MICROECONOMICS

MICROECONOMICS Theory, Practice and Evaluation Zahid S. Mughal Javed A. Ansari University of Karachi Press To our students so as to help them seek guidance from the intellectual foot-steps of Imam Al-Ghazali (RA) About Authors Zahid Siddique is Assistant Professor of Economics in the Management Science Department at National University of Computer and Emerging Sciences, FAST Islamabad. He has been conducting courses in the areas of economics and business sciences for the last seven years. He received his masters from the University of Karachi and then pursued M. Phil from Quaid-i-Azam University, Islamabad. Currently, he is enrolled in the PhD program of Quaid-i-Azam University, Islamabad. Major areas of his research interest include (1) comparative economic schools of thought, (2) political economy of economics, (3) microeconomics and (4) Islamic economics. He has published several papers in national journals and international conferences. Javed Akbar Ansari received his MSc from London and PhD from Sussex. He has taught Economics at City University, London and Sussex (ISIO). He has held different posts at the United Nations Industrial Development Organization, the United Nations Centre on Transnational Corporations, National Bank of Pakistan. Presently, he is the Dean and Professor of Economics and Finance at the Institute of Business Management, Karachi. He has published several articles in the reputed journals and has authored many books (e.g. Business Ethics in Pakistan, Money and Banking in Pakistan, Financial Management in Pakistan). Areas of his research include (1) History of economics thoughts, (2) Monetary and Financial Economics and (3) Western Philosophy. Contents About Authors v Contents vii Introduction to ‘Microeconomics’ xxiii 1: Why This Book? xxiii 2: How to Use this Book xxiv 3: Learning Tools xxv PART 1: PRELIMENARIES CHAPTER 1: INTRODUCTION TO ECONOMICS 1.1: What is Economics? 1 1.1.1: Scarcity 1 The Emergence of Economics 2 Scarcity and Choice 3 Choice and Allocation Problem 4 Allocation Strategies: Competition and Efficiency 5 The Objective Function 8 F Y I B O X 1.1 9 1.2: How Economists Do What They Do? 9 1.2.1: Science and Knowledge 9 F Y I B O X 1.2 10 Structure of an ‘Economic Theory’ 10 Economics as Paradigm 13 F Y I B O X 1.3 13 1.2.2: Positive Vs Normative Question 14 The Normative Essence of Economics 14 1.3: ‘What is Economics For?’: The Agenda of Capitalism 16 Economics and Politics: Link between Theory and Practice 17 1.4: Micro-Macro Distinction 19 Key Concepts 21 Chapter Summary 22 Review Questions 24 CHAPTER 2: INTRODUCTION TO CAPITALISM AND THEORY OF VALUE 2.1: The Capitalist System 27 2.1.1: Capitalist Norms and Values 27 2.1.2: Capitalist Regulation 28 The Role of Economic Theory 29 2.2: Theories of Capitalism and Value 30 2.2.1: What is Value? 31 2.2.2: Smith: Labor Commanded or Labor Input Theory of Value? 32 2.2.3: From Smith to Ricardo: The Embodied Labor Theory of Value 34 Ricardo on Wages 34 Profit and Rent in the Ricardian System 34 Ricardian Politics 36

Labor Input Theory after Ricardo 37 2.2.4: From Ricardo to Marx: The Abstract Labor Theory of Value 38 Marx’s Rejection of Profit 38 The Nature of Marx’s Economics and Politics 39 2.2.5: From Labor Commanded to Utility Theory of Value: The Marginalist Revolution or Rejoinder? 41 Nature of Marginalist / Utility Theory of Value 41 Nature of Neoclassical Economics 42 2.2.6: From Labor Input to the Cost of Production Theory of Value: Emergence of Social Democracy 44 Nature of Social Democrat Politics 45 2.3: Where Do We Go From Here? 46 Chapter Summary 48 Review Questions 51 PART 2: MARKETS: LIBERAL FRAMEWORK OF ANALYSIS CHAPTER 3: DEMAND AND SUPPLY: Basic Competitive Model 3.1: Demand 57 3.1.1: Determinants of Demand 57 Own Price and Demand 59 FYI: B O X 3.1 60 Income and Demand 62 Related Goods’ Prices and Demand 66 FYI: B O X 3.2 67 Taste and Demand 67 Taste and Advertisement 68 3.1.2: From Individual to Market Demand 68 3.2: Supply 72 Own Price and Supply 72 Input Prices and Supply 74 Technology and Supply 74 Other Determinants of Supply 75 A P P L I C A T I O N B O X 3.1 75 A P P L I C A T I O N B O X 3.2 76 3.2.2: From Individual to Market Supply 76 3.3: The Market And Equilibrium 78 Market with Excess Demand 78 Market with Excess Supply 79 Market in Equilibrium 80 3.4: Changes in Equilibrium: How Markets Allocate Resources? 81 3.4.1: Changes in Demand 81 Increase in Demand 82 A P P L I C A T I O N B O X 3.3 84 A P P L I C A T I O N B O X 3.4 85 Fall in Demand 85 3.4.2: Changes in Supply 86 Increase in Supply 86 A P P L I C A T I O N B O X 3.5 88 Fall in Supply 88 A P P L I C A T I O N B O X 3.6 89 3.4.3: Simultaneous Changes in Demand and Supply 90 Increase in Demand and Fall in Supply 90 3.5: Why Economists Insist on Equilibrium? 91 Key Concepts 94 Chapter Summary 95 Review Questions 97 CHAPTER 4: MARKETS and PRICE CONTROLS 4.1: Price-Ceiling 101 A P P L I C A T I O N B O X 4.1 102 Non-Price Rationing 103 A P P L I C A T I O N B O X 4.2 104 A P P L I C A T I O N B O X 4.3 106 A P P L I C A T I O N B O X 4.4 107 4.1.1: Black-Markets 107 4.1.2: Objectives of Price-Ceiling 109 Consumer Affordability 109 Price Stability 109 Maintaining Competitive Prices 110 Income Redistribution 111 4.2: Price-Floor 111 A P P L I C A T I O N B O X 4.5 113 FYI: B O X 4.1 114 4.3: Why Economists Preach Free-Markets? 114 Price as Information, Incentive and Allocative Device 114 4.3.1: Logic behind Elimination of Price-Controls 115 Distortion in Resource Allocation 115 Non-Money Competition 115 A P P L I C A T I O N B O X 4.6 116 4.3.2: Does Economics Discourage State Intervention? 117 Key Concepts 119 Chapter Summary 120 Review Questions 122 CHAPTER 5: ELASTICITY 5.1: Slope and Elasticity 125 Why not Slope? 126 Meaning of Elasticity 127 The Elasticity of Demand 129 5.2: Price Elasticity of Demand 129 Point Elasticity 130 Arc Elasticity 130 A P P L I C A T I O N B O X 5.1 132 5.2.1: Classifying Price Elasticity of Demand 133 5.2.2: Determinants of Own Price Elasticity 135 Availability of Substitutes 135

