SESSION 2:

ALLOCATION OF RESOURCES AND GOVERNMENT

POLICIES

Revisiting Microeconomic theories and the

emergence of Public Policies
 ECONOMICS

Scarcity: the limited nature of society’s resources

Economics: the study of how society manages its scarce resources, e.g.
• how people decide what to buy, how much to work, save, and spend
• how firms decide how much to produce, how many workers to hire
• how society decides how to divide its resources between national defense,
consumer goods, protecting the environment, and other needs
 ROLE OF ECONOMISTS

1. Researcher: try to explain the world

2. Policy Advisor: try to improve it

• As a researcher, economists make positive statements, which attempt

to describe the world as it is.
• Analyze theories of like Law Demand and Supply under certain assumptions

• As policy advisors, economists make normative statements, which

attempt to prescribe how the world should be.
• Economists can argue on normative statements
 MICROECONOMICS AND MACROECONOMICS

• Microeconomics is the study of how households and firms make decisions and
how they interact in markets.

• Macroeconomics is the study of economy-wide phenomena, including inflation,

unemployment, and economic growth.

• These two branches of economics are closely intertwined, yet distinct—they

address different questions.
 BASICS OF DEMAND

• The quantity demanded of any good is the amount of the good that buyers are willing and
able to purchase at a particular price.

• Law of demand: the claim that the quantity demanded of a good falls when the price of the
good rises, other things equal
• Other things equal: Ceteris paribus
• As long as people buy less at higher prices, then the demand curve will be downward sloping.
How much less? Brings up the question of elasticity
 LAW OF SUPPLY

• The quantity supplied of any good is the amount that sellers are willing and able to
sell.

• Law of supply: the claim that the quantity supplied of a good rises when the price of
the good rises, other things equal
 EQUILIBRIUM : SUPPLY AND DEMAND TOGETHER

P
$6.00 D S
P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
Equilibrium is the state where the market clears
SURPLUS (A.K.A. EXCESS SUPPLY):
when quantity supplied is greater than quantity demanded

P Example:
$6.00 D Surplus S
If P = $5,
$5.00 then
$4.00 QD = 9
$3.00 and
QS = 25
$2.00
resulting in a
$1.00 surplus of 16
$0.00 Q
0 5 10 15 20 25 30 35
SHORTAGE (A.K.A. EXCESS DEMAND):
when quantity demanded is greater than quantity supplied
P
$6.00 D S Example: If P = $1,

$5.00
then
$4.00 QD = 21
$3.00
and
$2.00 QS = 5
$1.00
resulting in a
$0.00 Shortage Q shortage of 16
0 5 10 15 20 25 30 35
 PRICE ELASTICITY OF DEMAND

Price elasticity of demand: How demand for ‘Good X’ will change if you raise ‘Price of
X’ ?

A ratio that represents how a fixed percentage change in the price of a good leads to a
percentage change in the quantity demanded from the original quantity is a price
elasticity of demand

Price elasticity of Percentage change in Qd

demand = Percentage change in P

Price elasticity of demand measures how much Qd responds to a change in P.

 M E AS URIN G P R ICE E L ASTI C I TY O F D E M A ND BY M I D - P O IN T TH EO R E M

end value – start value

% change in P equals x 100%
midpoint
𝑅𝑠 250−𝑅𝑠 200
× 100 % = 22.2%
𝑅𝑠 225

% change in Q equals

12−8
× 100 % = 40%
10

The price elasticity of demand equals

40/22.2 = 1.8

Along a D curve, P and Q move in opposite directions, which would make price elasticity negative.
We will drop the minus sign and report all price elasticities in absolute number
 VARIETY OF DEMAND CURVES

▪ The price elasticity of demand is closely related to the slope of the demand curve.

▪ Rule of thumb:
The flatter the curve, the higher is the price elasticity.
The steeper the curve, the smaller is the elasticity.
▪ Five different classifications of D curves.…
DIFFERENT DEMAND CURVES
 EXAMPLE : INSULIN VS. FLIGHT TICKETS?

Say : The prices of both of these goods rise by 20%.

For which good do you think Qd would drop the most? Why?

• To millions of diabetics, insulin is a necessity → little or no decrease in demand.

[ Relatively inelastic good]

• If the price of flight ticket rises, some people will forego it → may delay travel
→ may book train tickets etc. → can lead to substantial fall in demand
[Relatively elastic good]

Lesson: Price elasticity is higher for luxuries than for necessities.

 EXAMPLE : PEPSI VS. SALT

The prices of both of these goods rise by 20%. For which good does Qd drop the
most? Why?

• Pepsi has close substitutes

(may substitute with other types of cold-drinks) → so buyers can easily switch
if the price rises. [Relatively elastic good]

• Salt has no close substitutes → so a price increase would not affect demand
very much. [Relatively inelastic good]

Lesson: Price elasticity is higher when close substitutes are available.

