
class. This is a way to differentiate consumers based on preference, and therefore allows the
airline to capture more consumers’ surplus.
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c. Third degree price discrimination

In third degree price discrimination, price varies by attributes such as locationor by customer
segment, or in the most extreme case, by the individual customer's identity; where the attribute in
question is used as a proxy for ability/willingness to pay.

In other words, is called Group pricing (or third-degree price differentiation) dividing the
market in segments and charging the same price for everyone in each segment. This is essentially
a heuristic approximation that simplifies the problem in face of the difficulties with personalized
pricing.A typical example is student discounts.This the most common form of price
discrimination.

Let us suppose that the monopolist is able to identify two groups of people and can sell an item
to each group at different price. We suppose that the consumers in each market are not able to
resell the good. Let us use P 1(y1) and P2(y2) to denote the inverse demand curves of groups 1 and
2, respectively, and let c(y1+y2) be the cost of producing output. Then the profit maximization
problem facing the monopolist is max P1(y1)+P2(y2) - c(y1+y2).

The optimal solution must have MR1(y1) = MC(y1+y2) and MR2(y2) = MC(y1+y2). Meaning that,
the MC of producing an extra unit of output must be equal to the MR in each market.

If the MR in market 1 exceeded MC, it would pay to expand output in market 1, and similarly for
market 2. Since MC is the same in each market, this means of course that MR in each market
must also be the same. Thus a good should bring the same increase in revenue whether it is sold
in market 1 or in market 2.

We can use the standard elasticity formula for MR and write the profit-maximization conditions

1 1
as: [
P1(y1) 1− ]
|∈1( y 1)| = MC(y1+y2) and [
P2(y2) 1−
|∈2( y 2)| ] = MC(y1+y2); where

∈1 ( y 1 )∧∈2( y 2) represent the demand elasticities in the respective markets, evaluated at the
profit-maximization.

Please note the following:

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1 1
If P1˃ P2, then we have 1− [ |∈1( y 1)| ][
˂ 1− ]
|∈2( y 2)| , which in turn implies that

1 1
1− ˃1− , meaning that|∈ 2( y 2)|>|∈ 1( y 1)|
|∈ 2( y 2)| |∈ 2( y 2)|

Example: Suppose that a monopolist faces two markets with demand curves given by
D1(P1)=100-P1 and D2(P2)=100-2P2. Assume that the monopolist’s MC is constant at 20Rwf a
unit. If he can price discriminate, what price should he charge in each market in order to
maximize profits? What if it can’t price discrimination? Then what price should it charge?

Solution:

a) If there is discrimination:
P1(y1) = 100-y1 and P2(y2) = 50-y2/2
TR= TR1 +TR2
TR1 = P1(y1)* Y1 = (100-y1)y1=100y –y2
TR2 = P2(y2)* Y2 = (50 – Y2/2) Y2 = 50Y-Y2/2
MR1= 100-2Y and MR2= 50-Y2/2
The max condition MR1 = MR2= MC
MR1= 100-2Y=20; Y1= 40; and MR2= 50-Y2/2= 20; Y2= 30.
The price should be charge in each market:
We replace y1 and y2 by their corresponding values:
P1(y1) = 100-40=60 Rwf P2(y2) = 50-30/2 = 35 Rwf.
b) If there is no discrimination, meaning if he charges the same price in each market:
D(p) = D1(P1) + D2(P2) =100-P1+ 100-2P2 = 200-3p
P= 200—Y/3
TR= (200-Y/3)Y= 200Y-Y2/3
200 2
MR= − Y
3 3
MR=MC
200 2
− Y =20
3 3
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Y= 70 and P= 44.3 Rwf

Although price discrimination is more easily implemented by a monopolist, because he controls

the whole market supply of a given product, this price policy is quite commonly practiced by
most firms which change different prices or give different discounts to their customers
depending on the item they purchase, the length of time, their location.

Necessary conditions that must be fulfilled for successful implementation of price

Discrimination:

- The market must be divided into submarkets with different price elastic- ties of a market can
be sub-divided depending on age, sex, etc.
- There must be effective separation of the sub-markets to that no selling of the same product
can occur from a lower price sub-market to a high price sub-market. This explains why price
discrimination is more successful for serves than for commodities. Note that prices are
normally higher where demand is inelastic.

2.3 Oligopoly

Oligopoly is the study of market interactions with a small number of firms. Such an industry
usually does not exhibit the characteristics of perfect competition, since individual firms' actions
can in fact influence market price and the actions of other firms.

2.3.1 Choosing a strategy

If there two firms in the market and they are producing a homogeneous product, then there are
four variables of interest: the price that each firm charges and the quantities that each firm
produces.

When one firm decides about its choices for prices and quantities, it may already know the
choices made by other firm. If one firm gets to set its price before other firm, we call it the price
leaderand other firm the price follower. Similarly, one firm may get to choose its quantity first,
 18

in which it is a quantity leader and other becomes a quantity follower. The strategic interactions
in these cases form a sequential game.

On the other hand, it may be that when one firm makes its choices it doesn’t know the choices
made by other firm. In this case, it has to guess about the other firm’s choice in order to make a
sensible decision itself. This is a simultaneous game. Again there are two possibilities: the firms
could each simultaneously choose prices or quantities.
There is also another possible form of interaction that we will examine later. Instead of firms
competing against each other in one form or another they may be able to collude.In this case two
firms can jointly agree to set the prices and quantities that maximize the sum of their profits. This
sort of collusion is called a cooperative game.

2.3.2 Quantity Leadership

In the case of the quantity leadership one firm makes a choice before the other firm. This is
sometimes called the Stackelberg modelin honor of the 1st German economist whose name is
Heinrich von Stackelberg (October 31, 1905 - October 12, 1946)who systematically studied
leader-follower interactions.

The Stackelberg model is often used to describe industries in which there is a dominant firm, or a
natural leader. For example, IBM is often considered to be a dominant firm in the computer
industry.
Let us turn to the details of theoretical model. Suppose that firm 1 is the leader and that it
chooses to produce a quantity y1. Firm 2 responds by choosing a quantity y 2. Each firm knows
that the equilibrium price in the market depends on the total output produced. We use the inverse
demand function p(Y) to indicate the equilibrium price as a function of industry output, Y=
y1+y2.
Then, we can ask ourselves the following question: What output should the leader choose to
maximize its profits? The answer depends on how the leader thinks that the follower will react to
its choice. (He has to think about to the follower’s profit-maximization problem).
 19

2.3.2.1The Follower’s problem

We assume that the follower wants to maximize its profits, knowing that y 2= f(y1) which is the
reaction function since it tells us how the follower will react to the leader choice of output. Max
p(y1+y2)y2 –c2(y2). The follower’s profit depends on the output choice of the leader, which is
predetermined on the view of the follower. The equilibrium condition MR=MC, then MR 2 =

∆P
[p(y1+y2)y2]’= p(y1+y2)’y2 + p(y1+y2)y2’= y + p ( y 1+ y 2 )=MC 2 . The equation means, when
∆Y2 2
the follower increases its output, it increases its revenue by selling more output at the market
price, but it also pushes the price down by ∆p, and lowers its profits on all units that were
previously sold at the higher price.

Let us derive a reaction curve in the simple case of linear demand. p ( y 1+ y 2 )=a−b ( y 1+ y 2 ).
Then the ∏2(y1,y2) = [a-b ( y 1+ y 2 ) ], and T∏2(y1,y2) = ay2 – by1y2 – by22: this is isoprofit for the

a – by 1
Firm 2. MR2 = a – by1 – 2by2. Equalize MR2 to zero, we get a – by1 – 2by2=0, and y2= .
2b
 
 

b
 20

2.3.2.2 The Leader’s problem

We have already examined the follower’s problem, but also a leader has a problem. Presumably
he is aware that its actions influence the output choice of the follower. This relationship is
summarized by the reaction function y2= f2(y1).
The profit maximization for the leader therefore becomes: max p(y1+y2)y1 –c1(y1); such that y2=
f2(y1). Substituting the 2nd equation into the first gives us max p[y1+f2(y1)]y1 –c1(y1).
Note that the leader recognizes that when it chooses output y 1, the total output produced will be
y1+f2 (y1): its own output plus the output produced by the follower.

Changing his output has the influence on the follower. Let us examine this by using the linear

a – by 1
demand curve described above: y2 = = f2 (y1); and we’ve assumed that the MR=MC=0,
2b
then ∏1(y1,y2) = p(y1+y2)y1 = ay1 – by1y2 – by12. The output of the follower depends on the
leader’s choice via the reaction function f2 (y1); substituting this reaction fx, we get ay 1 – by1 f2

a – by 1 a – by 1 2 ay 1−2 b y 2−a y 1+b y 2

(y1) – by12 = ay1 –– by12 -- by1 = ay1 –– by12 -- y1 = =
2b 2 2

a b a a
y 1− y 21and MR = - by1, then after y1*= ; in order to find the follower’s output, we
2 2 2 2b

* *a−b y ¿ a
simply substitute y1 into the reaction function y2 = = .
2b 4b

These two equations give a total output of y1* + y2* = 3a/4b.

2.3.2.3 Price leadership

Instead of setting quantity, the leader may instead set price. In order to make a sensible decision
about how to set its price, the leader must forecast how the follower will behave. Accordingly,
we must first investigate the profit maximization problem facing the follower.
 21

The first thing we observe is that in equilibrium the follower must always set the same price as
the leader. This follows from our assumption that the two firms are selling identical products. If
one charged a different price from the other, all of the consumers would prefer the producer with
the lower price, and we couldn’t have equilibrium with both firms producing.

Suppose that the leader has set a price p. we will suppose that the follower takes this price as
given and chooses its profit- maximizing output. This the same as in competitive behavior,
because each firm takes the price as being outside of its control because it is such a small part of
the market; then in this current model, price leadership, the follower takes the price as being
outside of its control since it has already been set by the leader.

The follower wants to maximize profits: max py2 – c2(y2). The condition MR=MC. Let us turn to
the problem facing the leader. It realizes that if it sets a price p, the follower will supply S(p).
That means that the amount of output the leader will sell will be: R(p) = D(p) – S(p). This is
called the residual demand curve facing the leader. If the leader has a constant MC of
production c, then the profits that it achieves for any price p are given by: ∏ 1(p) = (p-c)[D(p) –
S(p)] = (p-c)R(p). Meaning that in order to maximize profits the leader wants to choose a price
and output combination where MR =MC.