Degree of Necessity 135 Time Factor 135 Budget Share of a Commodity 136 5.2.3: Price Elasticity and Revenue (Expenditure) Changes 137 A P P L I C A T I O N B O X 5.2 139 Elasticity of a Straight Line and Total Revenue Curve 140 A P P L I C A T I O N B O X 5.3 144 5.2.4: Geometric Interpretation of Price Elasticity 145 Elasticity of Two Straight Line Demand Curves 146 Elasticity of Two Pivoting Lines 147 Elasticity of Two Intersecting Lines 148 5.3: Income Elasticity of Demand 148 5.4: Cross Price Elasticity of Demand 150 5.5: Supply Elasticities 150 5.6: Elasticity and Capitalist Policy 151 Calculating Combing Effects 151 A P P L I C A T I O N B O X 5.4 154 Key Concepts 157 Chapter Summary 158 Review Questions 160 PART 3: BEHIND MARKETS: CONSUMER AND PRODUCER BEHAVIOR CHAPTER 6: PREFERENCES AND UTILITY 6.1: Who is Consumer? 167 6.2: Consumer Behavior and the Theory of Choice 169 6.3: Modeling Consumer Preferences 171 The Strict Preference Relation 172 The Indifference Relation 172 6.3.1: Assumptions about Consumer Preferences: Rationality Conditions 173 The Indifference Map 176 Convexity and the Slope of the Indifference Curve 182 Indifference Curve as Representative of Taste 182 Diminishing Marginal Rate of Substitution (DMRS) 184 6.4: Taste for Special Commodities: Example of IC 185 An Economic Bad 186 A Useless Good 186 Perfect Substitutes 187 Perfect Complements 188 6.5: The Utility Function 189 6.5.1: Indifference Curves and Utility Functions 189 A P P L I C A T I O N B O X 6.1 190 Marginal Utility 192 MRS as the Ratio of Marginal Utilities 194 Difference between Marginal Utility and MRS 195 FYI: B O X 6.2 196 Key Concepts 198 Chapter Summary 199 Review Questions 202 CHAPTER 7: BUDGET SET, CHOICE AND DEMAND 7.1: The Budget Set 207 Slope of Budget Line 209 7.2: Consumer Choice 211 What Does Consumer Want to Do? 211 7.2.1: Consumer Equilibrium 214 Why Tangency? 215 Meaning of Tangency 216 From Two-Goods to Infinity 218 Consumer Sovereignty 218 Freedom = Income 219 7.2.2: Assumption of Convexity and Uniqueness of Equilibrium 220 Consumer Optimum with Concave Preferences 221 7.2.3: Equi-Marginal Principle: Restating Consumer Equilibrium 222 Why Must this Condition Hold? 225 A P P L I C A T I O N B O X 7.1 225 Why Alternative Approaches? 227 7.3: Explaining Choice For Special Tastes 228 A Useless Good 228 An Economic Bad 229 Perfect Substitutes 230 Perfect Complements 231 7.3: Demand 231 7.3.1: Demand Functions 232 Taste Differentials and Demand 232 Homogeneity of Degree Zero: A Property of Demand Functions 235 7.3: Consumer Theory and Utilitarianism 236 What is Next? 238 Key Concepts 239 Chapter Summary 240 Review Questions 243 CHAPTER 8: CHANGES IN DEMAND: Comparative Static Analysis 8.1: Income Changes and Demand 247 8.2: Normal and Inferior Goods 249 8.2.1: Income-Consumption Path and Engel’s Curve 251 Shape of ICP or Engel’s Curve and Flaws in Economic Reasoning 252 Application BOX 8.1 254 8.3: Own Price Changes and Demand 254 8.3.1: Price Changes and Demand for ‘Normal’ Goods 256 The Substitution Effect 256

The Income Effect 256 Price Consumption Curve and Individual Demand Curve 258 Slope of Demand Curve: Graphical Analysis of Substitution and Income Effects 259 FYI: B O X 8.1 263 FYI: B O X 8.2 264 8.3.2: Price Changes and Demand for Inferior Goods 264 Graphical Analysis of Inferior Goods 265 8.4: From Individual to Market Demand: An Untold Story About the Contradictions of Economics 267 From One to Infinity 267 Economist’s Vision of Human Being and Society 269 8.4.1: The Collapse Begins: The Problems of Aggregation 269 Solution: One for All and All for One—the representative consumer 272 A P P L I C A T I O N B O X 8.2 274 Is it a Solution or Contradiction? 274 A P P L I C A T I O N B O X 8.3 275 Equilibrium in Question 276 Why Consumer Theory at All? There is even more to surprise 277 FYI: B O X 8.2 278 Does Capitalism Allow Heterogeneous Taste and Cultures? 280 8.4.2: The Possibility of Discontinuous Individual Demand Curve 281 Non-Convex Preferences and Individual Demand Curve 281 8.5: Cross Price Effect and the Slope of Price Consumption Path 282 Key Concepts 284 Chapter Summary 285 Review Questions 288 CHAPTER 9: FIRM AND PRODUCTION IN CAPITALIST SOCIETY 9.1: Firm: The Agent of Production in Capitalist Order 291 9.1.1: The Firm 292 A p p l i c a t i o n B O X 9.1 293 The Firm and the Entrepreneur 294 Plant and Industry 294 9.1.2: Legal Forms of the Firm 295 Proprietorship 295 Partnership 296 Corporation 296 9.2: Dynamics of Production in Capitalist Society 298 9.2.1: How it All Got Going: Transformation to Capitalist Production 298 9.2.2: Impact of Capitalist Production on Society 300 Capitalist Production Imposes New Social Discipline 301 A p p l i c a t i o n B O X 9.2 301 Capitalist Production Producing New Social Networks 302 Capitalist Production Eliminates the Natural Order of Life 303 Capitalist Production Destroys Family Institution 304 Capitalist Production and Capitalist Individuality 305 Key Concepts 307 Chapter Summary 308 Review Questions 310 CHAPTER 10: NEOCLASSICAL THEORY OF PRODUCTION 10.1: The Production Function 313 Classification of Inputs 314 Economists’ Preferred Form of Production Function 315 What is Capital? 316 Short Run and Long Run for Firm 317 A P P L I C A T I O N B O X 10.1 317 10.2: Production with Single Input Variable: Short Run Analysis 318 10.2.1: Returns to Factor Input 319 A P P L I C A T I O N B O X 10.2 320 Diminishing Marginal Product 321 Production Functions without Diminishing Marginal Product Assumption 323 Deriving Marginal Product Curve 324 10.2.2: Evaluating Diminishing Marginal Productivity 325 F Y I B O X 10.1 330 10.2.3: Relationship between Marginal and Average Products 330 Stages of production 333 10.3: Production with Two Inputs Variable : Long Run Analysis 335 A P P L I C A T I O N B O X 10.3 336 10.3.1: Iso-Quant Curves: Modeling Production with Several Inputs Variable 337 Marginal Rate of Technical Substitution 339 Properties of Iso-quant Curves 341 Changing a Single Input When Several Can be Changed 341 10.3.2: Returns to Scale 342