 INCOME ELASTICITY

Income elasticity of Percentage change in Qd

demand =
Percentage change in Income

The income elasticity of demand is the percentage change in quantity demanded

divided by the percentage change in income, as follows:

• When rise in income leads an increase in Qd→ normal goods (Income elasticity >0)
• If income elasticity of demand of a commodity <1, it is a necessity good.
• If the elasticity of demand > 1, it is a luxury good

• When the income elasticity of demand is negative (<0), the good is called an inferior good.
 C RO S S – P R I C E E L A S T I C I T Y O F D E M A N D

Cross-price elasticity of demand: measures the response of demand for one

good to changes in the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2

▪ For substitutes, cross-price elasticity > 0

▪ For complements, cross-price elasticity < 0
 IN- CLASS ACTIVITY : CALCULATE AN ELASTICITY

Use the following information to calculate the price elasticity of demand for a
good :
if P = Rs 135, Qd = 8600
if P = Rs165, Qd = 7400

Use midpoint method to calculate

% change in Qd : (8600 – 7400)/8000 = 15%
% change in P : (165 – 135)/ 150 = 20%

The price elasticity of demand equals = 15/20 = 0.75 [ Inelastic demand]

 PRICE ELASTICITY AND TOTAL REVENUE

Price elasticity Percentage change in Q

=
of demand Percentage change in P

Revenue = P x Q

• If demand is elastic, then price elast. of demand > 1

% change in Q > % change in P

• If P rises→ The fall in revenue from lower Q is greater than the increase in revenue from
higher P, so revenue falls.
 PRICE ELASTICITY AND TOTAL REVENUE

Elastic demand increased

Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
If P = $200, revenue
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
 PRICE ELASTICITY AND TOTAL REVENUE

Price elasticity = Percentage change in Q

of demand Percentage change in P

Revenue = P x Q

• If demand is inelastic, then

• price elast. of demand <1 ; % change in Q < % change in P

• The fall in revenue from lower Q is smaller

than the increase in revenue from higher P,
so revenue rises.
 PRICE ELASTICITY AND TOTAL REVENUE

Now, demand is
increased
Demand for
inelastic:
revenue due
your websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
In-class discussions:

How are taxation and revenue related then?

What type of goods government would tax to increase their revenue?

• What will World Health Organisation do to reduce alcohol or Tobacco consumption?

• The Economics of Tobacco and Tobacco Taxation in India
Impact of tax on consumption

A 10% increase in bidi prices could reduce bidi consumption by 9.2%. A 10% increase in cigarette prices could reduce
cigarette consumption by 3.4%.

(See page 27 of the report)

Impact of tax on
government revenue

See page 31

Cigarette taxes account for

approximately 38% of the
retail price. This falls well
below the rate
recommended by the World
Bank (from 65% to 80% of
retail price) that is commonly
present in countries with
effective tobacco control
policies.
 If taxing cannot reduce consumption:

Are there other ways for Government to control

prices?
 HOW GOVERNMENT CONTROL PRICES?

Price controls
• Price ceiling: a legal maximum on the price of a good or service Example: rent
control
• Price floor: a legal minimum on the price of a good or service Example:
minimum wage
• Taxes: The govt can make buyers or sellers pay a specific amount on each unit.

We will use the supply/demand model to see

how each policy affects the market outcome
(the price buyers pay, the price sellers receive,
and eq’m quantity).
 EXAMPLE 1: THE MARKET FOR APARTMENTS

Rental P S
price of
apts

$800
Eq’m w/o
price
controls
D
Q
300
Quantity
of apts
 HOW PRICE CEILINGS AFFECT MARKET OUTCOMES

P S
The eq’m price ($800) is
above the ceiling and
therefore illegal.
$800

Price
The ceiling $500
ceiling
is a binding constraint
shortage
on the price, causes a D
shortage. 250 400
Q
 HOW PRICE CEILINGS AFFECT MARKET OUTCOMES

P S
Price
$1000
ceiling
A price ceiling
above the $800
eq’m price is
not binding—
has no effect
on the market outcome. D
Q
300
 SHORTAGES AND RATIONING

• With a shortage, some consequences

(1) Black marketing of goods

(2) Discrimination according to sellers’ biases

These mechanisms are often unfair, and inefficient: the goods do not
necessarily go to the buyers who value them most highly.
 EXAMPLES OF PRICE CEILINGS

• PRICE CONTROL ON UBER, INDIA

• India's Price Ceiling On Uber Rides Hurts Riders,

Drivers And The Economy

• Karnataka government sets new minimum price

(2024)
 EXAMPLE 2: THE MARKET FOR UNSKILLED LABOR

Wage W S
paid to
unskilled
workers
$6.00
Eq’m w/o
price
controls
D
L
500
Quantity of
unskilled workers
 HOW PRICE FLOORS AFFECT MARKET OUTCOMES

W S

A price floor below the

eq’m price is not binding – $6.00
has no effect on the market
outcome. $5.00
Price
floor

D
L
500
 HOW PRICE FLOORS AFFECT MARKET OUTCOMES
labor
W surplus S
Price
$7.25
The eq’m wage ($6) is below floor
the floor and therefore
illegal. $6.00

The floor is a binding

constraint on the wage,
D
causes a surplus (i.e., L
unemployment). 400 550
 THE MINIMUM WAGE
unemp-
Min wage laws
W loyment S
do not affect
Min.
highly skilled $7.25
wage
workers.
They do affect $6.00
teen workers.
Studies:
A 10% increase
in the min wage D
L
raises teen 400 550
unemployment
by 1–3%.
In-class discussions:

The Government of India fixes

Minimum Support Price (MSP)
for 22 mandated agricultural
crops.