Let’s look at a simple algebraic example. Suppose that the inverse function of demand curve is
D(p) = a-bp. The follower has a cost function c2(y2) = y22/2, and the leader has a cost function
c1(y1)= cy1. For any price p the follower wants to operate where price equals MC. If the cost
function is c2(y2) = y22/2, it can be shown that the MC curve is MC 2(y2)=y2. Setting price equal to
MC gives us p= y2. Solving the follower’s supply curve gives y2 = S(p) = p.

The demand curve facing the leader, the residual demand curve, is R(p) = D(p) – S(p) = a – bp –
p= a – (b+1)p. From now on this is just like an ordinary monopoly problem. Solving for p as a

a 1
function of the leader’s output y1, we have: p= − y 1. This is demand function facing
b+1 b+1
 22

the leader. The associated MR curve has the same intercept and is twice as steep. This means that

a 2
it is given by MR 1= − y 1.
b+ 1 b+ 1
a 2
Setting MR=MC gives us the equation MR 1= − y 1 = c = MC1. Solving for the leader’s
b+ 1 b+ 1

a−c (b+1)
profit-maximizing output, we have: y*1= .
2

2.3.2.4 Simultaneous Quantity setting

One difficulty with the leader-follower model is that it is necessarily asymmetric: one firm is
able to make its decision before the other firm. In some situations this is unreasonable. For
example, suppose that two firms are simultaneously trying to decide what quantity to produce.
Here each firm has to forecast what the other firm’s output will be in order to make a sensible
decision itself.

In this section we are going to examine a one-period model in which each firm has to forecast the
other firm’s output choice. A situation where each firm finds its beliefs about the other firm to be
confirmed, the model is known as the Cournot model.

Cournot competition is an economic model used to describe an industry structure in which

companies compete on the amount of output they will produce, which they decide on
independently of each other and at the same time. It is named after Antoine Augustin Cournot
(1801–1877) who was inspired by observing competition in a spring water duopoly.

It has the following features:

 There is more than one firm and all firms produce a homogeneous product, i.e. there is no
product differentiation;
 Firms do not cooperate, i.e. there is no collusion;
 Firms have market power, i.e. each firm's output decision affects the good's price;
 The number of firms is fixed;
 Firms compete in quantities, and choose quantities simultaneously;
 23

 The firms are economically rational and act strategically, usually seeking to maximize
profit given their competitors' decisions.

Let us begin by assuming that firm 1 expects that firm 2 will produce y e2units of output. (The e
stands for expected output.) If the firm 1 decides to produce y 1 units of output, it expects that the
total output produced will be Y= y1+ye2, and output yield a market price of p(Y) = p(y 1+ye2). The
profit maximization of the firm 1 is then max p(y1+ ye2)y1-c(y1).

For any given belief about the output of firm2, ye2, there will be some optimal choice of output
for firm 1, y1= f1(ye2), and one of the firm 2 is y 2= f2(ye1). Now recall that each firm is choosing
its output level assuming that other firms output will be at y e1 or ye2. For arbitrary values of ye1
and ye2 this won’t happen in general firm 1’s optimal level of output, y1, will be different from
what firm 2 expects the output to be, ye1.

Let us seek an output combination (y*1,y*2) such that the optimal output level for firm 1,
assuming firm 2 produces y*2, is y*1 and the optimal output level for the firm 2, assuming that firm
1 stays at y*1, is y*2. In other words the output choices (y*1,y*2) satisfy: y*1= f1(y*2) and y*2= f2(y*1).
Such a combination is known as the COURNOT equilibrium.

An example of Cournot equilibrium

Recall the case of the linear demand function and MC that we investigated earlier. We saw that

a−b y 1e
in this case the reaction function for firm 2 took the form y 2= . Since in this example
2b

a−b y 2e
firm 1 is exactly the same as firm 2, its reaction curve has the same form: y1= .
2b

At Cournot equilibrium, each firm’s choice is the profit-maximizing choice, given its beliefs
about the other firm’s behavior, and each firm’s beliefs about the other firm’s behavior to be
confirmed by its actual behavior.
 24

In order to calculate the COURNOT equilibrium algebraically we look for the point (y 1, y2)
where each firm is doing what the other firm expects it to do. We set y 1= ye1 and y2= ye2, which

a−b y 2 a−b y 1
gives us the following two equations in two unknowns: y1= , and y2= .
2b 2b

Where R2(q1) is the reaction curve f2(y1), and R1(q2) is the reaction curve f1(y2). In this
example two firms are identical, so each will produce the same level of output in equilibrium.

a−b y 2
Hence we can substitute y1=y2 into one of the above equations, y1= to get: y1=
2b

a−b ( a−b2 b y ), at the end of the day y =q1= 3ab and also y =q2= 3ab because they are identical.
1
*
1
*
2

2b
Then the total industry output is y*1+y*2 = 2a/3b.
Many firms in Cournot equilibrium
 25

Suppose that we have several firms involved in Cournot equilibrium, not just two. In this case we
suppose that each firm has an expectation about the output choices of the other firms in the
industry and seek to describe the equilibrium output.
Suppose that there n firms and let Y = y 1+y2+…+yn be the total industry output. Then the
∆p
MR=MC condition for firm iis p ( Y )+ y =MC ( y i ). If we factor out P(Y) and multiplying the
∆Y i
second term by Y/Y, we can this equation as p ( Y ) ¿]¿ MC ( y i). Using the definition of elasticity of
y
the aggregative demand curve and letting si= i be firm i’s share of total market output, this
Y
reduces to p ( Y ) ¿]¿ MC ( y i)or p ( Y ) ¿]=MC ( y i ). This looks just like the expression for the
|∈(Y )|
monopolist except for the si term. We can think of as being the elasticity of demand curve
si
facing the firm: the smaller the market share of the firm, the more elastic the demand curve
faces.

If its market share is 1, the firm is a monopolist; the demand curve facing the firm is the market
demand curve, so the condition just reduces to that of the monopolist. If the firm is a very small
part of a large market, its market share is effectively zero, and the demand curve facing the firm
is effectively flat. Thus the condition reduces to that of the pure competitor: price equals
marginal cost, P=MC.

2.3.2.5 Simultaneous price setting

This is the other approach for thinking about how the firms can set their prices and letting the
market determine the quantity sold. This model is known as Bertrand competition.

Bertrand competition is a model of competition used in economics, named after Joseph Louis
François Bertrand (1822–1900). It describes interactions among firms (sellers) that set prices and
their customers (buyers) that choose quantities at the prices set. The model was formulated in
1883 by Bertrand in a review of Antoine Augustin Cournot's (1838) book in which Cournot had
put forward the Cournot model. Cournot argued that when firms choose quantities, the
equilibrium outcome involves firms pricing above marginal cost and hence the competitive price.
In his review Bertrand argued that if firms chose prices rather than quantities, then the
competitive outcome would occur with price equal to marginal cost. The model was not
 26

formalized by Bertrand: however, the idea was developed into a mathematical model by Francis
YsidroEdgeworth in 1889.

When a firm chooses its price, it has to forecast the price set by the other firm in the industry.
Just as in the case of COURNOT equilibrium we want to find a pair of prices such that each
price is a profit- maximizing choice given the choice made the other firm.
Suppose that two re selling output at some price p¿ greater than MC. Consider the position of the
firm 1. If it lowers its price by any small amount ϵ and if other firm keeps its price fixed at p¿, all
consumers will prefer to purchase from 1. By cutting price by an arbitrary small amount, it can
steal all of the customers from firm 2.

If firm 1 really believes that firm 2 will charge a price p¿ that s greater than MC, it will always
pay firm 1 to cut its price to p¿ −¿ϵ. But firm 2 can reason the same way. Thus any price higher
than MC cannot be equilibrium; the only equilibrium is the competitive equilibrium.

2.3.2.6 Collusion

In the models we have examined up until now the firms have operated independently. But if the
firms collude so as jointly determine their output, these models are not very reasonable. If
collusion is possible, the firms would do better to choose the output that maximizes total industry
profits and then divide up the profits among themselves.

Collusion is an agreement between two or more parties, sometimes illegal and therefore
secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal
rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair
advantage. It is an agreement among firms or individuals to divide a market, set prices, limit
production or limit opportunities.It can involve "wage fixing, kickbacks, or misrepresenting the
independence of the relationship between the colluding parties".In legal terms, all acts affected
by collusion are considered void.
 27

When firms get together and attempt to set the prices and outputs so as to maximize total
industry profits, they are known as a Cartel, which is simply a group of firms that jointly collude
to behave like a single monopolist and maximize the sum of their profits.

Thus the profit-maximization problem facing the two firms is to choose their outputs y 1and y2 so
as to maximize total industry profits: max p ( y 1+ y 2 ) [ y 1+ y 2 ] −c 1 ( y 1 )−c 2 ( y 2)
∆p * *
This will have the optimality conditions: p(y *1+y*2) + [y 1+y 2] = MC1(y*1) and p(y*1+y*2) +
∆Y

∆p * *
[y 1+y 2] = MC2(y*2).
∆Y

The interpretation of these conditions is interesting. When firm 1 considers expanding its output
by ∆y1, it will contemplate the usual two effects: the extra profits from selling more output and
the reduction in profits from forcing the price down. But in the 2 nd effect, it now takes into
account the effect of the lower price on both its own output and the output of the other firm. This
is because it I now interested in maximizing total industry profits, not just its own profits.

The optimality conditions imply that the MR of an extra unit of output must be the same no
matter where it is produced. It follows that MC 1(y*1) = MC2(y*2). If one firm has the costs
advantage, so that its MC curve always lies below that of the other firm, then it will necessarily
produce more output in equilibrium in the cartel solution.

The problem with agreeing to join a cartel in real life is that there is a temptation for cheating.
Suppose, two firms are operating at the outputs that maximize industry profits (y *1,y*2) and firm 1
considers producing a little more output, ∆y1. The Marginal profits accruing to firm 1 will be:

∆π
=¿ p(y*1+y*2) + ∆ p y*1 -- MC1(y*1). Please remember that the optimality condition is
∆ y1 ∆Y
∆p * ∆p *
p(y*1+y*2) + y + y -- MC1(y*1) = 0. Rearranging this equation gives us
∆Y 1 ∆Y 2
∆p * ∆p *
p(y*1+y*2) + y 1-- MC1(y*1) = - y > 0 . The last term follows since ∆p/∆Y is negative,
∆Y ∆Y 2
truly because the market demand has a negative slope.
 28

Thus in order to maintain an effective cartel, the firms need a way to detect and punish cheating.
If they have no way to observe each other’s output, the temptation to cheat may break the cartel.
By using the linear demand curve with zero MC, we get the following: the aggregate profit
2
function will be: π ( y 1 , y 2 )=[ a−b ( y 1+ y 2) ] ( y 1+ y 2 ) =a ( y 1 + y 2 )−b ( y 1 + y 2) , so MR=MC
conditions will be a−2 b(y*1+y*2) = 0, which implies that y*1+y*2 = a/2b.
Since marginal costs are zero, the division of output between the two firms doesn’t matter. All
that is determined is the total level of industry output.