Increasing Returns to Scale 344 Decreasing Returns to Scale 345 10.3.3: Input Substitution 345 Fixed Proportion Production Function 346 A P P L I C A T I O N B O X 10.4 347 Why Typical Iso-Quant? 348 Key Concepts 351 Chapter Summary 352 Review Questions 355 CHAPTER 11: NEOCLASSICAL THEORY OF COST 11.1: The Economic Concept of Cost 359 A P P L I C A T I O N B O X 11.1 360 The Cost Equation 361 11.2: Choice of Technique as Cost Minimization 361 Stating the Problem of Cost-Minimization 362 11.2.1: Cost Minimizing Input Choice 363 Graphical Solution 364 Uniqueness of Equilibrium and Convexity of Iso-quants 366 11.2.2: Firm’s Expansion Path 367 11.3: Short Run Cost Curves 369 11.3.1: Deriving Total Cost 369 Fixed and Variable Cost Curves 370 The Total Cost Curve 372 11.3.2: Per Unit Cost Curves 372 Deriving the Marginal Cost Curve 372 Relationship between Marginal and Average Total Cost Curves 374 Relationship between Average Total and Average Variable Cost Curves 377 11.3.3: The Sraffian Cost Curves 378 11.4 : Long Run Cost Curves 380 11.4.1: Long Run Average Total Cost 380 Issue of Reserve Capacity 382 11.4.2: Relation between Short-Run and Long run: The Envelop Curve 383 Key Concepts 386 Chapter Summary 387 Review Questions 390 PART 4: FIRM IN THE OUTPUT MARKET CHAPTER 12: PERFECT COMPETITION 12.1: Structure of Perfect Competition 395 12.1.1: Implications 395 Price Taking Behavior 395 Law of One-Price 396 A P P L I C A T I O N B O X 12.1 396 The Fiction of the ‘Horizontal-Demand-Curve’ 397 F Y I B O X 12.1 398 12.1.2: Revenue Structure of the Competitive Firm 399 12.2: Profit-Maximization and Firm Supply 401 12.2.1: Choice of the Scale of Output 401 The ‘Total-Condition’ 402 Marginalism: the Per-Unit-Condition for Profit Maximization 404 12.2.2: Firm Equilibrium and Derivation of the Supply-Curve 405 Profit-and-Loss 406 The Shut-Down Rule and the Supply Curve 407 A P P L I C A T I O N B O X 12.2 408 Market Supply Curve 409 12.3: Transition to Long Run Equilibrium 410 Market Period Supply 410 A P P L I C A T I O N B O X 12.3 411 12.3.1: Moving to Long Run Equilibrium 413 The Meaning of Normal Profit 414 Alleged Efficiency of Competitive Markets 416 12.3.2: The Real Politics behind Competitive Markets 416 A Night Watchman State 416 Cut Throat Markets 417 Freedom and Market-Justice 418 12.4: Perfect Competition Is Not Perfect 419 12.4.1: Sraffa on Perfect Competition 419 Competitive Market with Constant Marginal Product 420 Diminishing Marginal Product and Independence of Demand-Supply 421 What about the Real World? 423 Key Concepts 426 Chapter Summary 427 Review Questions 430 Appendix Chapter 12 431 Consumer Surplus 431 Producer Surplus 432 Social Welfare or Total Surplus 433 CHAPTER 13: MONOPOLY 13.1: Structure of Monopoly 438 13.1.1: Implications 438 Price Setting Behavior 439 Revenue Behavior 440 Algebraic Treatment of Marginal Revenue 441 F Y I B O X 13.1 444 13.2: Profit-Maximizing Output And The Monopolist’s Price 445 The Marginal Condition 445 Total Condition and Shut Down Rule 447 13.2.1: Monopoly Supply Curve 448

13.3: Monopoly Power 449 13.3.1: Measuring Monopoly Power 449 A Rule of Thumb for Monopoly Pricing 449 Lerner Monopoly Power Index 451 13.4: Creating and Sustaining Monopoly Power: Entry Barriers 451 A p p l i c a t i o n B O X 13.1 451 13.4.1: Franchise Rights 452 Why Franchise Rights? 453 13.4.2: Natural Monopoly 453 Sustainable Monopoly 456 13.4.3: Active Pricing Strategy 457 Inertia Shopping Rule 457 13.4.4: Investment Requirements and Capital Market Imperfections 459 A p p l i c a t i o n B O X 13.2 459 13.4.5: Competitive Advantages 460 A p p l i c a t i o n B O X 13.3 461 Capitalist Dynamics and the Emergence of Monopolies 461 13.5: Need for Regulating Monopoly and State Policy 463 13.5.1: Social Cost of Monopoly: The Standard Story 463 Monopoly and Deadweight Loss 464 13.5.2: State Instruments for Regulating Monopoly 466 Price Regulation 466 Rate of Return Regulation 468 A p p l i c a t i o n B O X 13.4 469 Price-Cap Regulation 469 13.6: Competition Mania Unveiled: Yet Another Untold Story of Economics 471 13.6.1: Horizontal Demand Curve Fallacy 472 F Y I B O X 13.3 475 13.6.2: No MR-Curve Fallacy 477 13.6.3: ‘P = MC Maximize Profit’ Fallacy 478 13.6.4: The Competition Better than Monopoly Fallacy 480 13.6.5: Other Fallacious Arguments 481 Argument from Market Dynamics 481 13.6.6: Abandon ‘one for all’ policy 483 Why Economics Preach Free Competition? 484 Key Concepts 486 Chapter Summary 487 Review Questions 491 CHAPTER 14: MONOPOLISTIC COMPETITION AND OLIGOPOLY 14.1: Monopolistic Competition 495 14.1.1: Structure and Implications 496 Marketing as Essential Ingredient of Firm 496 Monopoly Power and Negatively Sloped Demand Curve 497 14.1.2: Output and Pricing Decision: Equilibrium of the Firm 498 Short-Run Equilibrium 498 Long-Run Equilibrium 498 14.1.3: Efficiency of Monopolistic Competition 500 Justifying Excess Capacity 501 14.2: Oligopoly: Meaning and Equilibrium 502 14.2.1: Structure of Oligopoly 502 Firm Interdependence 502 Defining Oligopoly as Market Concentration 503 14.2.2: Equilibrium in Oligopoly Markets 506 14.3: Non-Collusive Oligopoly 507 14.3.1: Cournot Duopoly Model 507 Output Decision of Cournot Duopolist 508 Reaction or Best Response Function of Cournot Duopolist 509 Determining Cournot Equilibrium 510 Stability of Cournot Equilibrium 510 Linear Demand Curve Example of Cournot Duopoly Model 512 Welfare Properties of Cournot Duopoly 513 14.3.2: Stackelberg Duopoly Model: First Mover Advantage 515 Two Many Cooks Spoil the Curry 517 14.3.3: Bertrand Duopoly Model: Criticism of Cournot 518 Demand Function of the Bertrand Duopolist 518 Bertrand Equilibrium and its Efficiency 518 14.3.4: The Edgeworth Model 519 14.4: Collusive Oligopoly 520 14.4.1: Instability of Collusion 521 A P P L I C A T I O N B O X 14.1 522 Oligopoly Markets as Prisoner’s Dilemma 522 14.4.2: Making Collusion Stable 523 Repeated Games and Stability of Collusions 523 The Kinked Demand Curve Conjecture 524 14.4.3: Cartel Pricing Analysis 526 An All-Inclusive Cartel 526 Cartel as Dominant Firm 527 A p p l i c a t i o n B O X 14.3 529

14.4.4: Mergers and Acquisitions 530 Motives for Mergers 530 14.4.5: Antitrust Laws: Regulating Oligopoly 531 Regulation Methodology 532 Oligopoly Redefined 533 14.5: Conclusion 534 Key Concepts 535 Chapter Summary 537 Review Questions 541 Labor: an inverted commodity 547 PART 5: FIRM IN THE INPUT MARKET: INCOME DISTRIBUTION CHAPTER 15: MARKET FOR LABOR 15.1: Demand for Labor In A Competitive Market 547 The Meaning of Competitive Input Markets 548 15.1.1: Factor Demand with One Input Variable 549 The Shut Down Rule Revisited 551 Digression on Similarity between Input-Output Markets 552 Changes in Input Demand 553 15.1.2: Factor Demand with Two Inputs Variable 553 Substitution Effect of an Input Price Change 554 Output Effect of an Input Price Change 555 F Y I B O X 15.1 557 15.1.3: Market Demand for an Input 557 15.2: Supply of Labor: The Ideology of The Indifferent Worker 558 15.2.1: Time Allocation Problem 559 Preferences for Leisure and Income 560 Budget Set for Leisure and Income 560 Choice for Leisure and Income 562 15.2.2: Changes in Labor Supply 562 Substitution Effect of a Wage Change 562 Income Effect of a Wage Change 564 Slope of the Labor Supply Curve 565 15.3: Equilibrium in the Labor Market 566 A P P L I C A T I O N B O X 15.1 567 15.3.1: The Politics behind Labor Market Analysis 569 ‘Can’t Beat the Markets’—disintegrate the unions 570 To Each According to his Contribution 571 15.4: Problems with the Neoclassical Theory and Policy Package 571 15.4.1: Backward Bending Labor Supply Curve: The Case for Interventionist Labor Policy 571 15.4.2: Market Power & Labor Market: The Case for Unionized Labor 575 Market Power in the Output Markets 575 A P P L I C A T I O N B O X 15.2 578 Monopsony: Market Power in the Input Markets 579 Monopsonist Vs Labor Union 583 A P P L I C A T I O N B O X 15.3 585 Monopsony and the Minimum Wage Laws 586 15.4.3: Perfect Competition Equals Monopsony 587 15.4.4: Sraffa’s Aggregation Issues 590 Key Concepts 592 Chapter Summary 594 Review Questions 597 CHAPTER 16: MARKET FOR CAPITAL 16.1: Demand for “Capital” In A Competitive Market 602 16.1.1: Demand for Capital 602 16.1.2: Supply of Capital 604 Intertemporal Budget Set 604 Intertemporal Preferences 607 Optimization: Choice about Saving and Borrowing 608 Effects of Changes in Interest Rate 609 16.1.3: Equilibrium in the Capital Market 613 16.2: Euler’s Exhaustion Theorem: Solution to Class Conflict 614 16.3: Complexities Creep in: Some Untold Problems with Capital Market Analysis 617 16.3.1: Sraffa on Diminishing MP and Return on Capital 617 16.3.2: The Problematic ‘Circular Flow’ of Economics 618 16.3.3: The Capital Controversy 620 An Impossibility Theorem 622 Implications of the ‘Impossibility Theorem’ 624 Political Agendas of the Two Cambridges 626 16.4: Why Economics? 626 Is Economics Free of Ideology? 628 16.5: Economic Theory of Profit 629 Types of Risks 629 Schumpeter’s Account of Business Cycles and Profits 631 Keynes on Profit 632 Sraffian Position on Profit 632 Key Concepts 634 Chapter Summary 635 Review Questions 638