Some examples are provided

Read more at:

Price floor - Minimum Support
Price for various crops
 ACTIVE LEARNING 1
PRICE CONTROLS
The market for
P
140 hotel rooms
S
130
Determine
120
effects of:
110
A. $90 price 100
ceiling 90
B. $90 price 80 D
floor 70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 1
A. $90 PRICE CEILING
The market for
P
140 hotel rooms
The price S
falls to $90. 130
120
Buyers 110
demand 100
120 rooms, Price ceiling
90
sellers supply 80 D
90, leaving a shortage = 30
70
shortage. 60
50
40
0 Q
50 60 70 80 90 100 110 120 130
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 1
B. $90 PRICE FLOOR
The market for
P
140 hotel rooms
Eq’m price is S
130
above the floor,
120
so floor is not
110
binding.
100
P = $100, 90
Q = 100 rooms. Price floor
80 D
70
60
50
40
0 Q
50 60 70 80 90 100 110 120 130
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 EVALUATING PRICE CONTROLS

• Markets are usually a good way to organize economic activity.

• Prices are the signals that guide the allocation of society’s resources. This allocation is
altered when policymakers restrict prices.

• Price controls often intended to help the poor, but often hurt more than help.
(We have seen that the minimum wage can cause job losses, and rent control can reduce the
quantity and quality of affordable housing. Both policies make the poor worse off)

• So, it’s important for policymakers to apply such policies very carefully.
 TAXES

• The govt levies taxes on many goods & services to raise revenue to pay for
national defense, public schools, etc.
• The govt can make buyers or sellers pay the tax.
• The tax can be a % of the good’s price, or a specific amount for each unit sold.
• For simplicity, we analyze per-unit taxes only.
 THE EFFECTS OF A TAX

P
Eq’m with no tax:
Price = PE
Quantity = QE Size of tax = $T
PB S
Eq’m with
tax = $T per unit: PE
Buyers pay PB PS D
Sellers receive PS
Quantity = QT
Q
QT QE
 IN CLASS DISCUSSION
WHO SHARE THE HIGHER TAX BURDEN?

• When Demand is relatively inelastic than supply

• When Demand is elastic than supply

• When Supply is relatively inelastic than Demand

• When Supply is elastic than demand

Now through welfare analysis – we will see how this tax burden is measured in terms of society’s
welfare.
 WELFARE ECONOMICS

Now let's see how tax impacts the welfare or in other words how
tax impacts the allocation of resources and therefore economic
well-being.

Concepts of consumer and producer surplus

 THE CONCEPT OF EFFICIENCY IN THE
CONTEXT OF TAXES

• In a market economy, the allocation of resources is decentralized,

determined by the interactions of many self-interested buyers and sellers.

• Is the market’s allocation of resources desirable with taxation?

• To answer this, we use total surplus as a measure of society’s well-being, and

we consider whether the market’s allocation is efficient.

(Policymakers also care about equality, though our focus here is on efficiency.)
 WILLINGNESS TO PAY (WTP)

A buyer’s willingness to pay for a good is the maximum amount the buyer will
pay for that good.
WTP measures how much the buyer values the good.

name WTP
Anthony $250
Chad 175 Example:
4 buyers’ WTP for an iPod
Flea 300
John 125
 WTP AND THE DEMAND CURVE

Derive the demand schedule: P (price

who buys Qd
of iPod)
$301 & up nobody 0
name WTP
Anthony $250 251 – 300 Flea 1

Chad 175 176 – 250 Anthony, Flea 2

Flea 300 Chad, Anthony,
126 – 175 3
Flea
John 125
John, Chad,
0 – 125 4
Anthony, Flea
 CONSUMER SURPLUS

Price P The demand for shoes

per pair
$ 60
50
At Q = 5, the marginal buyer is
willing to pay $50 for pair of 40
shoes. 30
Suppose P = $30. 1000s of pairs
20 of shoes
Then his consumer surplus = $20.
10
D
0 Q
0 5 10 15 20 25 30
 MEASUREMENT OF CONSUMER SURPLUS

CS is the area b/w P and the P The demand for shoes

D curve, from 0 to Q. $ 60
50
Recall: area of a triangle equals h
½ x base x height 40
30
Height = 20
$60 – 30 = $30.
10
D
So,
0 Q
CS = ½ x 15 x $30 0 5 10 15 20 25 30
= $225.
 HOW A HIGHER PRICE REDUCES CS

P
If P rises to $40, 1. Fall in CS
60
due to buyers
50 leaving market
CS = ½ x 10 x $20
= $100. 40
Two reasons for the fall in CS. 30

2. Fall in CS due to 20
remaining buyers 10
paying higher P D
0 Q
0 5 10 15 20 25 30
 ACTIVE LEARNING
CONSUMER SURPLUS
P demand curve
A. Find marginal buyer’s WTP $ 50
at Q = 10. 45
B. Find CS for 40
P = $30. 35
30
25
Suppose P falls to $20. 20
How much will CS increase due 15
to… 10
5
C. buyers entering
0
the market
0 5 10 15 20 Q
25
D. existing buyers paying lower price
 ACTIVE LEARNING:
ANSWERS
demand curve
P
50
A. At Q = 10, marginal buyer’s WTP $ 45
is $30. 40
B. CS = ½ x 10 x $10 35
= $50 30
25
P falls to $20. 20
C. CS for the 15
additional buyers 10
= ½ x 10 x $10 = $50 5
D. Increase in CS 0
on initial 10 units = 10 x $10 = $100 0 5 10 15 20 Q
25
 COST AND THE SUPPLY CURVE

Derive the supply schedule from the P Qs

cost data: $0 – 9 0

10 – 19 1

20 – 34 2
name cost
35 & up 3
Jack $10
Janet 20
Chrissy 35
 PRODUCER SURPLUS
Producer surplus is also measured in
monetary units and defined as the P The supply of shoes
difference between revenues and supply
costs
S
(both investment and operation costs).