Exercise
Suppose a case of two firms where there is no the costs of production, but having the linear
demand function which is presented as follows: Q= 120-P. Find out the price, quantity (output),
and profit in the following cases:
 Cartel;
 Cournot;
 Stackelberg;
 Perfect competition.

Solution
a. For Cartel
Profit maximization problem:
Max ∏ = TR- TC
Where TR= PQ
Inverse demand function: P= 120-Q
∏ = PQ= (120-Q)Q= 120Q-Q2
Max condition MR=MC
∂π
M π= =120−2 Q
∂Q
Q= 60, and P= 60.
∏ = 120*60 – 602 = 3600.

b. For Cournot
 29

TR = (120- q1-q2)q1 with q1+q2= Q

∏1= 120q1-q21-q1q2
∏2= (120- q1-q2)q2 = 120q2-q22-q1q2
∂q1 ∂q2
Or, =
∂q2 ∂q1
∂π 1
MR1 = =120−2Q 1−Q 2=0
∂Q 1

∂π 2
MR2 = =120−2Q 2−Q 1= 0
∂Q 2
MR1=MR2 = MC
120-2q1-q2 = 120- 2q2-q1, where q1=q2
Knowing this equality, MR, will be:
∂π 1
MR = =120−2Q 1−Q 2=120−3 Q
∂Q 1
Q= 120/3= 40 ; q1=q2
P= 120- q1-q2 = 120-40-40 = 40
∏1= ∏2 = P*q1=P*q2= 40*40= 1600
∏ = ∏1+∏2= 1600+1600=3200
c. For Stackelberg
120−q 1
The follower reaction function: q 2=
2
120−q 1
Profit maximization of the leader:∏1= P*q1= [(120 - q1)-( )] q1
2
240−2 q 1−120+ q 1 120−q 1 120 q 1−q 2
∏1 = [
2
]q1= ( 2 )
q 1=
2
=0

∂π
MR1= =120−2 q 1=q 1=60,
∂Q 1
120−q 1 120−60
whileq 2= = =30
2 2
P= 120- (q1+q2) = 120- 60-30 = 30
∏1= PQ1 = 30*60 = 1800, and ∏2 = 30*30 = 900.
d. Perfect competition
P=0; Q= q1+q2= 120
 30

∏1= ∏2= 0.

CHAPTER THREE: GAME THEORY

3.1 Introduction

The last part of the previous chapter, talked about on the oligopoly theory presented the classical
theory of strategic interaction among firms. The economic agents can interact strategically in a
variety of ways, and among these have been studied by using the apparatus of game theory.

3.2 Definition

A game is a formal description of a strategic situation.

The game theory is concerned with the general analysis of strategic interaction. It can also be
defined as the formal study of decision-making where several players must make choices that
potentially affect the interests of the other players.
 31

The concepts of game theory provide a language to formulate structure, analyze, and understand
strategic scenarios.

3.3 History and impact of game theory

The earliest example of a formal game-theoretic analysis is the study of a duopoly by Antoine
Cournot in 1838. The mathematician Emile Borel suggested a formal theory of games in 1921,
which was furthered by the mathematician John von Neumann in 1928 in a “theory of parlor
games.” Game theory was established as a field in its own right after the 1944 publication of the
monumental volume Theory of Games and Economic Behavior by von Neumann and the
economist Oskar Morgenstern. This book provided much of the basic terminology and problem
setup that is still in use today.

In 1950, John Nash demonstrated that finite games have always have an equilibrium point, at
which all players choose actions which are best for them given their opponents’ choices. This
central concept of non-cooperative game theory has been a focal point of analysis since then. In
the 1950s and 1960s, game theory was broadened theoretically and applied to problems of war
and politics. Since the 1970s, it has driven a revolution in economic theory. Additionally, it has
found applications in sociology and psychology, and established links with evolution and
biology. Game theory received special attention in 1994 with the awarding of the Nobel prize in
economics to Nash, John Harsanyi, and ReinhardSelten.

At the end of the 1990s, a high-profile application of game theory has been the design of
auctions. Prominent game theorists have been involved in the design of auctions for al- locating
rights to the use of bands of the electromagnetic spectrum to the mobile telecom- munications
industry. Most of these auctions were designed with the goal of allocating these resources more
efficiently than traditional governmental practices, and additionally raised billions of dollars in
the United States and Europe.

3.4 The Payoffmatrix of the game

 32

Strategic interaction can involve many players and many strategies, but we will limit ourselves to
two-person games with a finite number of strategies. This will allow us to depict the game easily
in a payoff matrix that the tool which lists all payoffs with all possible combinations of
alternative actions and external conditions.

Suppose two people are playing a simple game. Person A will write one of two words on a piece
of paper, “top” or “bottom”. Simultaneously, person B will write independently on piece of
paper “left” or “right”. After doing it the data depicted are summarized in the below table:

Player B

Left Right

Player A Top 1, 2 0, 1

Bottom 2, 1 1, 0

Both players have the two alternative strategies; choosing top or bottom for A, and Left or Right
for B. It is always better for A to say bottom since his payoffs from that choice (2 or 1) are
always greater than their corresponding entries in top (1 or 0). Similarly, it is always better for B
to say left since 2 and 1 dominate 1 and 0. Thus we would expect that the equilibrium strategy is
for A to play bottom and B to play left.

In this case, we have the dominant strategy. There is one optimal choice of strategy for each
player no matter what the other player does. Hence, the above choices dominate the alternatives,
and we have the equilibrium in dominant strategies.

3.5 Nash Equilibrium

The Nash equilibrium was named after John Forbes Nash, American mathematician. A version
of the Nash equilibrium concept was first known to be used in 1838 by Antoine Augustin
Cournot in his theory of oligopoly.In Cournot's theory firms choose how much output to produce
to maximize their own profit. However, the best output for one firm depends on the outputs of
others. A Cournot equilibrium occurs when each firm's output maximizes its profits given the
 33

output of the other firms, which is a pure strategy Nash Equilibrium. Cournot also introduced the
concept of best response dynamics in his analysis of the stability of equilibrium.

Game theorists use the Nash equilibrium concept to analyze the outcome of the strategic
interaction of several decision makers. In other words, it provides a way of predicting what will
happen if several people or several institutions are making decisions at the same time, and if the
outcome depends on the decisions of the others. The simple insight underlying John Nash's idea
is that one cannot predict the result of the choices of multiple decision makers if one analyzes
those decisions in isolation. Instead, one must ask what each player would do, taking into
account the decision-making of the other.

Basing on the below table we get the followings:

Player B

Left Right

Player A Top 2, 0 0, 0

Bottom 0, 0 1, 2

Referring to the table above, when B chooses left the payoffs to A are 2 or 0. When B chooses
left, A would want to choose top; and when B chooses right, A would want to choose bottom.
Thus A’s optimal choice depends on what he thinks B will do. We will say that the pair of
strategies is Nash equilibrium if A’s choice is optimal, given B’s choice, and B’s choice is
optimal given A’s choice. Remember that neither person knows what the other person will do
when he has to make his own choice of strategy. But each person may have some expectations
about what the other person’s choice will be. A Nash equilibrium can be interpreted as a pair of
 34

expectations about each person’s choice such that, when the other person’s choice is revealed,
neither individual wants to change his behavior.

In game theory, the Nash equilibrium is a solution concept of a non-cooperative game involving
two or more players, in which each player is assumed to know the equilibrium strategies of the
other players, and no player has anything to gain by changing only their own strategy. If each
player has chosen a strategy and no player can benefit by changing strategies while the other
players keep theirs unchanged, then the current set of strategy choices and the corresponding
payoffs constitute a Nash equilibrium.

3.6 Mixed Strategies

A pure strategy provides a complete definition of how a player will play a game. In particular, it
determines the move a player will make for any situation he or she could face. A player's
strategy set is the set of pure strategies available to that player. (Choosing a strategy once for all,
making one choice, and sticking to it; this is called a pure strategy.)

A mixed strategy is an assignment of a probability to each pure strategy. This allows for a
player to randomly select a pure strategy. Since probabilities are continuous, there are infinitely
many mixed strategies available to a player, even if their strategy set is finite.

Let us analyze the following table:

Player B
Left Right
Player Top 0, 0 0, -1
Bottom 1, 0 -1, 3
A

If A and B follow the mixed strategies given above, of playing each of their choices half the
time, then they will have a probability of ¼ of ending up in each of four cells in the payoff
matrix. Thus the average payoff to A will be 0, and the average payoff to B will be ½.

A Nash equilibrium in mixed strategies refers to an equilibrium in which each agent chooses the
optimal frequency with which to play his strategies given the frequency choices of the other
 35

agent. If A plays top with probability ¾ and bottom with probability ¼, and B plays left with
probability ½ and right with probability ½, this will constitute a Nash equilibrium.

3.7 The Prisoner’s Dilemma

Another problem with Nash equilibrium of a game is that it does not necessarily lead to Pareto
efficient outcomes. The game which we want to talk about is known as the Prisoner’s dilemma.
The original discussion of the game considered a situation where two prisoners who were
partners in a crime were being questioned in separate rooms. Each prisoner had a choice of
confessing to the crime, and thereby implicating the other, or denying that he had participated in
the crime.

If only one prisoner confessed, then he would go free, and the other one required spending 6
months in prison. If both prisoners denied being involved, then both would be held for 1 month
on a technicality, and if both prisoners confessed they would both be held for 3 months. The
payoff matrix for this game is given in the table below:

Player B

Confess Deny

Player A Confess -3, -3 0, -6

Deny -6, 0 -1, -1

Put yourself in the position of player A. If player B decides to deny committing the crime, then
you are certainly better off confessing, since then you’ll get off free. Similarly, if the player B
confesses, then you’ll be better off confessing, since then you get a sentence of 3 months rather
than a sentence of 6 months. Thus whatever player B does, player A is better off confessing; and
vice versa for player B.

The unique Nash equilibrium for this game is for both players to confess. In fact, both players
confessing is not only a Nash equilibrium; it is a dominant strategy equilibrium, since each
player has the same optimal choice independent of the other player. But if they could both just
hang tight, they would each be better off. If they both could be sure the other would hold out, and
 36

both could agree to hold out themselves, they would each get a payoff of -1, which would make
each of them better off. The strategy (deny, deny) is Pareto efficient, there is no other strategy
choice that makes both players better off, while strategy (confess, confess) is Pareto inefficient.

