Microeconomics focuses on the activities of individual agents within the economy like households, workers and businesses. However, because human beings are at the centre of microeconomic activities, it is difficult to understand certain economic principles when you consider their ever-changing nature. Thus, to better understand microeconomic principles, economists developed theories or models, which are simplified representations of how two or more variables interact with each other enabling them to take complex, real-world issues and simplify it down to its essentials making them tools for determining the answers to a problem and not an illustrations of the answer to a problem. So, in this essay, we are going to look at some economic theories or models and structures and how they provide guidelines for the government to intervene.
To commence, we are going to look at the indifference curve model which was founded by British economist Francis Ysidro Edgeworth (Edgeworth, 1881). It was put into extensive use by economists J.R. Hicks and R.G.D Allen who criticized Marshallian cardinal approach of utility and developed indifference curve theory of consumer’s demand. This theory is also known as ordinal approach. In microeconomics, the indifference curve analysis model is an essential tool in the study of consumer behaviour.
As consumers we must allocate our money to buy a bundle (market basket or combination) of goods. The indifference curve models this behaviour by identifying those baskets of goods and services that consumers are indifferent to and are equally preferred. To do so, it assumes that the individual is rational and has a set taste or preference that guides them in choosing between goods by satisfying certain axioms of preferences which are, completeness (Perloff, 2012, p. 75), more-is-better, transitivity (Perloff, 2012, p. 75), convexity (Perloff, 2012, p. 77). Once these axioms have been satisfied, we can now model an individual’s bundle of preferences by using an indifference map which shows a complete set of indifference curves (the set of all bundles of goods that a consumer views as being equally desirable) that summarize a consumer’s tastes or preferences (Perloff, 2012). This is called the consumers theory model.
By understanding this model, we can derive the supply curve of labour. People must choose between leisure and labour. Using consumer theory, we can derive the daily demand curve for leisure, which is time spent on activities other than work. By subtracting the demand curve for leisure from 24 hours, we obtain the labour supply curve, which shows how the number of hours worked varies with the wage. Depending on whether leisure is an inferior good or a normal good, the supply curve of labour may be upward sloping or backward bending. This helps government know the effect on their taxes policy on the labour market. The shape of the supply curve for labour determines the effect of a tax cut. This helps government know the effect on their tax on the labour market and why tax cuts do not always increase the tax revenue of individuals as predicted by various administrations. (Perloff, 2012, p. 147)
We could also use the indifference Curve method can be used to gauge the effects of government subsidy on low earnings groups. We take a condition when the subsidy is not paid in money, but the consumers are supplied cereals at dispensation rates the price difference being paid by the government.
With the unrealistic hypothesis of perfect competition, the real competition cannot be ascertained. Likewise, all commodities are not divisible. Despite the criticisms, the indifference curve method is still regarded superior to Marshallian introspective cardinals (Tutorsonnet.com, 2019).
An oligopoly market structure is one in which there are a small group of firms in the market that have a substantial amount of market share and there are substantial barriers to entry and exit in the market. By better understanding the oligopolistic model, governments better understand the structures of cartels and collusive behaviours in markets enabling them to put in place policies that will take consumer welfare into account. So, we are going to look at the different models in the oligopolistic market structure – Cartels, the Cournot model, Stackelberg model, Bertrand model – how governments apply policies on real life firms that fir this model structures (Quarkoniums, 2019).
“People of the same trade seldom meet, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices” (Adam Smith, 1776). As Adam Smith noted, in oligopolistic markets, some firms have incentives to form cartels in which they decide to reduce their prices, and set higher prices leading to higher profits for individual firms and the firms collectively. This collusiveness comes as result because of the profit maximization property of firms. If a competitive firm produces where its marginal cost equals the market price and only one firm reduces its output, it loses profit because it sells fewer units at essentially the same price. By getting all the firms to lower their output together, the cartel raises the market price and hence individual firms’ profits. The less elastic the market demand the potential cartel faces, all else the same, the higher the price the cartel sets and the greater the benefit from cartelizing. If the penalty for forming an illegal cartel is relatively low, some unscrupulous business people may succumb to the lure of extra profits and join.
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By modelling this behaviour economist helped influence government intervention against cartels as they better understood why this collusive behaviour restricts competition and minimises the consumer welfare. This permits them to create antitrust laws or competition policies—that limit or forbid some or all cartels. Examples of antitrust laws or competition policies include: Canada’s Competition Act, a federal law that governs most business conduct, contains both criminal and civil provisions aimed at preventing anti-competitive practices, the European Union’s competition policy, which, under the Treaty of the European Community (EC Treaty or Treaty of Rome) in 1957, gives it substantial powers to prevent actions that hinder competition within or across member states. In the United Kingdom, the Competition Act 1998 was introduced to ensure that businesses compete on a level footing. It does so by prohibiting certain types of anti-competitive behaviour (the Chapter I and Chapter II prohibitions). Together with EC legislation in place, the competition act prevents of anti-competitive behaviour in cartels.
However, in today’s economy there are some international cartels - OPEC - that are protected legally and even though their collusive behaviour is well known, do not face any penalties as according to them they are active for consumers benefit by market stabilization. It is also argued that non-OPEC energy suppliers have maintained enough market share for a substantial degree of worldwide competition hence OPEC does not limit competition in its markets. Moreover, because of an economic 'prisoner's dilemma' that encourages each member nation individually to discount its price and exceed its production quota, widespread cheating within OPEC often erodes its ability to influence global oil prices through collective action.