PS is the area b/w P and the S curve,

from 0 to Q. h
The height of this triangle is
$40 – 15 = $25.

Q
So, PS = ½ x b x h
= ½ x 25 x $25
= $312.50
 EVALUATING THE MARKET EQUILIBRIUM

P
60
Market eq’m:
P = $30 50 S
Q = 15,000 40 CS
30
Total surplus PS
20
= CS + PS
10
D
When TS is maximum→ Welfare of 0 Q
the society is at highest 0 5 10 15 20 25 30
 THE EFFECTS OF A TAX ON WELFARE
P
Without a tax,
CS = A + B + C
A
PS = D + E + F S
B C
Tax revenue = PE
0 D E
D
F
Total surplus
= CS + PS
Q
QT QE
=A+B+C+D+E+F
 THE EFFECTS OF A TAX

With the tax, P

CS = A
PS = F A
PB S
Tax revenue B C
=B+D D E
PS D
Total surplus F
=A+B
+D+F Q
QT QE

The tax reduces total surplus by C + E

 THE EFFECTS OF A TAX
P

C + E is called the A
deadweight loss PB S
(DWL) of the tax, the B C
fall in total surplus E
D
that results from a PS D
market distortion, F
such as a tax.

Q
QT QE
 WHAT DETERMINES THE SIZE OF THE
DWL?

• Which goods or services should govt tax to raise the revenue it needs?
• One answer: those with the smallest DWL.
• When is the DWL small vs. large?
•
Turns out it depends on the price elasticities of supply and demand.

Recall:
The price elasticity of demand (or supply) measures how much QD (or QS)
changes when P changes.
 DWL AND THE ELASTICITY OF SUPPLY

When supply S
is inelastic,
it’s harder for firms
to leave the market
when the tax Size
reduces PS. of tax
So, the tax only
D
reduces Q a little,
Q
and DWL is small.
 DWL AND THE ELASTICITY OF SUPPLY

P
The more elastic is
supply,
the easier for firms S
to leave the market Size
when the tax of tax
reduces PS,
the greater Q falls
D
below the surplus-
maximizing quantity, Q

the greater the DWL.

DWL AND THE ELASTICITY OF DEMAND

When demand
P
is inelastic,
S it’s harder for
consumers to
Size
leave the market
of tax
when the tax
raises PB.
So, the tax only
D reduces Q a little,
Q and DWL is small.
DWL AND THE ELASTICITY OF DEMAND

P The more elastic is

demand,
S
the easier for buyers
to leave the market
Size when the tax
of tax increases PB,
D the more Q falls
below the surplus-
maximizing quantity,
Q and the greater the
DWL.
 THE EFFECTS OF CHANGING THE SIZE OF THE TAX

• Policymakers often change taxes, raising some and lowering others.

• What happens to DWL and tax revenue when taxes change?

We explore this next….

 DWL AND THE SIZE OF THE TAX

P
Initially, the tax is
new
T per unit. DWL
Doubling the tax S
causes the DWL
to more than 2T T
double. D
initial
DWL

Q
Q2 Q1
 DWL AND THE SIZE OF THE TAX
P
new
Initially, the tax is DWL
T per unit.
S

Tripling the tax 3T T

causes the DWL D

to more than initial
triple. DWL

Q
Q3 Q1
 DWL AND THE SIZE OF THE TAX

Implication Summary
When tax rates are low, raising When a tax increases,
DWL
them doesn’t cause much harm, DWL rises even more.
and lowering them doesn’t bring
much benefit.

When tax rates are high, raising

them is very harmful, and cutting
them is very beneficial.
Tax size
 REVENUE AND THE SIZE OF THE TAX

PB
When the tax is small, S
PB
increasing it causes tax
2T T
revenue to rise.
PS D
PS

Q
Q2 Q1
 REVENUE AND THE SIZE OF THE TAX

PB
PB
When the S
tax is larger, increasing it
causes tax revenue to fall. 3T 2T

D
PS
PS
Q
Q3 Q2
 REVENUE AND THE SIZE OF THE TAX

Tax
The Laffer curve
revenue
The Laffer curve shows
the relationship between
the size of the tax and tax
revenue.

Tax size
Remember : The
Tobacco tax and revenue
table?
 CONCEPT OF MARGINAL

• Rational consumers logically decides to buy a product when its possession

affords greater satisfaction than the price paid for it.

• Buy goods only if the price is less than their expected utility, i.e. the degree of
satisfaction or profit obtained by the consumer.