If each could trust the other, then they could both be made better off, but the problem is that
there is no way for two prisoners to coordinate their actions. This applies a wide range of
economic and political phenomena.

3.8 Repeated games

In the preceding section, the players met only once and played the prisoner’s dilemma game a
single time. However, the situation is different if the game is to be played repeatedly by the same
players. In this case there are new strategic possibilities open to each player. If the other player
chooses to defect on one round, then you can choose to defect on the next round. Thus your
opponent can be punished for bad behavior.

In repeated game, each player has the opportunity to establish a reputation for cooperation, and
thereby encourage the other player to do the same. Whether this kind of strategy will be viable
depends on whether the game is going to be played a fixed or an infinite number of times.

Players cooperate because they hope that cooperation will induce further cooperation in the
future. But this requires that there will always be the possibility of future play. Since there is no
possibility of future play in the last round, no one will cooperate then. But why should anyone
cooperate on the next to the last round? Or the one before that?

But if the game is going to be repeated an indefinite number of times, then you do have a way of
influencing your opponent’s behavior: if he refuses to cooperate this time, you can refuse to
cooperate next time. As long as both parties care enough about future payoffs, the threat of non-
cooperation in the future may be sufficient to convince people to play the Pareto efficient
strategy.

The winning strategy, the one with the highest overall payoff, turned out to be the simplest
strategy. It is called “tit for tat” and goes like this. On the 1st round, you cooperate, play the deny
strategy. On every round thereafter, if your opponent cooperated on the previous around, you
 37

cooperate. If your opponent defected on the previous around you defect. In other words, you
whatever the other player did in the last round.

The tit-for-tat strategy does very well b’se it offers an immediate punishment for defection. It is
also a forgiving strategy: it punishes the other player only once for each defection. If he falls into
line and starts to cooperate, then tit for tat will reward the other player with cooperation.

3.9 Sequential game

A long this chapter we have been thinking about games in which both players act
simultaneously. Simultaneous are games where both players move simultaneously, or if they do
not move simultaneously, the later players are unaware of the earlier players' actions (making
them effectively simultaneous). But in many situations one player gets to move first, and the
other player responds, example for Stackelberg.

Sequential games (or dynamic games) are games where later players have some knowledge
about earlier actions. This need not be perfect information about every action of earlier players; it
might be very little knowledge. For instance, a player may know that an earlier player did not
perform one particular action, while he does not know which of the other available actions the
first player actually performed.

Let us analyze a little a bit the below table:

Player B
Left Right
Player Left 1, 9 1,9
Right 0, 0 2, 1
A

The way to analyze this game is to go to the end of the backward. Suppose that player A has
already made his choice and we are sitting in one branch of the game tree. If player A has chosen
top, then it doesn’t matter what player B does, and the payoff is (1, 9). If player A has chosen
bottom, then, the sensible thing for player B to do is to choose right, and the payoff is (2, 1).

The difference between simultaneous and sequential games is captured in the different
representations discussed above. Often, normal form is used to represent simultaneous games,
and extensive form is used to represent sequential ones. The transformation of extensive to
 38

normal form is one way, meaning that multiple extensive form games correspond to the same
normal form.
 39

CHAPTER FOUR: APPLIED COMPETITIVE ANALYSIS AND EXTERNALITY

4.1 General overview

It is often assumed that agents are price takers, and under that assumption two common notions
of equilibrium exist: Walrasian (or competitive) equilibrium, and its generalization; price
equilibrium with transfers.

Broadly speaking, general equilibrium tries to give an understanding of the whole economy
using a "bottom-up" approach, starting with individual markets and agents. Macroeconomics, as
developed by the Keynesian economists, focused on a "top-down" approach, where the analysis
starts with larger aggregates, the "big picture". Therefore, general equilibrium theory has
traditionally been classified as part of microeconomics; and in other words it is called
competitive analysis.

The difference is not as clear as it used to be, since much of modern macroeconomics has
emphasized microeconomic foundations, and has constructed general equilibrium models of
macroeconomic fluctuations. General equilibrium macroeconomic models usually have a
simplified structure that only incorporates a few markets, like a "goods market" and a "financial
market". In contrast, general equilibrium models in the microeconomic tradition typically
involve a multitude of different goods markets. They are usually complex and require computers
to help with numerical solutions.

In a market system the prices and production of all goods, including the price of money and
interest, are interrelated. A change in the price of one good, for example bread, may affect
another price, such as bakers' wages. If bakers differ in tastes from others, the demand for bread
might be affected by a change in bakers' wages, with a consequent effect on the price of bread.
Calculating the equilibrium price of just one good, in theory, requires an analysis that accounts
for all of the millions of different goods that are available.
 40

4.2 Definition

General equilibrium theory or competitive analysis is a branch of theoretical economics

which seeks to explain the behavior of supply, demand, and prices in a whole economy with
several or many interacting markets, by seeking to prove that a set of prices exists that will result
in an overall equilibrium, hence general equilibrium, in contrast to partial equilibrium, which
only analyzes single markets. As with all models, this is an abstraction from a real economy; it is
proposed as being a useful model, both by considering equilibrium prices as long-term prices and
by considering actual prices as deviations from equilibrium.

4.3 Efficiency between production and consumption

The relation between production and consumption in a simple seven equation model (2x2x2
model) can be shown graphically. In the diagram below, the aggregate production possibility
frontier, labeled PQ shows all the points of efficiency in the production of goods X and Y. If the
economy produces the mix of good X and Y shown at point A, then the marginal rate of
transformation (MRT), X for Y, is equal to 3.

Point A defines the boundaries of an

Edge worth box diagram of consumption.
That is, the same mix of products that are
produced at point A, can be consumed by
the two consumers in this simple
economy. The consumers' relative
preferences are shown by the
indifference curves inside the Edgeworth
box. At point B the marginal rate of
substitution (MRS) is equal to 2, while at point C the marginal rate of substitution is equal to 3.
Only at point C is consumption in balance with production (MRS=MRT). The curve 0BCA
 41

(often called the contract curve) inside the Edgeworth box defines the locus of points of
efficiency in consumption (MRS1=MRS ²). As we move along the curve, we are changing the
mix of goods X and Y that individuals 1 and 2 choose to consume. The utility data associated
with each point on this curve can be used to create utility functions.

4.4 Social welfare maximization

Utility functions can be derived from the points on a contract curve. Numerous utility functions
can be derived, one for each point on the production possibility frontier (PQ in the diagram
above). A social utility frontier (also called a grand utility frontier) can be obtained from the
outer envelope of all these utility functions. Each point on a social utility frontier represents an
efficient allocation of an economy's resources; that is, it is a Pareto optimum in factor allocation,
in production, in consumption, and in the interaction of production and consumption (supply and
demand). In the diagram below, the curve MN is a social utility frontier. Point D corresponds
with point C from the earlier diagram. Point D is on the social utility frontier because the
marginal rate of substitution at point C is equal to the marginal rate of transformation at point A.
Point E corresponds with point B in the previous diagram, and lies inside the social utility
frontier (indicating inefficiency) because the MRS at point C is not equal to the MRT at point A.

Although all the points on the grand social utility frontier are Pareto efficient, only one point
identifies where social welfare is maximized. Such point is called "the point of bliss". This point
 42

is Z where the social utility frontier MN is tangent to the highest possible social indifference
curve labelled SI.

4.5 Pareto efficiency

One useful criterion for comparing the outcomes of different economies institutions is a concept
known as Pareto efficiency or economic efficiency.

Let us define some concepts relating to it:

 Pareto improvement: is the way of making some people better off without making
anybody else worse off. In other words both parties are better off, no one who is
worse off.
 If an allocation allows for Pareto improvement, it is called Pareto inefficient.
 If an allocation is such that no Pareto improvements are possible, it is called Pareto
efficient.

Pareto efficiency, or Pareto optimality, is a state of allocation of resources in which it is

impossible to make any one individual better off without making at least one individual worse
off. The term is named after Vilfredo Pareto (1848–1923), an Italian economist who used the
concept in his studies of economic efficiency and income distribution. The concept has
applications in academic fields such as engineering.

Given an initial allocation of goods among a set of individuals, a change to a different allocation
that makes at least one individual better off without making any other individual worse off is
called a Pareto improvement. An allocation is defined as "Pareto efficient" or "Pareto optimal"
when no further Pareto improvements can be made.

For example, suppose there are two consumers A & B and only one resource X. Suppose X is
equal to 20. Let us assume that the resource has to be distributed equally between A and B and
thus can be distributed in the following way: (1,1),(2,2),(3,3), (4,4), (5,5), (6,6),(7,7),(8,8),(9,9),
(10,10). At point (10,10) all resources have been exhausted. No further distribution is possible -
if redistribution continues, it will lead to a position (11,9) or (9,11) that makes one better off and
 43

the other worse off. Hence, point (10,10) is Pareto optimal; no further Pareto improvements can
be made.

Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a socially
desirable distribution of resources: it makes no statement about equality, or the overall well-
being of a society. The notion of Pareto efficiency can also be applied to the selection of
alternatives in engineering and similar fields. Each option is first assessed under multiple criteria
and then a subset of options is identified with the property that no other option can categorically
outperform any of its members.

4.6 Externalities

4.6.1 Definition

An externality is a cost or benefit that accrues to someone who is not the buyer (demander) or the
seller (supplier). If externalities exist, it means that those involved in the demand and supply in
the market are not considering all the costs and benefits when making their market decisions.

When the market fails to yield optimal results, the externalities exist, and they are the effects of a
decision on a third party that is not taken into account by the decision-maker.

Private costs and benefits are costs and benefits that are borne solely by the individuals involved
in the transaction.

4.6.2 Types of externalities

Externalities can be either positive or negative:

 Negative externalities occur when the effects of a decision not taken into account by the
decision-maker are detrimental to others.
 Positive externalities occur when the effects of a decision not taken into account by the
decision-maker are beneficial to others.

Examples of the negative externalities:

Marginal social cost includes all the marginal costs borne by society.
 44

It is the marginal private costs of production plus the cost of the negative externalities associated
with that production.

When there are negative externalities, the competitive price is too low and equilibrium quantity
too high to maximize social welfare.

A negative externality may result when some of the costs of an activity are not borne by
consumers or firms not directly involved in the activity.

Social cost: the total social cost of a transaction is the private cost plus the external cost.