CHAPTER 17: ALTERNATIVES TO MICROECONOMICS 17.1: Macroeconomics, Keynesianism and Post-Keynesianism 641 17.2: Sraffians and Marxists 644 17.3: Islamic Economics 647 17.4: Institutional Economics 650 17.5: Behavioral Economics 653 Expected Utility Theory 654 The Endowment Effect 654 Hyperbolic Discounting 654 Social Preferences 654 17.6: Management Sciences 656 17.7: Conclusion 659 Review Questions 662 GLOSSARY 665 Introduction to ‘Microeconomics’ 1: Why This Book? Introductory texts used in undergraduate and post graduate courses in Pakistan are usually those used in America and Britain. They are written for British and American students and they present Economics as if its teachings were universally applicable––as if it did not matter whether we were trying to organize production and trade in the market for financial services in New York in 2011 or studying the production and distribution of ajraks in Hala. Those who learn Economics therefore develop an understanding about how the American and British system is supposed to be working. They have no clue of what is happening in the markets of countries like Pakistan. This is a particularly important deficiency in understanding as far as microeconomics is concerned. For while the Pakistani state has been colonized, markets remain embedded in our traditional society. Decisions about whom to employ, what to produce, where to invest, how much to save and in what form–––all these decisions are taken on the basis of values and preferences which are not recognized by Economic theory, since it has a historically contingent conception of economic rationality and assumes that this “economic rationality” is universal. Moreover market institutions as they have evolved in South Asia over the last five thousand years are quite different in several crucial ways from the market organization and regulation practices of present day Britain and America. Assuming that markets in Pakistan are organized and regulated according to the presumptions of Economic theory ignores and obscures reality and makes it difficult for students to understand how Pakistani markets really function. The primary purpose of this textbook is to assess the usefulness of microeconomic theory as a basis for understanding how markets actually work in Pakistan and in other “third world” countries which have broadly similar historical experiences and social organization. Every chapter begins with a detailed user friendly presentation of mainstream microeconomic theory. You do not need to have read any other Economics textbook before you read this book. It covers all the topics included in any standard microeconomics book in as much detail. The book has been written for introductory Economics courses in BBA, MBA and MA / MSc programs and a special effort has been made to ensure that no topic covered in the microeconomics syllabus of these programs has been left out in this book. Many Pakistani authors have written Economics textbooks. But none of them have tried to assess the extent to which this theory enables the student to understand how markets really work in Pakistan. This book tries to do this by describing the social, political and intellectual background against which Economics as a discipline emerged, the philosophical and ideological assumptions on which it is based and the objectives it seeks to achieve. This book thus presents a critique of microeconomic theory and not merely an exposition. Such a critique has so far not been produced in Pakistan.

In the development of this critique we also present arguments and assessments of a range of “heterodox” economists such as Pierro Sraffa, Karl Marx, Theorenstein, Veblen, Rudolf Hilferding and Joan Robinson who have pointed out the inconsistencies in microeconomic analysis and thus identified the limits of the functionality of Economics discourse. Like them we reject the claim that Economics is a positive science—which merely seeks to describe the world of production and exchange as it really is. Sraffa, Veblen and many other have argued that Economics does not adequately describe how modern capitalist economies function. Instead Economics is a normative science which assesses the operations of an economy on the basis of a specific ideal type. This ideal type is a world characterized by perfect markets, total price flexibility and general equilibrium. Actually existing capitalist systems do not correspond to this ideal type and Economics therefore cannot describe them accurately. It concerns itself with prescribing rules and criteria on the basis of which their performance must be judged and improved upon. An obvious limitation of Economics is that its analysis and prescriptions are relevant only to capitalist systems. The extent to which a system of production and exchange is non-capitalist (as is the case for most Third World societies), to that extent Economic analysis is essentially irrelevant. Most Third World rulers are trying to convert their non-capitalist societies into capitalist ones. Economics provides them with a set of criteria on the basis of which they can measure the extent to which they have succeeded in this effort. Summarizing we may say that this book: enables the student to cover the whole range of topics included in the syllabi of introductory microeconomics courses. It is meant to replace standard American and British textbooks; such as Samuelson, Lipsey, Parkin, Nicholson and Mankiw introduces the students to major critiques developed by Sraffa, Joan Robinson and Rudolf Hilferding. Standard textbooks never discuss this work because it shows up the fundamental weaknesses and incoherence of Economics analysis. This work shows that Economics is not a positive science. It does not describe how modern capitalist systems actually work enables the student to appreciate the essentially normative nature of microeconomics analysis and thus to understand the reasons why Economics provides an incomplete and sometimes quite false picture of what is actually happening in Pakistani markets 2: How to Use this Book The book is divided into 5 parts: Part 1: Preliminaries: It consists of two chapters: Introduction to Economics Introduction to Capitalism and Theory of Value Part 2: Markets: Liberal framework of analysis: It consists of three chapters: Basics of Demand and Supply Market and Price Controls Elasticity Part 3: Behind Markets: Consumer and Producer Behavior: It consists of six chapters: Preferences and Utility Budget Set and Choice Demand and Changes in Demand