• Increase in the level of satisfaction is measured in terms of marginal utility,

where marginal means the additional utility obtained by consuming one
additional unit of a given product or service.
 TOTAL UTILITY – DEFINITION

The sum total of satisfaction which a consumer receives by consuming the various unity
of the commodity. (The more unit of a commodity he consumes, the greater will be his
total utility)

Objective of a consumer:

Consumers seek to maximise the difference between the satisfaction obtained when purchasing a
certain amount of product, q [Total utility TU (q)] and the sum paid for that amount of product,
calculated as the product of price, p, times the amount purchased, q.
 MARGINAL
UTILITY –
DEFINITIONS

Marginal Utility (MU) - The

change in utility associated with a
small change in the amount of one
of the goods consumed holding the
quantity of the other good fixed.

Similar concepts with

• Marginal revenue

• Marginal cost
 LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility states that, “as a consumer consumes more
and more units of a specific commodity, utility from the successive units goes on
diminishing.

These assumptions are

• Various units of goods are homogenous.
• There is no time gap between consumption of the different units
• Consumer is rational (So aims at maximization of utility of the product)
• Tastes, preferences, and fashion remain unchanged
• Consumers possess perfect knowledge of the price in the market
 EXAMPLES OF DIMINISHING MARGINAL UTILITY

Water and thirst

Suppose a person is thirsty and the price of water is zero.

• He takes one glass of water which gives him great satisfaction. We can say the first glass of
water has great utility for him.

• He then takes second glass of water. The utility of the second glass of water is less than
that of first glass of water.

• If he drinks third glass of water, the utility of the third glass will be less than that of second
and so on.

• The utility goes on diminishing with the consumption of every successive glass of water till
it drops down to zero.
 CONCEPT OF PARETO EFFICIENCY

• In a general sense, an economy is efficient when it provides its consumers

with the most desired set of goods and services, given the resources and
technology of the economy

• (Pareto) Efficiency:
• Nobody can be made better off without making someone else worse off.
• Resources are most optimally used under (Pareto) Efficiency
• When no possible reorganization of production or distribution can make anyone
better off without making someone else worse off.
 EXAMPLE

Consider an idealized situation where all individuals are identical.

Further assume:
• ( a ) Each person works at growing food. As people increase their work and cut back on their leisure hours,
each additional hour of sweaty labour becomes increasingly tiresome.

• ( b ) Each extra unit of food consumed brings diminished marginal utility ( MU ).

• ( c ) Because food production takes place on fixed plots of land, by the law of diminishing returns each extra
minute of work brings less and less extra food – total amount of food is increasing but the additional
amount of food produced by one extra labour or by working one extra hour is decreasing
 WHAT DO WE
KNOW OF :

• Consumer surplus

• Producer surplus

• Total Surplus

In a pareto efficient market

total surplus is maximised
 MARKET FAILURES

When market fails to reach the pareto optimum → we call them market failures

When internal and external factors prevent an economy from reaching Pareto efficiency

Market failures leads to inefficient distribution of goods and services – like black marketing etc.

Parties (consumers/producers) do not take account of the costs their decisions impose on others. This is
social dilemma problem which is also a market failures.

Some markets are perfect – Total surplus is maximised → Pareto efficient economy

But most markets suffer from market failures → Total surplus is less than desirable → Not pareto efficient
Core Econ book link
 STUDY OF MARKETS

Need to study markets

- Because public policy emerged from market failures

- Examples of markets that suffers from market failures
- Government policies in the wake of market failures
 CON CE PTS OF MA R KE TS

Goods and services are exchanged in the market where the equilibrium
conditions are arrived at.
Free willing individuals coming together to sell/buy (or exchange) goods and
services.
Factors determining market structure

No. of sellers and buyers

Nature of the product
Degree of seller concentration
Product differentiation
Conditions of entry
Information symmetry
 WHAT IS PERFECT COMPETITION?

Many buyers and many sellers.

The goods offered for sale are largely the same / homogeneous good.
Firms can freely enter or exit the market.
Buyers and sellers have perfect knowledge
Producers are price takers

Examples of PC markets? ………………………………

• Perfect competition is one such market that is ideal and achieves
pareto optimal

• Marginal Cost = Price (given) = Marginal revenue

• What do you think the demand curve look like?

 UNDERSTANDING DD&SS CURVE OF A FIRM

Rule: MR = MC at the profit-maximizing Q.

• At Qa, MC < MR. So, increase Q to the MC curve acts the

supply curve.
raise profit. Costs
MC

• At Qb, MC > MR. So, reduce Q to

raise profit.
P1 MR

• At Q1, MC = MR.
Q
Qa Q1 Qb

• Changing Q would lower profit.

 IS PERFECT COMPETITION
A REALITY?

In some cases, yes.

But, in developing country setting, markets mostly fail…

…and (Pareto) Efficiency isn’t achieved.

 WHY MARKET FAILS?

• Imagine Health sector - Is it pareto efficient?

[ Information asymmetry]

• Imagine residents of Delhi living under pollution

[Externalities]

• Imagine only one company giving ride services

[ Inadequate competition]

• Imagine firms not adhering to contracts and agreements

[ Non-agreement ]

• Imagine a private sector providing defense services in India

[ Public good and free rider issue]
 MONOPOLY MARKET

• A monopoly is a firm that is the sole seller of a product without

close substitutes.