If all of the costs of a transaction are borne by the participants in the transaction, the private costs
and the social costs are the same.
 45

Negative Externalities
With a negative
externality, the supply
curve does not reflect the
true cost of the good. As
a result, the supply that is
provided is greater than it
would be if suppliers had
to pay all the costs
(including the external
cost). SP is the supply
provided, whereas SS is
the supply as it would be
if the suppliers had to pay
the external cost.

A Negative Externality*

S1 = Marginal social cost

Cost
S = Marginal private cost
Marginal cost
P1 from externality
P0

D = Marginal
social benefit
0 Q1 Q0 Quantity

Examples on positive externality:

Private trades can benefit third parties not involved in the trade.
 46

A person who is working and taking night classes benefits himself directly, and his co-workers
indirectly. Marginal social benefit equals the marginal private benefit of consuming a good plus
the positive externalities resulting from consuming that good.
 47

A Positive Externality

S = Marginal private and social cost

Cost
P1
D1 = Marginal social benefit
Marginal benefit of an externality
P0

D0 = Marginal private benefit

0 Q0 Q1 Quantity
 48

Positive Externalities
With a positive
externality, the demand
curve does not reflect all
the benefits of the good.
As a result, the demand
that is given in DP is less
than it would be if
demanders received all
the benefits (including
the external one). DS is
the demand as it would
be if the demanders
received the external
benefit.

4.6.3 Production and externalities

A steel mill produces jointly steel and pollution. The pollution adversely affects a nearby fishery.
Both firms are price-takers and Ps is the market price of steel and Pf is the market price of fish.

If Cs(s,x) is the steel firm’s cost of producing s units of steel jointly with x units pollution and if
the steel firm does not face any of the external costs of its pollution production then its profit

function is π s ( s, x )=Ps . S−Cs (s, x)

∂Cs (s, x ) ∂Cs(s ,x )

PS =
The first-order profit-maximization conditions are: ∂S and 0= ∂x states
that the steel firm should produce the output level of steel for which price = marginal production
cost.
 49

∂Cs (s , x )
PS =
∂S is the rate at which the firm’s internal production cost goes down as the

∂Cs(s ,x )
pollution level rises, so - ∂x is the marginal cost to the firm of pollution reduction.

What is the marginal benefit to the steel firm from reducing pollution?

Zero, since the firm does not face its external cost. Hence the steel firm chooses the pollution

∂Cs(s , x )
level for which - ∂x =0

2 2
Example: Suppose Cs(s,x)= S +( x−4 ) and Ps=12, then

2 2
π s ( s , x )=12 S−S −( x−4 ) and the first-order profit-maximization conditions are:

12= 2s and 0= -2(x-4)

Ps=12=2s, determines the profit-max

¿
Output level of steel S =6

-2(x-4) is the marginal cost to the firm from pollution reduction. Since it gets no benefit from this
¿
it sets x =4

2 2
The steel firm’s maximum profit level is thus π s ( s , x )=12 s−s −( x−4 ) =36

The cost to the fishery of catching f units of fish when the steel mill emits x units of pollution is
Cf(f,x).

Given f, Cf (f,x) increases with x, i.e, the steel firm inflicts a negative externality on the fishery.

The fishery’s production function is π f (f , x )= pf . f −cf (f , x ) so the fishery’s problem is to

max π f (f , x )= pf . f −cf (f , x )
 50

∂Cf (f , c)
The first-order profit-maximization condition is Pf= ∂f

Higher pollution raises the fishery’s marginal production cost and lowers both its output level
and its profit. This is the external cost of the pollution.

Suppose Cf(f,x)= f 2 + xf and Pf=10. The external cost inflicted on the fishery by the steel
firm is xf. Since the fishery has no control over x it must take the steel firm’s choice of x as a
2
given. The fishery’s profit function is thus π f (f , x )=10 f −f −xf

Given x, the first-order profit-maximization condition is 10=2f+x, so given a pollution level x

inflicted upon it, the fishery’s profit-maximizing output level is

¿ x
f =5−
2

Notice that the fishery produces less and earns less profit, as the steel firm’s pollution level
increases.

The steel firm, ignoring its external cost inflicted upon the fishery, chooses x=4, so the fishery’s
profit-maximizing output level given the steel firm’s choice of pollution level is f=3, given the
2
fishery a maximum profit level of π f (f , x )=10 f −f −xf =9

Are these choices by the two firms efficient?

When the steel firm ignores the external costs of its choices, the sum of the two firm’s profit is
36+9= 45

Is 45 the largest possible total profit that can be achieved?

Merger and Internalization

Suppose the two firms merge to become one. What is the highest profit this new firm can
achieve?

The first-order profit-maximization conditions are:

 51

∂ πm
=12−2 s=0
∂s

∂ πm
=10−2 f −x=0
∂f

∂ πm
=−2( x−4 )−f =0
∂x

The solution is

S m=6
f m=4
x m=2

Suppose the two firms merge to become one. What is the highest profit this new firm can
achieve?

π m (s , f , x )=12 s+10 f −s2 −( x−4 )2 −f 2 −xf and the merged firm’s maximum profit level

is

2 2
π m ( s m , x m , f m )=12 sm +10 f m−sm−( x m−4 ) −f m−x m f m =48

This exceeds 45, the sum of the non-merged firms.

 Merger has improved efficiency

 On its own, the steel firm produced x=4 units of pollution
 Within the merged firm, pollution production is only x=2 units.

So, merger has caused both an improvement in efficiency and less pollution production. Why?

2 2
The steel firms’ profit functions is π s ( s , x )=12 s−s −( x−4 ) so the marginal cost of
producing x units of pollution is Mc (x)=2(x-4)
 52

When it does not have to face the external cost of its pollution, the steel firm increases pollution
until this marginal cost is zero, hence x=4

2 2 2
In the merged firm the profit function is π m ( s , f , x )=12 s+10 f −s −( x −4 ) −f −xf

The marginal cost of pollution is thus Mc=2(x-4)+f > 2(2-4) = Mc (x)

The merged firm’s marginal pollution cost is larger because it faces the full cost of its own
pollution through increased costs of pollution in the fishery, so less pollution is produced by the
merged firm.

But why is the merged firm’s pollution level of

x m=2 efficient?

The external cost inflicted on the fishery is xf, so the marginal external pollution cost is
e
MC x =f

The steel firm’s cost of reducing pollution is −MC m (x )=2( x−4 )

e
Efficiency requires MC x =MC m ( x )⇒ f =2( x−4 )

 Merger therefore internalizes an externality and induces economic efficiency

 How else might internalization be caused so that efficiency can be achieved?

4.6.4 Coase and production externalities

In law and economics, the Coase theorem describes the economic efficiency of an economic
allocation or outcome in the presence of externalities. The theorem states that if trade in an
externality is possible and there are sufficiently low transaction costs, bargaining will lead to an
efficient outcome regardless of the initial allocation of property. In practice, obstacles to
bargaining or poorly defined property rights can prevent Coasian bargaining.

Suppose the property right to the water is created and assigned to one of the firms. Does this
induce efficiency?
 53

Suppose the fishery owns the water. Then it can sell pollution rights, in a competitive market, at
Px each.

2
The fishery’s profit function becomes π f (f , x )= pf . f −f −xf + p x x

Given pf and px, how many fish and how many rights does the fishery wish to produce? (Notice
that is now a choice variable for the fishery).

The profit-maximum conditions are:

∂ πf
=−x + p x =0 ¿
∂x and these are f = p x (Fish supply)

x s = p f −2 p x
¿
(Pollution right supply)

The steel firm must buy one right for every unit of pollution it emits so its profit function
2 2
becomes: π s ( s, x )=P s S−S −( x−4 ) −P x x

Given pf and px, how much steel does the steel firm want to produce and how many rights does
it wish to buy?

2 2
π s ( s , x )=PsS−S −(x −4 ) − px . x

The profit-maximum conditions are:

∂ πs
= ps−2 s=0
∂s

∂ πs
=−2(x −4 )− px=0
∂x

Ps Px
S ¿= X d =4−
And these give 2 (steel supply), and 2 (Pollution right demand)
 54

In a competitive market for pollution rights the price px must adjust to clear the market so, at

Px
X d =4− =Pf −Px=Xs⋅¿ ¿
equilibrium 2

4.6.5 Solutions of externalities

One class of solutions to the externality problems involves internalizing the costs and benefits, so
that the market can work better.

 Pollution Tax: if a firm is creating a negative externality in the form of pollution, create a
tax on the polluting firm equal to the cost of cleaning up the pollution.
 55

Regulation Through Taxation*

Cost Marginal social cost

Marginal private cost

P1
Efficient tax
P0
Marginal social
benefit
0 Q1 Q0 Quantity

Pollution Tax

 Another approach is command rather than imposing a tax or offering a subsidy; the
government simply requires or commands the activity.
 56

– For a negative externality like pollution, the government simply requires the
company to stop polluting.
– For a positive externality, like inoculation, the government requires certain classes
of citizens to be inoculated.
 57

CHAPTERFIVE: SLUTSKY EQUATION

5.1 Introduction
The economists are concerned with how a consumer’s behavior changes in response to changes
in the economic environment. The case is how a consumer’s choice of a good responds to
changes in its price.

Every price change can be decomposed into an income effect and a substitution effect; the price
effect is the sum of substitution and income effects.

If the good in question is a normal good, then the income effect from the rise in purchasing
power from a price fall reinforces the substitution effect. If the good is an inferior good, then the
income effect will offset in some degree the substitution effect. If the income effect for an
inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less
expensive, a Giffen good (commonly believed to be a rarity).

5.2 The Substitution effect

When the price of a good changes, there are two effects: the rate at which you can exchange one
good for another changes, and the total purchasing power of your income is altered. If, for
example, good 1 becomes cheaper, meaning that you have to give up less of the good 2 for
purchasing good 1. The change in price of good 1 has changed the rate at which the market
allows you to substitute good 2 for good 1.

At the same time, if good 1 becomes cheaper it means that your income will buy more of good 1.
The purchasing power of your income has gone up. Even though the amounts of money has not
been changed but what you it will be able to buy has increased.

Let us calculate how much we have to adjust money income in order to keep the old bundle just
affordable. Let m’ be the amount of money that will just make the original consumption bundle
affordable. Since (x1, x2) is affordable at both (p1, p2, m) and (p’1, p2, m’), we have:
 58

¿
m ¿= p x 1 + p 2 x 2

m= p1x1+p2x2

¿
m/-m= x 1 [ p1− p1 ]

m/-m or ∆ m=x1 ∆ p1

More precisely, the substitution effect, ∆ x s1, is the change in the demand for good 1when the
¿
price of good 1 changes to p1and at the same time, money income changes to m/:

∆ x s1= x 1 ( p 1¿ , m¿ ) – x 1 ¿

m
Example: Suppose that the consumer has a demand function for milk of the form x1= 10+ .
10 p 1
Originally his income is Rwf 120 per week and the price of milk is Rwf 3 per quart. Thus his
demand for milk will be10+120/(10*3)=14 quarts per week.

