Q6: What do you understand by the Market for Lemons?

The Market for Lemons: Quality, Uncertainty and the Market Mechanism is 1970 paper by the economist George Akerlof. It discussed information asymmetry which occurs when a seller knows more about a product than a buyer. Imagine that owners of lemons are willing to sell for $1000 and owners of plums are willing to sell for $2000. Imagine that purchasers are willing to pay up to $1200 for a lemon and up to $2400 for a plum. Assume that sellers know what kind of car they have, but buyers can't tell. All buyers know is that half of all used cars are lemons. Therefore, based on the expected probability that a given car is a lemon, they will pay only up to $1800 for any car (1/2*1200 + 1/2*2400). But plum owners aren't willing to sell for only $1800, so only lemon owners will sell. The logical conclusion is that only the lemons will be sold, and the equilibrium price will be between $1000 and $1200. The mere presence of inferior goods destroys the market for quality goods (an externality problem) when information is imperfect. Plum owners need some way of signaling their car's quality. Possible market solutions: warranties/guarantees (shared risk), iterated interaction (brand names, chains), certification (diplomas, JD Powers, credit reporting). Possible non-market solutions: government certification agencies (FDA), licensing. To put this in terms of X and Y, asymmetric information (X) leads to adverse selection (Y).

Asymmetric information: The buyer and seller have unequal information about the vehicle's type. Adverse selection: The buyer risks buying a car that is not of the type he expects-e.g. buying a lemon when he thinks he is buying a plum.

Basically, the "lemon principle" is that bad cars chase good ones out of the market. This is related to Gresham's law (bad money drives out good money through mechanism of exchange rates).

Q5: What do you understand by Oligopoly?

Oligopoly is the form of market organization in which there are few sellers of a homogeneous or differentiated product. If there are only two sellers, we have a duopoly. If the product is homogeneous, we have a pure oligopoly. If the products are differentiated, we have a differentiated oligopoly. Although entry into an oligopolistic industry is possible, it is not easy. Characteristics: Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue equals marginal costs. Ability to set price: Oligopolies are price setters rather than price takers. Entry and exit: Barriers to entry are high. The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to entry often result from government regulation favoring existing firms making it difficult for new firms to enter the market. Number of firms: "Few" a "handful" of sellers. There are so few firms that the actions of one firm can influence the actions of the other firms. Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits. Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles). Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic factors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price, cost and product quality. Interdependence: The distinctive feature of an oligopoly is interdependence. Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market action, a firm must take into consideration the possible reactions of all competing firms and the firm's countermoves.[7] It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining how to achieve his or her objectives. For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. Or if the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold

existing prices constant. This high degree of interdependence and need to be aware of what other firms are doing or might do is to be contrasted with lack of interdependence in other market structures. In a perfectly competitive (PC) market there is zero interdependence because no firm is large enough to affect market price. All firms in a PC market are price takers, as current market selling price can be followed predictably to maximize short-term profits. In a monopoly, there are no competitors to be concerned about. In a monopolistically-competitive market, each firm's effects on market conditions are so negligible as to be safely ignored by competitors. Non-Price Competition: Oligopolies tend to compete on terms other than price. Loyalty schemes, advertisement, and product differentiation are all examples of non-price competition.

Q3: Explain the kinked demand curve model.

The kinked demand curve model, introduced by Paul Sweezy in 1939, attempts to explain the price rigidity that is often observed in some oligopolistic markets. Sweezy postulated that if an oligopolist raised its price, it would lose most of its customers because the other firms in the industry would not match the price increase. On the other hand, an oligopolist could not increase its share of the market by lowering its price, since its competitors will immediately match the price reduction. As a result, according to Sweezy, oligopolists face a demand curve that is highly elastic for price increases and less elastic for price reductions. That is, the demand curve faced by oligopolists has a kink at the established price; and, because of this, oligopolists try to keep prices constant even in the face of changed costs and demand conditions. This is shown in the Figure 11.4.

Figure: 11.4

Q4: Explain the Cournot model.

In the Cournot model oligopolists never recognize their interdependence on rivalry. As such, this model is quite unrealistic. The basic behavioral assumption made in Cournot model is that each firm, while trying to maximize profits, assumes that the others duopolists hold it output constant at the existing level. The result is a cycle of moves and countermoves by the duopolists until each sells one-third of the total industry output. In addition to the assumptions stated above, the Cournot duopoly model relies on the following: 1. Each firm chooses a quantity to produce. 2. All firms make this choice simultaneously. 3. The model is restricted to a one-stage game. Firms choose their quantities only once. 4. The cost structures of the firms are public information. In the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. Both firms know the market demand curve, and each firm knows the cost structures of the other firm. The essence of the model is this: each firm takes the other firm's choice of output level as fixed and then sets its own production quantities. The best way to explain the Cournot model is by walking through examples. Before we begin, we will define the reaction curve, the key to understanding the Cournot model (and elementary game theory as well). A reaction curve for Firm 1 is a function Q 1 *() that takes as input the quantity produced by Firm 2 and returns the optimal output for Firm 1 given Firm 2's production decisions. In other words, Q 1 *(Q 2)is Firm 1's best response to Firm 2's choice of Q 2 . Likewise, Q 2 *(Q 1) is Firm 2's best response to Firm 1's choice of Q 1 . Let's assume the two firms face a single market demand curve as follows: Q = 100 - P where P is the single market price and Q is the total quantity of output in the market. For simplicity's sake, let's assume that both firms face cost structures as follows: MC_1 = 10 MC_2 = 12 Given this market demand curve and cost structure, we want to find the reaction curve for Firm 1. In the Cournot model, we assume Q 2 is fixed and proceed. Firm 1's reaction curve will satisfy its profit maximizing condition, MR= MC . In order to find Firm 1's

marginal revenue, we first determine its total revenue, which can be described as follows Total Revenue = P * Q1 = (100 - Q) * Q1 = (100 - (Q1 + Q2)) * Q1 = 100Q1 - Q1 ^ 2 - Q2 * Q1 The marginal revenue is simply the first derivative of the total revenue with respect to Q 1 (recall that we assume Q 2 is fixed). The marginal revenue for Firm 1 is thus: MR1 = 100 - 2 * Q1 - Q2\ Imposing the profit maximizing condition of MR = MC , we conclude that Firm 1's reaction curve is: 100 - 2 * Q1* - Q2 = 10 => Q1* = 45 - Q2/2 That is, for every choice of Q 2 , Q 1 * is Firm 1's optimal choice of output. We can perform analogous analysis for Firm 2 (which differs only in that its marginal costs are 12 rather than 10) to determine its reaction curve, but we leave the process as a simple exercise for the reader. We find Firm 2's reaction curve to be: Q2* = 44 - Q1/2 The solution to the Cournot model lies at the intersection of the two reaction curves. We solve now for Q 1 * . Note that we substitute Q 2 * for Q 2 because we are looking for a point which lies on Firm 2's reaction curve as well. Q1* = 45 - Q2*/2 = 45 - (44 - Q1*/2)/2 = 45 - 22 + Q1*/4 = 23 + Q1*/4 => Q1* = 92/3 By the same logic, we find: Q2* = 86/3 Note that Q 1 * and Q 2 * differ due to the difference in marginal costs. In a perfectly competitive market, only firms with the lowest marginal cost would survive. In this case, however, Firm 2 still produces a significant quantity of goods, even though its marginal cost is 20% higher than Firm 1's.