• The key difference:

A monopoly firm has market power, the ability to influence the
market price of the product it sells. A competitive firm has no
market power.

• The main cause of monopolies is barriers to entry—other firms

cannot enter the market.
 A MONOPOLY’S REVENUE

Q P TR AR MR
0 $4.50 n.a.

1 4.00
2 3.50
3 3.00
4 2.50
5 2.00
6 1.50
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Here, P = AR, Q P TR AR MR
same as for a competitive firm. 0 $4.50 $0 n.a.
$4
1 4.00 4 $4.00
3
Here, P > MR 2 3.50 7 3.50
2
3 3.00 9 3.00
1
So, a monopoly is setting a price 4 2.50 10 2.50
higher than their MR 0
5 2.00 10 2.00
–1
6 1.50 9 1.50

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 PROF IT- MA X IMI ZATI ON

Costs and
Revenue MC

1. The profit-maximizing Q
is where MR = MC.
D
2. Find P from the demand
MR
curve at this Q.
Q Quantity

Profit-maximizing output
 MONOPOLY AND PERFECT COMPETITION

A competitive firm takes P as given- “price taker’

A monopoly firm is a “price-maker,” not a “price-taker”

• Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR =
MC.

• Once the monopolist identifies this quantity, it sets the highest price consumers are willing to
pay for that quantity.

• It decides [makes] this price from the D curve.

 THE WELFARE COST OF MONOPOLY

Competitive eq’m:
• quantity = QC
• P = MC

Total surplus is maximized

Monopoly eq’m:
• quantity = QM
• P > MC
Deadweight loss (Total surplus <
Competitive market surplus)
 SOLUTION – ADDRESSING MARKET FAILURE

ANTITRUST LAWS
• Laws that regulates the conduct and organization of business corporations, to promote fair competition for the benefit of
consumers

• The Competition Act, 2002 (as amended) aims at fostering competition and at protecting Indian markets against anti-competitive
practices by enterprises.

• The Act prohibits anti-competitive agreements, abuse of dominant position by enterprises, and regulates combinations (mergers,
amalgamations and acquisitions) with a view to ensure that there is no adverse effect on competition in India.

• The Act prohibits any agreement which causes, or is likely to cause, appreciable adverse effect on competition in markets in India.
For example - Cartelisation is one of the horizontal agreements that shall be presumed to have appreciable adverse effect on
competition.

• Competition Commission of India – can investigate such matters and take the monopolist to court
 EX AMPLES

Coal India Ltd & Anr. v. Competition Commission of India & Another (Supreme Court – June 2023) - Competition
Act is applicable to State-owned monopolies.

After a ten-year legal battle between Coal India Ltd (CIL) and the CCI on its jurisdiction to examine the
conduct of State-owned monopolies, the Supreme Court held that the provisions of the Competition Act,
2002 (Competition Act) apply to CIL and similar public sector undertakings.

The Supreme Court decision clarified that the Competition Act is applicable to all government companies
and statutory monopolies that operate to further “common good” under the Constitution of India.

Given the Supreme Court’s decision, the CCI’s jurisdiction to investigate and take measures against
statutory monopolies similar to CIL in abuse of dominance cases has been confirmed.

Source: Bar and Bench

 IN- CL ASS DISCUSSION
CASE OF GOOGLE IN VIOL ATION OF MONOPOLY POWER

1. Google versus C C I: 2018 Case

On August 28, 2018, Umar Javeed, Sukarma Thapar, and Aaqib Javeed filed a complaint under Section 19(1)(a) of
the Act, 2002 with the Competition Commission of India, claiming that Google is dominant in India’s market for
android-based smartphones and that they engage in anti-competitive practices.

After reviewing the complaint, the Competition Commission of India (CCI) directed some preliminary
investigation. After listening to all involved parties, the Commission determined that Google had violated
several provisions of Companies Act , 2002 and was fined Rs.1337.76 Crore for breaking sections of the Act.

2. What is the current battle of google in 2024? Google versus CCI, 2024? – Find out and discuss in class

3. Also read – Google abusing monopoly power in the USA – legal battle between Google and US. Justice
department
See NPR for the details of the case
App developers and Google:

On 1 March, Google issued notices to 10 startups who operated over 200 apps on its Play Store, warning them
of non-compliance with its service fee policy and suspending them from the platform. The startups, who
incidentally had already filed appeals against the Big Tech firm accusing it of abusing its dominant market
power, subsequently filed appeals against the suspension.

Google levies a service fee of 11-30% from apps that sell “digital services” on its Play Store, a fee that many
parties say is disproportionate to the service that Google provides. On 15 March, CCI initiated a fresh probe
into Google’s Play Store pricing. The investigation is expected to be completed by next week.

Google is charging 4-5x of its cost to the app developers, which on a prima facie level appears to be
disproportionate to the economic value of services being rendered to the app developers and appears to be an
abuse of dominant position by Google
 MARKET FAILURES:

ASYMMETRIC INFORMATION

HIDDEN CONTRACTS

NON-ADHERENCE TO AGREEMENTS
 OLIGOPOLY

Oligopoly: a market structure in which only a few sellers offer similar or identical products.
Strategic behavior in oligopoly:

• A firm’s decisions about P or Q can affect other firms and cause them to react.
• The firm will consider these reactions when making decisions.