Now suppose that the price of milk falls to Rwf 2 per quart. Then his demand at this new price
will be be10+120/(10*2)=16 quarts per week. Following the formula:
∆ m=x1 ∆ p1=14∗( 2−3 )=−14 .

Thus the level of income necessary to keep purchasing power constant is m /=m+∆ m= 120-
14=106. What is the demand consumer’s demand for milk at the new price, Rwf 2 per quart, and
this level of income? Just plug the numbers into the demand function to find:

x 1 ( p 1¿ , m¿ )= x1(2, 106) = 15.3: thus the substitution effect : ∆ x s1= x1(2, 106)- x1(3, 120)= 15.3
– 14= 1.3.

5.3 The Income effect

Let s turn now on the second stage of the price adjustment (the shift movement).t is known that a
parallel shift of the budget line is the movement that occurs when income changes while relative
 59

prices remain constant. We simply change the consumer’s income from m / to m, keeping the
¿
prices constant at ( p1 , p2).

More precisely, the income effect, ∆ x n1, is the change in demand for good 1 when we change
¿
income from m/ to m, holding the price of good 1 fixed at p1 ;

then ∆ xn1 =x1 ( p 1 , m) – x 1 ( p 1 , m ).

¿ ¿ ¿

When the price of the good decreases, we need to decrease income in order to keep purchasing
power constant. If the good is normal good, then this decrease in income will lead to a decrease
in demand. If the good is an inferior good, then the decrease in income will lead to an increase in
demand.

Example:

x 1 ( p 1¿ , m)= x1(2, 120)= 16

x 1 ( p 1¿ , m¿ ) = x1(2, 106) = 15.3

Thus the income effect for this problem is: ∆ x n1=x 1 ( p 1¿ , m) – x 1 ( p 1¿ , m¿ ) = x1(2, 120) - x1(2,
106) = 16- 15.3 = 0.7. Since milk is a normal good for this consumer, the demand for milk
increases when income increases.

5.4 The Total change in demand

The total change in demand, ∆ x 1 , is the change in demand due to the change in price, holding
income constant: ∆ x 1 , = x 1 ( p 1¿ , m) – x 1 ( p1 , m1).

The summation of the two parts: Substitution and Income effect, compose the Price effect. In
terms of the symbols defined above: ∆ x 1=∆ x 1s +∆ x n1

x 1 ( p 1¿ , m) – x 1 ( p1 , m1) = ¿.This equation is called Slutsky identity, named for the

EugenSlutsky (1880-1948), a Russian economist who investigated demand theory.
 60

5.5 Rates of change

Algebraically, we have seen how the Slutsky identity is described as: ∆ x 1=∆ x 1s +∆ x n1, which
simply says that the total change in demand is the combination of substitution effect and income
one. The Slutsky identity here is stated in terms of absolute changes, but it is more common to
express it in terms of rates of change.

When we express the Slutsky identity in terms of rates of changes it turns out to be convenient to
define ∆ x m1 to be the negative of the income effect: ∆ x m1 =x1 ( p 1¿ , m¿ ) - x 1 ( p 1 , m )= - ∆ x n1.
¿

Given the definition the Slutsky becomes, ∆ x 1=∆ x s1−∆ xm1 , if we divide each side of the identity

∆ x 1 ∆ x s1 ∆ x1m
by ∆p1, we have: = − .
∆ p 1 ∆ p 1 ∆ p1

The first term of the right hand side is the rate of the change of demand when price changes and
income is adjusted so as to keep the old bundle affordable, the substitution effect. Let us work on
the second term. Since we have an income change in the numerator, it would be nice to get an
income change in denominator.

Remember that the income change, ∆ m, and the price change, ∆ p1, are related by the formula:

∆m
∆ m=x1 ∆ p . Solving for∆ p1, we find ∆ p1= . Now substitute this expression by the last term,
1
x1

∆ x 1 ∆ x s1 ∆ x1m
in the following identity = − .for getting the final formula:
∆ p 1 ∆ p 1 ∆ p1

∆ x 1 ∆ x s1 ∆ x m1
= − x . This is the Slutsky in terms of rates of change. Each term can be
∆ p1 ∆ p1 ∆m 1

∆ x1 x1 ( p 1¿ , m) – x 1 ( p1 ,m 1)
interpreted as follows: = , is the rate of change in demand as price
∆ p1 ∆ p1

∆ x s1
changes, holding income fixed; =x 1 ( p 1 ,m ) −x 1 ¿ ¿, is the rate of change in demand as the
¿ ¿
∆ p1
 61

price changes, adjusting income so as to keep the old bundle just affordable, that is, the
substitution effect;

∆ x m1 x1 ( p 1¿ , m ¿ )−x 1 ( p 1¿ , m )
and x = x1 , which is the rate of the change of demand holding
∆m 1
¿
m −m
prices fixed and adjusting income, that is the income effect.

The income effect is itself composed of two pieces: how demand changes as income changes,
times the original level of demand. When the price changes by∆ p 1, the change in demand due to

x 1 ( p1¿ , m¿ )−x 1 ( p 1¿ ,m )
the income effect is ∆ x m1 = x1 ∆ p .
∆m 1

But this last term, x 1 ∆ p , is just the change in income necessary to keep the old bundle feasible.
1

That is, ∆ m=x1 ∆ p , so the change in demand due to the income effect reduces to
1

m x 1 ( p1¿ , m¿ )−x 1 ( p 1¿ ,m )
∆x =
1 ∆ m, Just as we had before.
∆m

Note that the Slutsky identity can be found from observable things, namely, the derivative of the
Marshallian demand with respect to price and income. This relationship is known as the Slutsky
equation.

∂ x j ( p , m) ∂h j( ( p , v ( p , m) ∂ x j ( p , m)
= + x i ( p , m)
Slutsky equation: ∂ pi ∂ pi ∂m

Note carefully the meaning of this expression. The left-hand side is how the compensated
demand changes when pi changes. The right-hand side says that this change is equal to the
change in demand holding expenditure fixed at m* plus the change in demand when income
changes times how much income has to change to keep utility constant.

As we mentioned previously, the restrictions all about the Hicksian demand functions are not
directly observable. However, as indicated by the Slutsky equation, we can express the
 62

derivatives of h with respect to p as derivatives of x with respect to p and m, and these are
observable.
Example: The Cobb-Douglas Slutsky equation. Let us check the Slutsky equation in the

αm
α 1−α x 1 ( p1 , p 2 , m)=
Cobb-Douglas case: e ( p 1 , p2 ,u )=up 1 p2 p1 ;
;
α −1 1−α
h( p1 , p2 , u)=αp 1 p2 u
.
 63

Graph showing the Income and Substitution Effects:

Normal Good

Clothing
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
C1 A relative prices but keeps real
(satisfaction) constant.

The income effect, EF2,

( from D to B) keeps relative
D B prices constant but
C2 increases purchasing power.

Substitution U2
Effect U1
Food (units
O F1 Total Effect E S F2 T per month)
Income Effect

CHAPTER SIX: UNCERTAINTY

 64

6.1 Definition

Uncertainty is a situation which involves imperfect and/or unknown information. It arises in

subtly different ways in a number of fields, including insurance, philosophy, physics, statistics,
or economics.

6.2 Contingent consumption

The consumer is rational in his way of making a choice, but then let us think about to what will
happen under uncertainty. The consumer is presumably concerned with the probability
distribution of getting different consumption bundles of goods.

Let us use an example for the more understanding the above term used: Suppose that an
individual initially has Rwf 35,000 worth of assets, but there is a possibility that he may lose
Rwf 10,000. In the case of stooling his car or a storm may damage his house. Suppose that the
probability of this event happening is 0.01. Then the probability distribution the person is facing
is a 1% probability of having Rwf 25,000 of assets, and 99% probability of having Rwf 35,000.

Insurance offers a way to change this probability distribution. Suppose that there is an insurance
contract that will pay the person Rwf 100 if the loss occurs in exchange for a Rwf 1 premium. Of
course the premium must be paid whether or not the loss occurs. If the person decides to
purchase Rwf 10,000 of insurance, it will cost him Rwf 100. In this case he will have a 1%
chance of havingRwf 34,900 = Rwf 35,000 of other assets – Rwf 10,000 loss +Rwf 10,000
payment from the insurance payment – Rwf 100 insurance premium; and a 99% chance of
having Rwf 34,900= Rwf 35,000 of other assets– Rwf 100 insurance premium. Thus the
consumer nds up with the same wealth no matter what happens. He is now fully insured against
loss.

In general, if the person purchases K Rwf of insurance and has to pay a premium ɣK, then he
will face the following situation: Probability 1% of getting Rwf 25,000 +K- ɣK; and probability
99% of getting Rwf 35,000 - ɣK.

6.3 Utility Functions and Probabilities

The person values consumption in one way or another, depending upon the probability that the
state in question will actually occur. Let us analyze the consumption situation in the different
periods: Rainy and Sunny; the rate at which I am willing to substitute consumption if it rains for
consumption if it doesn’t should have something to do with how likely I think it is rain. The
preferences of consumption in different states of nature will depend on the beliefs of the
individual about how likely those states are. Let us denote C 1 and C2 represent consumption in
states 1 and 2, and let π1 and π2 be the probabilities that state 1 or 2 actually occurs.
 65

If the two states are mutually exclusive, so that only one of them can happen, then π 2= 1-π1.
Given this notation, the utility f(x) of the consumption in the sates 1 and 2 is written as follows:
u ( C 1, C 2 , π 1 , π 2 ) .

Example: Suppose that the utility function of the form: u ( C 1, C 2 , π 1 , π 2 )=π 1 C1 + π 2 C 2 .In the
context of uncertainty, this kind of expression is known as the expected value. It is just the
average level of consumption that you would get.

Another example of a utility f(x) that might be used to examine choice under uncertainty in the
Cobb-Douglas utility function: u ( C 1, C 2 , π 1 , π 2 )=C π1 C1−π
2 =

ln u ( C 1 , C2 , π 1 , π 2 )=π 1 ln C1 +1−π 1 ln C 2=π 1 lnC 1+ π 2 ln C 2.