There are some cases in which oligopoly market models firms that act independently, market output and the firms’ profits lie between the competitive and monopoly levels. Firstly, the Cournot model, in which each oligopoly firm sets its output at the same time. In the Cournot (Nash) equilibrium, each firm produces its best-response output given the output its rival produces. As the number of Cournot firms increases, the Cournot equilibrium price, quantity, and profits approach the price-taking levels. In a Stackelberg model, if one firm, the Stackelberg leader, chooses its output before its rivals, the Stackelberg followers, the leader produces more and earns a higher profit than each identical-cost follower firm. A government may subsidize a domestic oligopoly firm so that it produces the Stackelberg leader quantity, which it sells in an international market and example of how this model helps government policies in real life is seen in the aircraft industry where Governments like France, Germany, Spain, and the United Kingdom own and heavily subsidize Airbus, which competes in the wide-body aircraft market with the U.S. firm Boeing. The U.S. government decries the European subsidies to Airbus while directing lucrative military contracts to Boeing that the Europeans view as implicit subsidies. In 1992, the governments signed a U.S.–EU agreement on trade in civil aircraft that limits government subsidies (including a maximum direct subsidy limit of 33% of development costs and various limits on variable costs).
Irwin and Pavcnik (2004) found that aircraft prices increased by about 3.7% after the 1992 agreement. This price hike is consistent with a 5% increase in firms’ marginal costs after the subsidy cuts. Since then, Washington and the European Union have continued to trade counter-complaints in front of the WTO. Each repeatedly charged the other with illegally subsidizing its aircraft manufacturer. In 2010, the World Trade Organization ruled that Airbus received improper subsidies for its A380 super- jumbo jet and several other airplanes, hurting Boeing, as the United States charged in 2005, and the cycle of subsidies, charges, agreements, and new subsidies continues.
Now we that we have looked at the oligopolistic market structure and how it helps government policies in real life situations, we know that firms compete on many fronts beyond setting quantity or price, to gain an edge over rivals, a firm makes many decisions, such as how much to advertise, whether to act to discourage a new firm from entering its market, how to differentiate its product, and whether to invest in new equipment. This leads us now to Game theory, which is a set of tools that economists, political scientists, military analysts and others use to analyse decision making by players who use strategies. Games in this sense are competitions between players, such as individuals or firms, in which each player is aware that the outcome depends on the actions of all players.
Economists use game theory when a player’s optimal strategy depends on the actions of others, which is called strategic interdependence. For example, oligopolistic cola manufacturers such as Coca-Cola and Pepsi carefully monitor each other’s behaviour. Because relatively few firms compete in such a market, each firm can influence the price, and hence the payoffs, of rival firms. The need to consider the behaviour of rival firms makes each firm’s profit maximization decision more difficult than that of a monopoly or a competitive firm. A monopoly has no rivals, and a competitive firm ignores the behaviour of individual rivals—it considers only the market price and its own costs in choosing its profit-maximizing output. Thus, we use game theory to study oligopolistic behaviour but not competitive or monopolistic behaviour.
There are two main types of games in Game theory: static game and dynamic games. In this essay we are going to be analysing static games and how this influences government policies. Static games are games in which each player acts only once and the players act simultaneously (or, at least, each player acts without knowing rivals’ actions). In these games, firms have complete information about the payoff functions but imperfect information about rivals’ moves an example of these games are the Cournot and Bertrand Model in the oligopolistic market structure, or an employer’s negotiation with a potential employee.
In a static game, such as in the Cournot model or the prisoners’ dilemma game, players each make one move simultaneously. Economists use a normal-form representation or payoff matrix to analyse a static game. Typically, economists’ study static games in which players have complete information about the payoff function — the payoff to any player conditional on the actions all players take — but imperfect information about how their rivals behave because they act simultaneously. The set of players’ strategies is a Nash equilibrium if, given that all other players use these strategies, no player can obtain a higher pay off by choosing a different strategy. Both pure-strategy and mixed-strategy Nash equilibria are possible in static games, and there may be multiple Nash equilibria for a given game. There is no guarantee that Nash equilibria in static games maximize the joint payoffs of all the players. An example of the static game is the prisoner’s’ dilemma game whereby all players have dominant strategies that lead to a profit (or another payoff) that is inferior to what they could achieve if they cooperated and pursued alternative strategies.
Throughout this essay we have seen how economic models and structures in microeconomics help governments to implement policies to better their economy and keep consumer welfare at its interest. However, it is not in all cases that the government will need intervene in the market for example when using the prisoner’s dilemma model where they allow the ‘invisible hand’ of the market to take its course.
Bibliography
- Edgeworth, F. Y., 1881. Mathematical Psychics: An Essay on the Application of Mathematics to the Moral Sciences. London: C. Kegan Paul and Co.
- Perloff, J. M., 2012. Microeconomics. In: 6th edition ed. s.l.:Pearson, pp. 75,77,78.
- Tutorsonnet.com. (2019). Uses Or Application Of Indifference Curve Study | TutorsOnNet. [online] Available at: https://www.tutorsonnet.com/uses-or-application-of-indifference-curve-study-homework-help.php [Accessed 6 Aug. 2019].
- ThoughtCo. (2019). Introduction to Utility Maximization. [online] Available at: https://www.thoughtco.com/introduction-to-utility-maximization-1146939 [Accessed 6 Aug. 2019].
- Quickonomics. (2019). The Four Types of Market Structures - Quickonomics. [online] Available at: https://quickonomics.com/market-structures/ [Accessed 6 Aug. 2019].
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