Game theory: the study of how people behave in strategic situations.

Concentration ratio
• Oligopoly is a market structure with high concentration ratios.
• Concentration ratio is the percentage of the market’s total output supplied by its four
largest firms.
EXAMPLE: 2 MOBILE PHONE COMPANIES

P Q ▪ Small town has 140 residents

0 140 ▪ The “good”:
5 130 cell phone service with unlimited anytime minutes and free phone
10 120 ▪ Smalltown’s demand schedule
15 110 ▪ Two firms: Airtel and Jio
20 100
25 90 ▪ (duopoly: an oligopoly with two firms)
30 80 ▪ Each firm’s costs: FC = 0, MC = 10
35 70
40 60
45 50
 EXAMPLE: TAKE THIS EXAMPLE

P Q Revenue Cost Profit Competitive

0 140 0 1,400 –1,400 outcome:
P = MC = Rs10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = Rs 0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350
Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = Rs 40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = Rs
1,800
 POSSIBLE STRATEGIES TO ARRIVE AT THE EQUILIBRIUM

One possible duopoly outcome: collusion

• Collusion: an agreement among firms in a market about quantities to

produce or prices to charge
• e.g., Airtel and Jio in the outcome with collusion

Airtel and Jio could agree to each produce half of the monopoly output:

For each firm: Q = 30 (Half of market output where profit was max),
P = 40, profits = 900 (Half of the total market profit)

What do you think? Will they stick to the agreement?

COLLUSION VS. SELF -INTEREST

Duopoly can stick with the collusion:

P Q Each firm agrees to produce Q = 30,
0 140 Earns profit = Rs 900
5 130
10 120
15 110 Any firm can act on self-interest
20 100 If Airtel reneges on the agreement and produces Q = 40,
25 90 what happens to the market price? Airtel’s profits?
30 80 Is it in Airtel’s interest to renege on the agreement?
35 70
If both firms renege and produce Q = 40, determine each
40 60
firm’s profits.
45 50
 WHEN ONE FIRM RENEGES

P Q If both firms stick to agreement, each firm’s profit = Rs 900

$0 140
5 130 If act on self interest
10 120
If Airtel breaks the agreement & produces Q = 40: (thinking that Jio will stick
15 110 to the agreement)
20 100 Market quantity = 70 [ Airtel =40 + Jio’s 30]
25 90 What is the price at Q=70?
30 80
P = 35
35 70
Airtel’s profit = TR-TC = P*Q – MC*Q = Q* (P-MC)
40 60
40 x (35 – 10) = 1000
45 50
Airtel’s profits are higher if it reneges.
 WHEN BOTH RENEGES

Jio will conclude the same → Jio will know that Airtel will break
collusion for higher profits and Jio will also do the same [Jio P Q
produces Q = 40] 0 140
→ultimately both will break the agreement 5 130
10 120
15 110
• What is the market quantity and Price when both breaks
collusion? 20 100
25 90
• Produces a market quantity = 80 [Both =40] ;
30 80
• At Q =80→ P = 30
35 70
40 60
What is the profit of each firm when both produces Q=40? 45 50
Each firm’s profit = 40 x (30 – 10) = 800 < Profit under
collusion = 900
 THE EQUILIBRIUM FOR AN OLIGOPOLY

Given that Jio produces Q = 40, Airtel’s best move is to produce Q = 40.

Given that Airtel produces Q = 40, Jio’s best move is to produce Q = 40.

Nash equilibrium: a situation in which economic participants interacting with

one another each choose their best strategy given the strategies that all the
others have chosen

Our duopoly example has a Nash equilibrium in which each firm produces Q = 40
(their individual best strategy was to produce Q=40 because the individual profit was higher)
 AIRTEL & JIO CASE IN THE PRISONERS’ DILEMMA

Each firm’s dominant

strategy: renege on
agreement, produce Q = 40.
Airtel
Q = 30 Q = 40
But optimal could have been
to stick to collusion and Airtel’s profit Airtel’s profit
produce at Q=30 = 900 = 1000
Q = 30
Jio profit = Jio profit =
900 750
Jio
Airtel’s profit = Airtel’s profit
750 = 800
Q = 40
Jio Jio profit =
profit = 1000 800
 PRISONERS’ DILEMMA AND SOCIETY’S WELFARE

• The non-cooperative oligopoly equilibrium

• Bad for oligopoly firms: prevents them from achieving monopoly profits
• Good for society:
• Q is closer to the socially efficient output
• P is closer to MC
[ Some form of Competition is needed in the market]

• In other cases, the inability to cooperate may reduce social welfare.

• Overuse of common resources
 GAME THEORY

Game theory helps us understand oligopoly and other situations where “p

layers” interact and behave strategically.

• Dominant strategy:
a strategy that is best for that individual player in a game regardless of the
strategies chosen by the other players

Prisoners’ dilemma: a “game” between two captured criminals that illustrates

why cooperation is difficult even when it is mutually beneficial
 PRISONERS’ DILEMMA
EXAMPLE

• The police have caught Bonnie and Clyde, two suspected bank robbers, but only
have enough evidence to imprison each for 1 year.
• Bonnie and Clyde had agreed before being caught to remain silent which will
give them 1 year in jail.