6.4 Expected utility

Let us take the following form:( C 1 , C2 , π 1 , π 2 ) =π 1 v (C ¿¿ 1)+ π 2 v (C ¿¿ 2)¿ ¿. Where v(C¿¿ 1)¿
and v(C¿¿ 2) weig h tedsumofconsumptionfunctionineac h state ; ¿and weights are given by
probabilities π 1∧π 2 .

The perfect substitutes, or expected value utility f(x), had this form where v ( c )=c . The Cobb-
Douglas didn’t have this form originally, but when we expressed it in terms of logs, it had the
linear form with v ( c )=lnc.

If one of the states is certain, so that π 1=1 , say , then v(C¿¿ 1)¿ is the utility of the certain
consumption in the state 1. Similarly, if π 2=1, v(C¿¿ 2)¿ is the utility of consumption in state 2.
Thus the expression π 1 v (C¿¿ 1)+ π 2 v (C¿¿ 2)¿ ¿ represents the average utility, or the expected,
of the pattern of consumption (C 1, C 2).

The function v ( u ) =au+b where a>0, is a positive affine transformation which means simply
multiplying by a positive number and adding a constant. This is a special kind of monotonic
transformation.

6.5 Reasonability of Expected utility

The consumption will be done in different circumstances.

e.g: House can be burnt:

 Co: Wealth now

 C1: Wealth if the house burns down
 C2: Wealth if it does not
 π 1 : Probability of burning a house
 π 2:Probability that it does not.
 66

u(π 1 , π 2 , C 0 , C1 , C 2 , ) The consumption function

Assume that: u ( C 1, C 2 , C 2, )=π 1 u ( C1 ) + π 2 u ( C2 ) + π 3 u ( C3 )

You have to consider how much consumption you will have in the other state of nature –how
much wealth you will have if the house is not destroyed.

The third situation depends on goods 1 and 2.

∆ u(C 1 , C2 , C 3)/ ∆C 1
MRS12=
∆ u(C 1 , C2 , C 3)/ ∆C 2

π 1 ∆ u(C1 )/∆ C1
=
π 2 ∆ u(C2 )/∆ C2

6.6 Risk aversion

Eg: Suppose a consumer currently has Rwf 10 of wealth and is contemplating a gamble that
gives him a 0.50% probability of winning Rwf 5 and 50% of losing Rwf 5. His wealth will
therefore be random: He has a 50% probability of ending up with Rwf 5 and 50% of ending up
by Rwf 15. The expected value of his wealth is Rwf 10, and the expected utility is:

1 1
u(Rwf 15) + u(Rwf 5): It is the expected utility of wealth.
2 2

But the expected value of wealth: u(Rwf 10).

The expected utility of wealth is less than the utility of the expected of wealth:

1 1 1 1
U ( ∗¿15) + U( ∗¿ 5)= U(10) > u(15) + u(5)
2 2 2 2

Graph on a board

Risk aversion: A risk-averse consumer, the utility of the expected value of wealth, u(10), is
greater than the expected utility of wealth. 0.5u(15) + 0.5u(5). He prefers to have the expected
value of his wealth rather than face the situation (gamble).

Graph on a board

Risk loving: the expected utility of wealth, 0.5u(5) + 0.5u(15), is greater than the utility of the
expected value of wealth, U(10).

Recall the example:

Wealth: Rwf 35,000

 67

Loss: Rwf 10,000: probability of loss=1% and it costs him γK to purchase K Rwandan franc of
−γ
insurance. MRS=
1−γ

C1: Rwf 35,000 – γK

C2: Rwf 35,000 – Rwf 10,000+K - γK

π ∆ u(C 2)/ ∆C 2 −γ
MRS¿ =
1−π ∆ u(C 1)/∆ C 1 1−γ

With probability π they must pay out K and with probability (1−π) they pay out nothing. No
matter what happens, they collect the premium γK .Then the expected profit, P, of the insurance
company is: P= γK −πK - (1−π)0= γK −πK

P= γK −πK =0

Which implies π = γ

π ∆ u(C 2) /∆C 2 −π
=
1−π ∆ u(C 1)/∆ C 1 1−π

Marginal utility of an extra Rwf of income if the loss occurs should be equal be equal to the
Marginal utility of an extra Rwf of income if the loss doesn’t occur, if C1=C2.
 68

VCHAPTER SEVEN: RISK ASSETS

How the stock markets serve to allocate risk.

7.1 Mean variance utility

Another approach to choice under uncertainty is to describe the probability distributions that are
the objects of choice by a few parameters and think of the utility f(x) as being defined over
those parameters. This approach is mean-variance model.

Let us suppose that a random variable W takes on the values Ws for s=1,…..s with probability π s

s
. The mean of a probability distribution is simply its average value: μw =∑ π s W s
s=1

s
And then, σ 2=( w−μ w )2= ∑ π s (w s−μw )2: measures the spread of the distribution and is a
s=1

reasonable measure of riskiness involved.

The mean σ 2 model assumes that the utility of a probability distribution that gives the investor
wealth Ws with a probability of π s .

Suppose that you can invest in two different assets. One of them with the risk-free asset always
pays a fixed rate of return rf. Eg: Treasury-bills. The other one is a risk asset, for buying a
stock. Let ms be the return on this asset if sate S occurs, and let π s be the probability that sate
will occur. We will use r m o denote the expected return of the risky asset and σ mto denote the
standard deviation of its return.

If you hold a fraction of wealth x in the risk asset, and a fraction (1-x) in the risk-free asset, the

s
expected return on your portfolio will be given by: r s=∑ (xms+(1−x ) rf ) π s =
s=1

s
x ∑ ms π s+(1−x )rf ¿ ¿ ∑ π s
s=1
 69

Then ∑ π s=1

Also, r s=xrm+(1−x)rf

NB: This chapter is dedicated to the students as the assignment.

CHAPTER EIGHT: INTERTEMPORAL CHOICE

8.1 Definition
Intertemporal choice is the study of the relative value people assign to two or more payoffs at
different points in time. Most choices require decision-makers to trade-off costs and benefits at
different points in time.

Different views according to the various economists

8.2 Intertemporal Choice by Irving Fisher

The consumption function introduced by Keynes relates current consumption to current income.
This relationship, however, is incomplete at best. When people decide how much to consume
and how much to save, they consider both the present and the future. The more consumption they
enjoy today, the less they will be able to enjoy tomorrow. In making this tradeoff, households
must look ahead to the income they expect to receive in the future and to the consumption of
goods and services they hope to be able to afford.

The economist Irving Fisher developed the model with which economists analyze how rational,
forward-looking consumers make intertemporal choices that is, choices involving different
periods of time. Fisher’s model illuminates the constraints consumers face, the preferences they
have, and how these constraints and preferences together determine their choices about
consumption and saving.
 70

Fisher's Model of Intertemporal Consumption

Irving Fisher developed the theory of intertemporal choice in his book Theory of interest (1930).
Contrary to Keynes, who related consumption to current income, Fisher’s model showed how
rational forward looking consumers choose consumption for the present and future to maximize
their lifetime satisfaction.

According to Fisher, an individual's impatience depends on four characteristics of his income

stream: the size, the time shape, the composition and risk. Besides this, foresight, self-control,
habit, expectation of life, and bequest motive (or concern for lives of others) are the five personal
factors that determine a person's impatience which in turn determines his time preference.

Budget constraint

In order to understand the choice exercised by a consumer across different periods of time we
take consumption in one period as a composite commodity; in fact we want to examine how the
consumer’s income in the two periods constrains consumption in the two periods.

C2 = m2 + (m1-c1)+r(m1-c1)

= m2 + (1+r) (m1-c1)

If he is a borrower, c1 > m1, and the r he has to pay in the second will be r(c1-m1), then

C2= m2 -r (m1-c1)-(m1-c1)

= = m2 + (1+r) (m1-c1)

 If m1-c1 is positive, the consumer earns th e interest, if not he pays the interest to the
amount borrowed.

 If C1=M1, then C1=M2, he is neither a Borrower nor a Lender. This consumption

position is a “Polonius point”.
 71

Note that in the first period S = M 1- C1. Then in the second period, consumption equals to the
accumulated saving, including the interest earned on that saving, plus second period income.
That is C2= (1+r)S+ M2; by replacing S by its value we get: C2= (1+r)(M1-C1)+M2.

Then (1+r) C1+C2= (1+r)M1+M2 Future value. If we divide both sides by 1+r, we get:

C2 M2
C 1+ =M 1+ . Present value. This equation relates the consumption in the two
1+ r 1+r
periods to income in two periods. It is the standard way of expressing the consumer’s
intertemporal budget constraint.

The left hand side of the above equation shows the present value expenditure and right hand side
depicts the present value income respectively. Multiplying the equation by 1+r gives us the
future value. If the interest rate is zero, the budget constraint says that total consumption in the
two periods equals total income in the two periods. In the usual case in which the interest rate is
greater than zero, future consumption and future income are discounted by a factor 1+r. This
discounting arises the interest earned on savings.

The figure depicts the intertemporal choice exercised by the consumer, given the utility

m2
preferences and the budget constraint; where c2= (1+r)m1+m2: Future value, and m1+ :
1+ r
Present value

Now consumer has to choose a C1 and C2 such that maximize U(C1,C2) subject to

C2 Y2
C 1+ =Y 1+ .
1+ r 1+r
 72

The change in the real interest rate affects surely the consumption; graphically the look like the4
followings:

If the consumer is a net saver, an increase in interest rate will have an ambiguous effect on the
current consumption.

If the consumer is a net borrower, an increase in interest rate will reduce his current
consumption.

A consumer may be a net saver or a net borrower. If he's initially at a level of consumption
where he's neither of the above (i.e. a net borrower or net saver), an increase in income may
 73

make him a net saver or a net borrower depending on his preferences. An increase in current
income or future income will increase current and future consumption (consumption smoothing
motives).

Now, let us consider a scenario where the interest rates are increased. If the consumer is a net
saver, he will save more in the current period due to the substitution effect and consume more in
the current period due to the income effect. The net effect thus, becomes ambiguous. If the
consumer is a net borrower, however, he will tend to consume less in the current period due to
the substitution effect and income effect thereby reducing his overall current consumption.

In nutshell Fisher’s model expresses that consumption depends on a person’s lifetime income.

8.3 Franco Modigliani and life-cycle hypothesis

The income that varies over people’s lives and the saving allows consumers to move income
from those times in life whether is high or low. So, the interpretation of that consumer behavior
formed the basis for life-cycle hypothesis.