Firm and Production in a Capitalist Society Neoclassical Theory of Production Neoclassical Theory of Cost Part 4: The Firm in the Output Market: It consists of three chapters: Perfectly Competitive Market Monopoly Monopolistic Competition and Oligopoly Part 5: Firm in the Input Market: Distribution of Income: It consists of two chapters: Market for Labor: Determination of Wages Market for Capital: Determination of Interest The last chapter “Alternatives to Microeconomics” (Chapter 17) summarizes several alternative approaches to an analysis of product and factor market behaviors. It provides a basis for assessing both the role and the limitations of microeconomics analysis of capitalist systems of production and exchange. We present the text in a reader friendly manner with many examples worked out in the text. The main findings of each chapter are summarized at the end. The chapters conclude with a set of review questions answering which will enable students to assess their understanding of the main arguments presented in the chapter. We have tried to minimize the use of algebra and no prior knowledge of mathematics is presumed. Special care is given to explain the meaning behind technical analysis in a simple manner. 3: Learning Tools Several learning tools have been incorporated the text to facilitate your understanding. These include: For Your Information (FYI) Box: present ancillary material for understanding. These are usually used for clarifying difficult material and for providing additional information about economic theory. Relatively difficult mathematical material is also presented in these boxes Application Box: to create a link between economic theory and the real world. Chapter Summaries: Every chapter ends with a summary of its major issues. These summaries can be used for a quick review of the chapter, especially during preparation for examinations Key Concepts: Learning the vocabulary of a discipline is an important part of any course. Key concepts are highlighted in boldface within the chapter. The complete list of key words introduced in any chapter along with their definition is given at the end of each chapter Review Questions: After reading a chapter, students can check their understanding by answering the questions posted at the end of each chapter Glossary: A glossary of more than 250 words is given at the end of the book to keep students familiar with the language of microeconomics P A R T O N E: Preliminaries Economics as a Framework for Capitalist Analysis Chapter 1: Introduction to EconomicsChapter 2: Introduction to Capitalism and Theory of Value Chapter 1: Introduction to Economics Chapter 2: Introduction to Capitalism and Theory of Value Chapter 1 INTRODUCTION TO ECONOMICS 1.1: What is Economics? Every economics textbook —Lipsey, Samuelson, Mc Connell, Mankiw—pretends that economics answers a question that applies to all times and all societies. That question is ‘how scarce resources should be efficiently allocated among alternative uses?’ This definition of economics was formulated by Lionel Robbins in 1932 and it enjoys widespread acceptance among modern economists. But is this really a general question? Have all societies in recorded history—a period of about 8,000 years—faced scarcity? In a famous book the anthropologist Sahlins has shown that stone-age (Paleolithic) societies in Australia have always been affluent societies. When James Meoae, a noble prize winner, was sent by the UN in the late 1940s to make a plan for Kiribati—a group of South Pacific Islands—he found that the Kiribatians had everything they wanted. Why then bother with economics? Heins Arndt, a famous Australian economist, expressed much the same perplexity after visiting Mao’s China. Historically, there was no economics in its present formal sense in the ancient Egypt or Mesopotania, the old Chanare Kingdoms, Greece and Rome, medieval Europe, the Khilafat-e-Rashida, Asoka, Akbar’s India and the Ottoman Empire. Why did none of these societies experience scarcity? The answer to this question does not rest in the inadequacy of thinking capacity of these people; rather the key to answer lies in the acceptance of the very concept of scarcity, the heart of modern economics.

1.1.1: Scarcity In order to understand economics clearly, we must understand the concept of scarcity because it is this idea that underlies ‘what economics actually is’. Scarcity does not refer to goods that are hard for an individual to obtain today or tomorrow. Similarly, it does not mean that something is rare or available in some limited quantity. Rather something is said to be scarce if it is perceived as rare by consumers. To take Lionel Robbins’ famous example, ‘bad eggs’ may be “rare”, but if people do not desire bad eggs, then even one bad egg is already “too many” in their eyes and thus will not be regarded as rare and scarce. In contrast, if people’s desire for cars is very great, then in their perception even a large number of cars will be “too few”, thus cars will be regarded as scarce. The important point to note is that the subjective element of desire is an integral part of the concept of scarcity. Scarcity does not belong to objects or resources; rather it arises due to a mismatch between human desires and availability of resources. Something becomes scarce for an individual when he begins to feel that he does not have as much of it as he wants. Thus, scarcity is a subjective phenomenon—it is an outcome of desire for more. Not all societies experience scarcity; rather scarcity is encountered by a society when the wants of individuals living within it continuously exceed the resources that society has available for satisfying these wants. The rate of growth of wants always exceeds the rate of growth of resources in such a society. Wants are of course psychological. A person living in a society characterized by scarcity not only wants all, but also wants more and more of this all. Thus even if Bill Gates is given all the resources of the world, he can wish for all the resources in all the universes; i.e., he can wish to create new universes. There is no limit to his desires. However, his ability to create new resources is limited. Economists define resource as anything that can satisfy a human want. Gates can never create new universes. An aspiring fast bowler cannot become eight feet tall. Wants and desires if they are unlimited must necessarily remain unfulfilled because Gates cannot create resources by merely wishing to do so (this point is incorporated in microeconomic analysis through the concept of the budget line, see chapter 7). It is important to note that in capitalist society, Gates does not merely want more of a particular commodity, say car; rather he wants ‘more of all’ goods and services. Hence scarcity is infinite. On the other hand, if wants are limited, scarcity can be limited. Finally, if wants are less than the available resources scarcity is abolished. Thus, it is possible to overcome scarcity. This idea can be expressed in a simple equation. Since scarcity (S) is the differences between wants (W) and resources (R), we have: S = W – R (1.1) We can see that S can be infinite if W is infinite, positive if W > R, and negative if W < R. This is shown in Figure 1.1.

Figure 1.1: Concept of scarcity in different societiesNon-capitalist societyWants > Resources Positive ScarcityCapitalist societyInfinite Wants Infinite ScarcityReligious societyWants < Resources Negative Scarcity Figure 1.1: Concept of scarcity in different societies Non-capitalist society Wants > Resources Positive Scarcity Capitalist society Infinite Wants Infinite Scarcity Religious society Wants < Resources Negative Scarcity The Emergence of Economics The religious texts—both the Quran and the Bible—regard scarcity as a consequence of the forgetfulness of death and the afterlife. Such a life is the life of the typical capitalist individual who first appeared in Europe in the early modern period. This type of life is theorized and justified by the philosophers of the Enlightenment and their scientific precursors (Bacon, Descartes, Kant, Rousseau, Hume, Smith) in the seventeenth and eighteenth century) as something just and natural. Economics is a project of the Enlightenment movement. It appeared in France and Scotland in the eighteenth century when capitalist individuality (individuality dominated by infinite wants) had become widespread, capitalist society had taken roots and capitalist states (Restoration England, Republican France, independent America) were consolidating their hold on power. All pre-Enlightenment societies—ancient Greece, medieval Europe, the Khilafat-e-Rashida—were affluent societies in the sense that there was no scarcity in these societies. Scarcity as a separate academic concept is a product of the Enlightenment which legitimated capitalism. Capitalism is a way of life in which human beings are committed to the objective of ‘maximization of freedom’ and forget about or seek to push back limits and constraints. The one constraint that cannot be pushed back infinitely is life itself. Therefore, Enlightenment sciences, including economics, never mention death or the afterlife realities. All other constraints are in principle relaxable provided one has the motivation to relax them. Economics presumes that wants are unlimited and that it is natural to seek their maximum satisfaction through continuing, never ending and eternal capital accumulation. Capitalist man is (as Rousseau said) born free and it is in his nature to want more and more of all. Freedom produces scarcity (unlimited wants) and economics answers the question “should wants be limitless in relation to resources” with a loud and resending “yes”—this is the indisputable norm underlying all positive economic analysis. Economics celebrates scarcity. It recognizes that eliminating scarcity would be eliminating freedom and its associated justification for never ending and eternal capital accumulation. Accepting scarcity as natural and rational is accepting the capitalist way of life. Scarcity and Choice Scarcity implies choice. If scarcity means that Gates does not have all that he wants, it also means that Gates cannot fulfill all his desires with available resources, no matter how abundant these resources may be. Gates will have to decide which desires to satisfy and which to leave unsatisfied: choice is inevitable. This choice is made among alternative uses of resources. To see this, consider a student who is contemplating about his future career plans after passing intermediate exam. He might have several plans regarding his studies: he might be willing to become a doctor because his father wants him to be this, an engineer because his mother has a strong desire to see him an engineer, a lawyer because none of his family members have ever done this before, an Alim-e-Deen because he has personal interest in Islam. But the problem is that he has limited time available (24 hours a day) that he has to allocate among many daily activities, like praying five times a day, sleeping, eating, other household activities and of course studying. Another fact that constraints his study plans is that almost all such degree programs presume full-time study from a student. Therefore, his desires compete with each other and a given resource can be used to fulfill only one (or some) of them at a time. However, if the length of a day were, say 1,000 hours, then the student would not be thinking which degree program to choose because he could afford to attend classes of different programs at different places during such a long day. In other words, he would not be confronted with the problem of choice if there were no scarcity of time.