• The police question each in separate rooms, offer each the following deal
(Robber’s didn’t know before what deal Police will give them)
• If you confess and implicate your partner, you go free.
• If you remain silent but your partner implicates you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.
 PRISONERS’ DILEMMA EXAMPLE

Confessing is the dominant strategy for both players.

Nash equilibrium reached : Both
confess Bonnie’s decision
But optimal equilibrium would Confess Remain silent
have been to Remain silent
Bonnie gets Bonnie gets
8 years 20 years
Confess
Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie goes Bonnie gets
Remain free 1 year
silent Clyde Clyde
gets 1 year
gets 20 years
The prisoners’ dilemma shows how difficult it is for firms to maintain cooperation,
even when doing so is in their best interest.
 NARRATION OF THE PREVIOUS SLIDE

• 1) If Clyde confesses, then Bonnie gets 8 years if she confesses or 20 years if she does not.

• 2) If Clyde remains silent, Bonnie goes free if she confesses or gets 1 year if she does not.

Bonnie’s best move therefore is to confess, regardless of Clyde’s decision—hence, “confess” is Bonnie’s
dominant strategy.

• 3) If Bonnie confesses, Clyde gets 8 years if he confesses or 20 years if he does not.

• 4) If Bonnie remains silent, Clyde goes free if he confesses or gets 1 year if he does not.

Regardless of Bonnie’s decision, Clyde’s best move is to confess.

• Both players have a dominant strategy of confessing → which is not a optimal outcome.
 OTHER EXAMPLES OF MARKET
FAILURE:

ADVERSE SELECTION

When buyers and sellers have access to different information, one with more
private information about the quality of the product would enter into an
economic activity that benefit them the best.

• E.g. People may not share their full medical history with insurer
• Example – Buyers of second-hand cars do not know all the attributes of the car
e.g. quality, but the sellers do.
EXAMPLE 1: THE MARKET FOR USED CARS

• The seller knows more than the buyer about the quality of the car being sold.
• Owners of “lemons” are more likely to put their vehicles up for sale.
• So buyers are more likely to avoid used cars.
• Owners of good used cars are less likely to get a fair price, so may not bother trying to sell.
[George Akerlof won Nobel price for this research]

EXAMPLE 2: INSURANCE
• Buyers of health insurance know more about their health than health insurance companies.
• People with hidden health problems have more incentive to buy insurance policies.
• So, prices of policies reflect the costs of a sicker-than-average person.
• These prices discourage healthy people from buying insurance.
 MORAL HAZARD

One person takes more risks when someone else bears the cost of risks.

• Eg:

1. You drive your car even with Learner's license – because you know you
will get the money back under insurance

2. A person ends up utilizing more health care services when he/she is

insured: The hospital intends for an overnight stay if the patient is
insured even if under normal circumstances hospitalization might not be
needed.
 EXAMPLES OF NEGATIVE EXTERNALITIES

1. Air pollution from a factory

2. The neighbor’s barking dog
3. Late-night stereo blasting from
the dorm room next to yours
4. Noise pollution from
construction projects
5. Health risk to others from © M. Shcherbyna/Shutterstock.com

second-hand smoke
6. Talking on cell phone while driving makes the roads less safe for others
7. Punjab crop burns affecting people of Delhi – air pollution
8. Not wearing Mask or not getting vaccinated in COVID
WHY MARKET FAILURE HAPPENS?
CASE OF PUBLIC GOOD
 PUBLIC GOODS PROVIDED BY PRIVATE ENTITY

Public goods has two characteristics:

1.Non-rivalry
2.Non-exclusionary

Failure to produce public goods and services, despite being needed or wanted.

• Individuals not paying for sanitation work in the village that can create pollution free environment

•
• People not willing to pay taxes / evading taxes but wanting to use police services
 SOLUTIONS:
CORRECTIVE TAXES AND SUBSIDIES

Corrective tax: A tax designed to induce private decision-makers to take

account of the social costs that arise from a negative externality

Also called Pigouvian taxes after Arthur Pigou (1877-1959).

The ideal corrective tax = external cost.

Similarly for activities with positive externalities,

The ideal corrective subsidy = external benefit.

But, how to figure out the exact amount of external cost or benefit ?
 TRADABLE POLLUTION PERMITS

• A tradable pollution permit system reduces pollution at lower cost than regulation.

• Firms with low cost of reducing pollution do so and sell their unused permits.
• Firms with high cost of reducing pollution buy permits.

• SO2 permits traded in the U.S. since 1995.

• Nitrogen oxide permits traded in the northeastern U.S. since 1999.
• Carbon emissions permits traded in Europe since January 1, 2005.

Result: Pollution reduction is concentrated among those firms with

lowest costs.
 PRIVATE SOLUTIONS TO EXTERNALITIES

Ronald Coase 1960 paper, ‘The Problem of Social Cost’

• The Coase theorem:

If private parties can costlessly bargain over the allocation of resources, they can solve the
externalities problem on their own.

• When there are well-defined property rights and costless bargaining, then negotiations
between the party creating the externality and the party affected by the externality can bring
about the socially optimal market quantity.