A retirement is one of the many reasons which causes income to vary over a person’s life. Most
people plan to retire at about age of 65 and expect a large drop in their income; yet they do not
want a large drop in their consumption. Most people provide for their retirement by saving.

Consider a consumer who expects to live another T years, has a wealth of W, and expects to earn
income Y until he retires R years from now. What level of consumption will the consumer
choose if he wishes to maintain a smooth level of consumption over his life?

Please note that the consumer’s lifetime resources are composed of initial wealth W and lifetime
earnings R*Y; then he can divide up his lifetime resources among his T remaining years of life.

(W + RY ) 1 R
The consumption function becomes, C= or C= W + Y
T T T
 74

Example: A given consumer X, expects to live for 50 more years and work for 30 more years.
Determine his consumption function.

1 30
Answer: T= 50, and R=30; then his consumption function becomes: W + Y= 0.02W+0.6Y.
50 50
Meaning that an extra Rwf of income raises consumption by 60% per year, and an extra Rwf of
wealth raises consumption 2% per year.

1 ,∧R
Assume that =α =β ; t h enconsumptionfunctionbecomesc=αW + βY .
T T

αW + βY W
αaMPCoutofwealt h , andβisMPCoutofincome . And APC= =α + β
Y Y

Let us show his hypothesis by using a graph:

Where S is saving.

8.4 Inflation
Basing on the formula of Irving Fisher, in the second period a consumer will consume:

P2C2= P2m2+(1+r) (m1-C1)

1+ r
C2= m2 + ( m1−C 1)
p

1+r
Because we know that P1= 1, and then P2= 1+ π, then C2= m2 + (m 1−C 1)
1+ π

1+ r
Let us assume that ρ is the real interest rate: 1+ ρ= , so the budget constraint becomes:
1+ π
 75

C2= m2 + 1+ρ( m1−C 1). One plus the real interest rate measures how much extra consumption
you can get in period 2 if you give up some consumption in period 1.

1+ r
1+ ρ=
1+ π

1+ r 1+r 1+ π r−π
And then, ρ= −1= - = ; then ρ ≈ r−π
1+ π 1+ π 1+ π 1+ π

8.5 Present value

(1+r)C1+C2= (1+r) m1+m2

C2 m2
If we divide each part by 1+r, we getC 1+ =m 1 + : for the 1 period
1+r 1+r

C2 C3 m m3
For the several periods: C 1+ + 2
=m1 + 2 +
1+r (1+r ) 1+ r (1+r )2

1
Then, Pt =
(1+r )t−1

m2 P2
Therefore, m 1+ > P1 + : The present value of the income stream exceeds the present value
1+r 1+r
of its costs, so this is a good investment. It will increase the present value of the endowments.

An equivalent way to value the investment is to use the idea of Net Present Value (NPV):

M¿
M 1−P1 + ¿.
1+r

Eg: considering 2 investments A and B. Investment A pays Rwf 100 now and will also pay Rwf
200 next year. Investment B pays Rwf 0 now, and will generate Rwf 310 next year. Which one is
better investment?

The answer depends on the interest rate.

 If r=0 PVA= 100+200=300

PVB=0+310=310
 76

200
 If r=20% PVA= 100+ =266.67
1.20
310
PVB=0+ =258.33
1.20

8.6 Bonds
Bonds are the financial instruments that promise certain patterns of payment schedules.

Bonds are issued by the governments and corporations. They are basically a way to borrow
money. The borrower the agent who issues the bond promises to pay a fixed number of money
(Rwf) x (the coupon) each period until a certain date T (the maturity date), at which point the
borrower will pay an amount F (the face value) to the holder of the bond.

x x F
PV= 1+ r + 2
+ …+ T
(1+r ) (1+r )

An interesting special kind of a bond is a bond that makes payment forever. These are called
Consols or Perpetuities.

x x
Then, PV= 1+ r +
(1+r )2

1 x x
PV= 1+ r [x + 1+r + +… ]
( 1+ r )2

1
PV= [x + PV ]
1+ r

x
PV=
r
 77

CHAPTER NINE: ASSET MARKET

9.1 Definition
Assets are the goods that provide a flow of services overtime.

Assets can provide a flow of consumption services, like housing services, or can provide a flow
of monetary that can be used to purchase consumption. The ones that provide a monetary flow
are called financial assets.

9.2 Rates of Return

Assume two assets: one has a higher rate of return and the other one not; then no one would want
to buy the asset with the lower rate of return. So in equilibrium, all assets that are actually held
must pay the same of return.

Eg:
 78

 Asset A has current price P 0 and is expected to have a P 1 tomorrow. There is no dividend
or other cash payments between periods 0 and 1.
 Asset B that one can hold between periods 0 and 1 that will pay an interest rate of r.

Either invest 1 Rwf in A and cash it in next period, or invest 1 Rwf in B and earn interest of r
over the period.

We 1st ask how many units of the asset we must purchase to make a one Rwf investment in it.
Letting x be this amount we have the equation:

1
PO x =1,∧¿then, x=
P0

P1
Future value: FV= P1X= .
P0

On the other hand, if we invest 1 Rwf in asset B, we will have 1+r Rwf next period. If assets A
and B are both held in equilibrium, then 0 Rwf invested in either one of them must be worth the

P1
same amount second period. Thus we have an equilibrium condition: 1+r =
P0

P1
If 1+r > , people who own asset A can sell one unit for P 0 Rwf in the first period and invest the
P0
money in asset B. Next period their investment in asset B will be worth P 0(1+r), which is greater
than P1 in the above equation. This will guarantee that 2nd period they will have enough money to
repurchase asset A, and be back where they started from, but now with extra money.

 Buying some of one asset and selling some of another to realize a sure return is known as
riskless arbitrage or arbitrage. Basing on the last example, anyone who held asset A
would want to sell it first period, since they were guaranteed enough money to repurchase

P1
it in the 2nd period; the equilibrium happens if 1+r = .
P0
P1
 Arbitrage and Present value: Po = .
1+ r
 79

9.3 Asset with consumption returns

Many assets pay off only in money.

Assume that someone has a house, he is the owner, will not pay the rent. No explicit rental
payment; but it turns out to be fruitful to think a homeowner as implicitly making such payment.
The implicit rental rate on your house is the rate at which you could rent a similar house.

 If the implicit rental payment on your house is estimated at T Rwf per year;
 Your house is also an investment, if you sell it, the value of it could have been increased:
Appreciation.

Let A represents the expected appreciation in the Rwf value of your house over a year. The total
return to owning your house is the sum of the rental return, T, and the investment return, A. If
your house initially cost P, then the total rate of return on your initial investment in housing is:

T+A T A
h= ; where is a consumption rate of return, and is an investment rate of return.
P P P

Let us use r to represent the rate of return on other financial assets. Then the total rate of return

T+A
on housing should, in equilibrium, be equal to r = .
P

Think about this way. At the beginning of the year, you can invest P in a bank and earn rP Rwf,
or you can invest P Rwf in a house and T Rwf of rent and earn A Rwf at the end of the year.

If T+A < Rp: Better putting your money in bank and you pay a rent “T”. You would have

Rp-T > A Rwf at the end of the year.

If T+A> Rp: Housing is a better choice.

9.4 Application
 Depletable resources: Ressources épuisabales (comme pétrolières)

Suppose having many oil suppliers and the costs is zero. Then how will the price of the oil
change overtime? It turns out that the price of the oil must rise at the rate of interest. If we
 80

consider that the price of the oil is the asset like others; then the cost for holding it should be
equal to the one he could get elsewhere.

If we let Pt+1 and Pt be the prices at times t+1 and t, the we have: Pt+1= (1+r)Pt

Suppose that the demand for oil is constant at D barrels a year and that there is a total world of S

S
barrels. Thus we have a total of T= years of oil left. If there is no oil, the substitutes can be
D
used, at a constant cost of c. Now T years from now, when the oil is just being exhausted, how
much must it sell for? Assume Po is the today’s price of barrel of oil.

Then, Po(1+r )T =c

C
Also, Po =
(1+r )T

When to cut a forest

Suppose that a size of a forest measured in terms of the limber that you can get from it is some
function of time, F(t). Suppose further that the price of lumber is constant and that rate of growth
of the tree starts high and gradually declines. When should the forest be cut?

Answer:

F (T )
When the rate of growth of the forest equals the interest rate, PV =
(1+r )T
 81

NB: The explanation of those graphs, have a look on board

Demonstration

Suppose that you invest 1 Rwf in an asset yielding an interest rate r where the interest is paid
once a year. Then after T years you will have (1+r )T Rwf.

r 12T
 If the interest is paid monthly: (1+ ) Rwf.
12
r 36 5 T
 If it is daily: (1+ ) Rwf.
365
r nT
 In general if the interest is paid n times a year: (1+ )
n
nT
r
Then, e rt = lim (1+ ) where e: 2.7183
n→∞ n
Since forest will be worth F(T) at time T:
F (T ) −rt
V(T) or PV= rt =e F (T )
e
'
V (T )=e F ' (T )+ (e ¿¿−rt )' F (T ) ¿
−rt
 82

V’(T) = e−rt F '( T )- ℜ−rt F (T )=0

V’(T)= e−rt [ F' ( T ) −rF ( T ) ]=0

Thus, e−rt =0

and [ F ' ( T )−rF (T ) ]= 0

F ' (T )
r=
F (T )

This equation says that the optimal value of T satisfies the condition that the rate of interest
equals the rate of growth of the value of the forest.

Eg: Assume the value of Caisse of wine is Kf and that value increases basing on the increasing
function rate Vt= ke √ t , if it is assumed that the value of storage is null, find out P(t):

k e √t
Max P(t)= rt
=k e √ t∗e−rt =k e−rt +√ t
e

lnP(t)= ln(k e−rt +√ t)= lnP(t)= (√ t -rt)lne+lnk

Making a derivative:

dP
∗1 1 12
- dt )’-r =0 ( t −r) = 0
=¿ ¿ 2
P
dP 1 1
- =P( t 2 −r )=0, knowing that P≠0
dt 2
1
- =r
2√ t
- T h en ,ifr=10 %
1
- =0.1
2√ t
1 1
- =
2 √ t 0.1
- 2 √ t=10
- √ t=5
- t=25
 83

INDICATED BOOKS

Hal R. Varian.2003. Intermediate Microeconomics: A modern approach. 6thedition. W.w. Norton

& Company, New York.

William A. McEachern. 2008. Microeconomics: A Contemporary Introduction.

Pindyck, R. &Rubenfeld, D. 2005. Microeconomics. 6th Ed. New Jersey: Prentice Hall. (ISBN: 0-13-
191207-0)

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