Almost all resources have several uses, i.e. can be used to satisfy more than one end before they have been put into use for some specific end. For example, the student could use his time in several ways before he actually takes admission in any particular discipline. Once admitted, say, in the morning engineering program at NED, he cannot spend his morning time, say, studying at Karachi University in the Economics department without losing his lectures at NED. To take another example, a piece of land within the city can be used for many purposes: for constructing a house, for establishing an educational institution or some office space, developing it as a playing ground or a park, and so on. But once an educational institution has been established, this piece of land cannot be used as a house or a park. Although some resources have multiple uses (a piece of land being used as foot-ball and cricket ground at different times); yet using one resource in one way does involve giving up its use in some other way at that time. A ground cannot be used for playing foot-ball and cricket at the same time. And even if it could be used for both games at a time, it could not be used as a school. With scarce resources, one is forced to make choices for the attainment of specific wants: trade offs are required among desires. Thus, doing something in one way involves giving up something else. In other words, each choice has a cost in a sense that one has to pay for the most desired alternative by giving up the opportunity to have some other alternatives, called its opportunity cost. Opportunity cost of a particular choice is the satisfaction that would have been derived from the next best alternative foregone; in other words, it is the value of forgone activities in making a certain choice or decision (see chapter 11 for details). Choice and Allocation Problem Why have we been dwelling so much into the concept of choice? This is because it is choice which creates the problem of allocation. When you are facing a situation involving choice, you are basically thinking how a given resource should be allocated among its many possible uses. A student undertaking career planning is actually considering how to allocate his available time that can be used in many ways. Thus, wherever scarcity of resources exists, the problem of allocating those resources needs to be addressed. As an example, think why no one cares about who will use how much air to breathe or sea water to drink? It is because these resources are not scarce; in the sense that demand for them is less than their supply at zero price (this may not remain true for both air and water due to pollution). And because they are not scarce, no allocation problem arises. Correctly speaking, scarcity of a resource exists only if the individual’s desire for it exceeds its supply when it is made available at zero price. The relationship between scarcity, choice and allocation is depicted in figure 1.2. Figure 1.2: Scarcity, Choice and Allocationax: a Scarce resourceAllocation Problem: Not all can be selected at a time for xbcChoice among

Figure 1.2: Scarcity, Choice and Allocation a x: a Scarce resource Allocation Problem: Not all can be selected at a time for x b c Choice among If scarcity implies allocating resources among alternative uses, how is this problem solved? In other words, how can it be decided to which use a particular resource should be allocated? Economists argue that since any single resource can be put to alternative uses, optimum allocation problem requires it to be used where it produces the best results. But what is that result and how can that result be attained? Allocation Strategies: Competition and Efficiency If the economic problem were merely the allocation of scarce resources, economics would be an insubstantial discipline because this problem could be solved as easily as by drawing lottery or some other simple scheme. Think of a university planning its BBA admissions for the year 2011. Suppose it offers 100 seats for admissions while only 100 candidates apply against these 100 seats. Will this university face an allocation problem? No, because all applicants will, by default, get admission (provided no minimum admission criteria exist). But assume that the number of applicants is 500. Now the university will have to decide which candidates to select out of these 500 for the announced 100 seats; in other words an allocation problem arises. Suppose that a meeting is called and a number of proposals are advanced. Some of them are listed below: Lottery: one of the members suggests the strategy of writing down the names of all 500 candidates on paper slips and drawing 100 slips randomly. The lucky 100 whose names appear on those drawn slips should be given admission. The beauty of this proposal is that it requires the university to do very little evaluation and administration First-come-first-serve: Another member proposes to offer admissions only to those 100 students who are listed among the 100-earliest applicants. Or may be to those 100 applicants who happen to deposit the university fee earliest Dictatorship: Yet another person, who is probably the chief, suggests delegating all powers to a single person or to a group of selected people who can then decide which applicant to select as per their personal likeness Competition: Finally some one comes up with the idea of conducting an entry test and selecting only the 100 top-scorers All these strategies, and probably many more, are available to the university administration. Which one should be chosen? This question cannot be answered until the objective of allocating resources has been defined. The choice of a particular allocation strategy depends upon the objective of allocation. For example, if the university wants to minimize time spent on allocation then the first two of these four will be the most convenient. Will such allocation strategies be acceptable to an economist? Obviously not. But why? To know this, let us go back to the definition of economics which goes as: efficient allocation of scarce resources among alternatives uses. So, an economic problem is not merely allocation, it is efficient allocation which is desired. Efficiency is another important term which carries a specific and technical meaning in economics, but roughly speaking it means ‘producing maximum utility and profit from given resources’. The objective (in capitalism) is to maximize efficiency and the economic problem is to devise strategy which allocates scarce resources among their alternative uses so that maximum utility and profit is obtained from those resources.

In the light of this advice from an economist, which strategy should the university adopt? Obviously, the university administration should discard the first three of these strategies because they do not guarantee the attainment of efficiency. The best strategy will be competition because it is believed that the process of competition will ensure efficiency. Let us explain this link between competition and efficiency. Competition is a process which involves rivalry among many individuals who are struggling against each other to obtain the same scarce resource. It ensures efficiency because it forces the resources to flow to those individuals who are the most deserving or who have the ability to produce profit and utility using them. The lottery system does not guarantee that the names of students which appear on drawn slips would be of those who deserve them the most; that is who can score maximum grades and thus be good business administrators maximizing profits for their future employers. The final strategy alone, students competing against each other for the same given resource (100 admission seats) is the most likely to identify the top 100 student who would perform best in terms of examination grades among all 500 applicants in future and be the most efficient (profit maximizing) employees in the future. In other words, they will be the best utilizers of scarce university seats; that is they will produce maximum utility and profits from given resources. The competitive process will automatically weed out those not interested in or not capable of maximizing utility and profit. Efficiency is the utilization of limited resources for the maximum satisfaction of unlimited ends. This unlimited end is capital accumulation—an ever increasing but never ending expansion in the resources of a firm or a society. Never ending capital accumulation requires the maximization of profit and since profits are obtained through the satisfaction of desires, the maximization of profits is the maximization of utility in ‘pure’ capitalist society. The objective of competition in capitalist society is thus the maximization of profit and utility—the maximization of the rate of capital accumulation. Economics, as capitalism’s ideology, seeks the promotion of competition (and a particular type of competition) because non capitalist individuals and societies do not accept competitive behavior as a moral or rational response to the problem of limited resources. The famous incident of the formation of brotherhood between the Mohajireens and the Ansars after Hijrah (known as ‘Mawakhat-e-Madina’) shows that competition is neither a natural nor an inevitable response to resource limitation. Sahlins’ research—and that of many other anthropologists’—shows that co-operation is the norm in virtually all non-capitalist societies. Thus competitive individuality does not emerge spontaneously as believed by economists. Creating the emotional, intellectual and spiritual characteristics that sustain competitive individuality is a difficult task, as the IMF found out when it tried to introduce competitive markets in the post Communist Societies of East Europe during the 1990s.

To see why competition is not a natural response to the problem of limited resources, we need to appreciate the real essence of competition. First note that competition occurs among those individuals who want the same resource, not just between those who have the resource and those who want it. The possession of a particular resource by one individual will not take him away from this rivalry for more because he wants more of what both he and others posses. To take an example, suppose you have a cloth-shop at Jamia Cloth Market, where there are many other cloth-shops. As an economic man, (someone who is dominated by his self-interest and lust for more) you should assume that all other cloth-merchants in the market are your rivals, so you must try your best not only to increase the number of your own customers, but also do your maximum to snatch the customers of others. If you successfully implement this strategy, you will be able to force some other merchants to quit the market, selling their shops to you and, hence, increasing your profit. That is how the logic of competition works: success in competition is not only a function of your own strengths, but also a function of your rival’s weaknesses. A successful manager is one who is able to devise a strategy which is capable not only of increasing his company’s reputation but also of hurting his rival’s position. That is how you get control of more resources. Since other merchants will also be competing to deprive you of your resources, the strategic control of more resources under your possession requires an even more efficient strategy. But, what if the shop next to your one is that of your brother? Will you still behave in the same way? Economics says that if you are a rational individual—only an economic man is a rational individual—you will, and you must. Suppose that someone behaves as capitalist rationality requires him to do and forces his brother out of the market. How will such an individual be treated by a religious society? Clearly, he will be considered a man with bad morals. Now recall that Muslims are said to be brothers of each other according to Quran. If competing out your own brother from business for money is considered an unworthy act, how can this competition against other Muslims be justified? The justification of competition is summarized in figure 1.3 which shows that there can be more than one ways to address the issue of scarcity. The reason economists opt for ‘growth and the optimization of resource utilization’, instead of ‘reducing wants’, is based upon their presumption that it is the efficiency and growth that ought to be achieved in case of scarcity. This idea becomes further clear if we focus upon the objective function of economics. Figure 1.3: Relationship between scarcity, efficiency and competitionUnlimited wantsLimited ResourcesScarcity of ResourcesEconomic Problem(Make Choices or Allocation)(Society‘s options to deal with scarcity)Growth (permanent rise in Resources)Reducing WantsEfficiency (Improving the use of available resources)Competition(Desired strategy to be used for these ends)

Figure 1.3: Relationship between scarcity, efficiency and competition Unlimited wants Limited Resources Scarcity of Resources Economic Problem (Make Choices or Allocation) (Society‘s options to deal with scarcity) Growth (permanent rise in Resources) Reducing Wants Efficiency (Improving the use of available resources) Competition (Desired strategy to be used for these ends) The Objective Function Let us summarize what we have discussed so far. We began with a definition of economics and came to the conclusion that economics undertakes a project to explain how scarce resources of a society should be allocated so that maximum wants of its citizens could be satisfied. It is the process of competition which best solves such an allocation problem. Microeconomics is fundamentally concerned with the description of the competitive process: its functioning, consequences and legitimacy. Microeconomics commits itself to a specific end. This end is capital accumulation. Capital accumulation is ‘an end in itself’ in the sense that in capitalist society it is accumulated for the only purpose of accumulating more capital. It is on this basis that the capitalist markets value all goods and inputs (see chapters 16). Even in the case of the allocation of the time resources of a person who has few or no interactions with the financial markets ‘the law of value’ (the compulsion to maximize utility / profits) plays a determining role. The objective function of resource allocation in capitalist markets is always utility / profit maximization—utility / profit maximization as an end in itself. To clarify this idea, let us go back to the example of career choice. On what basis should you decide whether to become an engineer or a manager or an Alim? In capitalist society there is overwhelming pressure to make these choices on the basis of what you will earn, i.e., what will eventually be your ‘net worth’. In capitalist society you do what the market expects you to do and the market rewards you for obeying its commands (this idea is captured in ‘consumer equilibrium’, see chapter 7). You are free to obey the market and you cannot be free in any other way, for disobeying the market is necessarily rejecting freedom. The market is an instrument for capital accumulation and it is access to capital that can make you free (capital is the only concrete form of freedom, see chapter 2). This shows that behind the technical question of allocation of time lies the prior commitment to a particular set of (normative) objectives. Economics calls this ‘efficiency’ and defines it as the maximization of utility and profits. It is very important to note that the questions ‘what one gets utility from’ and ‘what one does with profit’ are not completely irrelevant to economic analysis. Economics is concerned with these questions because not all sources of utility and uses of profits lead to the objective of efficiency. It endorses only that particular source of utility and a particular use of profits that contributes to further accumulation of capital; i.e. ‘efficiency’. Thus using profits to support the Taliban is illegal—this is called ‘money laundering’—but using profits to bribe the Taliban to join the Karzai regime is permissible—the former is and the later is not ‘money laundering’—because this reduces resistance to global capitalist order. Mahish Yogi’s religious senances are acceptable because they contribute to capital accumulation and can be submerged within the media industry while Jihadi lectures are not prescribed because they exhort people to find “value” in Shahadat. FYI Box 1.1 gives a brief introduction to economics by summarizing the above discussions.

F Y I B O X 1.1 So What is Economics? It is an ideology of capitalism and provides instruments for governing capitalist societies It presumes that the rational individual is committed to freedom; i.e. endless capital accumulation It advocates an organization of individuality and society to facilitate maximization of utility and profit. This it calls “efficiency” and regards competition among self interested individuals as necessary means for maximizing efficiency It solves the technical problem of resource allocation on the basis of its normative conception of “efficiency”. All social acts and outcomes are accepted, rejected and valued in terms of their contribution to unending and eternal capital accumulation which is recognized as the only valid objective function of individuals and societies 1.2: How Economists Do What They Do? Economics is respected as a science. Science is conventionally defined as a ‘systematic body of knowledge that aims at discovering universal truths’. The word ‘systematic” means connecting facts in causal relationship—cause-and-effect relationship—using some appropriate methodology (to be discussed below). For a fact to qualify as a universal truth, it must fulfill two conditions: first the relevant fact should be impersonal, i.e. should be independent of ‘who’ is observing it. For example, if a ball when thrown in the air by me falls on the earth but does not fall when you throw it, then this phenomenon of ball ‘falling on the earth’ cannot be called a universal one because it depends upon who is throwing the ball. Secondly, the fact should be impartial, i.e. should be independent of the ‘place’ from where they are observed. For example, if the ball falls on the earth when thrown in Karachi but does not fall in Hyderabad, then it will not be a universal fact. In brief, a universal truth or fact is one that can be attained by any person using the same methodology. Thus, it is believed that scientific facts are independent of ‘who’ is observing them from ‘where’; rather they depend on ‘how’ he is observing them. 1.2.1: Science and Knowledge When it comes to the question of knowledge, there arise two important questions: (i) what is the source of knowledge (where and how does it come from), and (ii) what is the guarantee that knowledge obtained by that source is valid. Science claims to be the only way to obtain true knowledge. It thereby challenges the authority of all revealed religions, particularly Christianity and Islam. Science was born in the early modern period and its social dominance was made possible by the Enlightenment movement of the seventeenth and eighteenth centuries (see FYI Box 1.2). F Y I B O X 1.2 Are You Enlightened? According to Emanuel Kant, the Enlightenment movement’s leading philosopher, you are ‘enlightened’ only if you have the following beliefs: There is no ultimate authority except humanity Every human has the equal right to define good and evil as he likes to define it and to change the definition at his will

Every human can obtain knowledge through reason and through reason alone Reason is the pursuit of self-interest in a manner which does not obstruct the pursuit of self interest by all other human individuals Everyone’s self interest is realized through the maximization of freedom; i.e. maximization of the rate of capital accumulation One can have no knowledge of life after death, therefore it must be forgotten The philosophers of the Enlightenment, and especially their seventeenth century predecessors Bacon and Descartes, argued that in order to discover universal truth (which is both impersonal and impartial) it is necessary to adopt a pre-scientific stance—a position where from we put meaning and value in all that we observe. That stance is the stance of humanity. It is to begin with the beliefs that ‘man is self-determined’ (see chapter 6 for details on this topic) and this universe is nothing more than ‘a large mechanical machine’ having no objectivity. ‘Humanity’ is different from ‘mankind’ (the Christian conception of being). Humanity is committed to freedom while mankind is committed to worship. Freedom is increasing satisfaction of unlimited desires. Reason in this discourse is defined as self-interested pursuit of freedom. Bacon and Descartes (and later Locke and Kant) argued that man becomes capable of discovering true knowledge when he adopts a rational stance; i.e. when he seeks to master nature for the maximum satisfaction of his unlimited desires through pushing back ‘scarcity frontiers’ (see chapter 6 to see more on rationality). This rational stance has the implication that true knowledge must be validated with reference to experience. Knowledge which cannot be validated, for example the economist’s standard doctrine that all humans are self interested, cannot provide a premises of true knowledge (Kant called this ‘belief in reason’). Only those presumptions provide the valid premises—i.e. beliefs which are in principle non-falsifiable—for scientific knowledge which facilitate the achievement of its purpose; i.e. the mastery of nature for the maximum satisfaction of limitless desires. Thus “all men are self interested” is a valid premise because on this basis a knowledge system can be constructed for maximization of profit and utility. On the other hand the presumption “there is life after death” does not qualify as a valid scientific presumption because it disputes the rationality of capital accumulation (as an end in itself) in this life. Structure of an ‘Economic Theory’ Economists usually accept the validation theory called ‘falsificationism’ developed by Karl Popper. According to this theory a statement is scientific only if it is possible to refute it by exposing it to the test of human experience. A typical economic theory thus has the structure given in figure 1.4. The diagram also illustrates an example (you will fully grasp the essence of this example after going through chapters 3 through 8). Economic theory has following elements:

Figure 1.4: Structure of a typical economic theory and its exampleExampleHumans are self-interestedDemand falls and supply rises as price goes upDo not interfere in marketsMaximize utility & profitIf proved falseSubject to the test of experimentDemand rises and supply falls as price goes upCorrect market failuresPresuppositionsTestable HypothesisPolicy RecommendationObjectivesIf confirmedSubject to the test of experimentChange the hypothesisApply the policyOutcomeIf falsifiedChange Policy Figure 1.4: Structure of a typical economic theory and its example Example Humans are self-interested Demand falls and supply rises as price goes up Do not interfere in markets Maximize utility & profit If proved false Subject to the test of experiment Demand rises and supply falls as price goes up Correct market failures Presuppositions Testable Hypothesis Policy Recommendation Objectives If confirmed Subject to the test of experiment Change the hypothesis Apply the policy Outcome If falsified Change Policy Presupposition: that all humans are self interested—cannot be subject to the test of experience Objective: the objective of self-interested humans is the maximization of utility and profit—cannot be subjected to the test of experience Hypothesis and policies: these are based upon the presumptions and are used for the purpose of achieving the given objective—can be subjected to the test of human experience and may even be changed if required Outcome: if the hypothesis (predicted behavior) matches the data trends (actual or observed behavior), the theory is applied to achieve the given end. If it could not stand the test of data, either the hypothesis or policy recommendations are revised It should thus be clear that both the presumption and the objective are given and are never subject to the test of falsifiability through experience. The theory is a prediction derived from the presumption for the realization of the objective. Whether the prediction is true or not can then be tested by observation. For example, economics presumes that: Mr. Farooq seeks utility maximization given his income (budget constraint). This leads to the prediction that He will buy the cheapest potatoes in the market Having derived this prediction, we can then observe Farooq’s purchase behavior and validate (if Farooq buys the cheapest potatoes) or reject (if he does not) our hypothesis. If our hypothesis is rejected we can: “Rationalize” his behavior; e.g. by saying that the potatoes that Farooq buys give him more utility than the cheapest potatoes and this excess of utility outweighs the excess of cost or that Farooq does not know which thela (cart) is selling the cheapest potatoes or that Mr. Farooq is ignorant. He has been buying potatoes from the same thela (the owner of which like Farooq is a member of the Tablighi Jama’at) for the last five years and does not “test the market”. But remember that we can’t reject the presumption or the objective in case our hypothesis is falsified—we can’t conclude that ‘Mr. Farooq does not maximize utility’ or that ‘Mr. Farooq is not a self-interested human’. This is so because if we come to the conclusion that Mr. Farooq is ‘irrational’; i.e. he does not seek utility maximization through buying the cheapest potatoes, then economics will cease to exist as it provides no other basis for developing predictions about Farooq’s behavior. If the normative presumption that ‘Mr. Farooq ought to be rational (utility maximizer)’ is invalidated (through an examination of Farooq’s behavior), economic methodology becomes redundant. Economists can say nothing about how Farooq will behave, if he is not ‘rational’ (utility maximizer). This is the reason why economists either rationalize his behavior (as shown above) or condemn his behavior—i.e. disapprove of Farooq for not being ‘rational’. The economic policy, both micro (i.e. related to the functioning of ‘households’ and firms) and macro (related to the functioning of the national and global economy), is overwhelmingly focused on persuading and forcing Farooq to act ‘rationally’. It is only where Farooq is self-interested and acts ‘rationally’ that economic methodology can predict his behavior. Falsification applies to economic hypothesis derived from presumption—and not to the presumption itself. If a hypothesis (theory) cannot be tested, it cannot be falsified. Since presumptions—that all humans are rational and Farooq is a human—cannot be falsified, Popperian methodology regards them as pre-scientific. Only the (scientific) hypotheses derived from these (pre-scientific) presumptions can be validated or rejected. Pre-scientific presumptions can be neither refuted nor confirmed.

Economics as Paradigm Men have to be self-interested maximizers of profit and utility for economics methodology to become operational. If men are not utility / profit maximizers, economics cannot predict their behavior. Economics begins from presuppositions (like all other sciences) not from observation. Economics is thus a paradigm. A paradigm consists of: presumption about the behavior of individuals and groups of individuals. These presumptions reflect the “world view” of economics. This world view can be expressed as “it is natural and rational for individuals and societies to accept capitalist norms and procedures” a set of fundamental laws (most importantly the ‘laws’ of demand and supply) derived from these pre-scientific presumption provide the conceptual framework for organizing the analysis of observable data (say the development of a model showing what price formation should occur in the potato market) the application of analytical methods (essentially constrained maximization techniques) for evaluating observable data organized on the basis of the fundamental laws [say, the analysis of actual formation of potato prices and indication of the extent to which they deviate from the ‘ideal’ (‘competitive, profit utility maximizing’) prices] the derivation of policy conclusions regarding Why observations differ from predictions How can observed behavior be made to conform to predictions of the economists (suggestion of reform to increase the ‘efficiency’ of the potato market). FYI Box 1.3 summaries the tasks that economists are supposed to perform as scientists. F Y I B O X 1.3 The Tasks of Economists as Scientists Economists are supposed to: accept as natural and rational the doctrine that utility and profit maximization provides the sole basis for organizing individual and social life. develop a theoretical framework for conceptualization of production, consumption and exchange on the basis of the necessary veracity of the principle of utility / profit maximization. collect observable data on the basis of this theoretical framework and subject it to tests of constrained maximization leading to an assessment of the extent to which observed behavior conforms to theoretical predictions. suggest policies for making observed behavior conform to economic rationality (maximization of utility and profit). A particular presumption—the belief in utility / profit maximization—is the fundamental iman (faith) of the economist. The economist is conditioned / educated to accept this iman as natural and rational. Indeed the economics paradigm defines rationality and nature on the basis of this iman. If Farooq does not accept utility / profit maximization as his fundamental belief, then he is crazy, ignorant, deviant, unnatural and a freak. The purpose of the course on microeconomics is to convince you to accept that profit / utility maximization is the only natural and rational belief on the basis of which individual and social life ought to be organized. 1.2.2: Positive Vs Normative Question

It is conventional to classify science into two distinct categories, both assumed to be independent of each other. Table 1.1 shows some broad parameters on which this sharp distinction is said to be based on. Positive science is supposed to consist of the domain of knowledge or propositions which in one way or the other have to do with what is the case, or what may be expected in the future. This is said to be an area of human knowledge where scientists study the properties, and laws governing the processes of a mechanism and its consequences as objective reality; i.e. a reality free of human preferences, opinions and expectations. Positive propositions take the form of descriptive statements, statements that describe some fact as it is. “Two units of hydrogen and one of oxygen make one unit of water” is a typical example of positive propositions. Table 1.1: Differentiating between Normative and Positive Science Positive (Study of physical order) Normative (Study of people in social order) What is? What ought to be? Descriptive Prescriptive Facts Value judgments Objective Subjective Testable Weakly testable Wide agreements Significance disagreements Conversely, normative science is concerned with that part of knowledge which answers the question ‘what ought to be’ or ‘what ought not to be’ the case in a given situation. For example, the statement ‘one should not smoke’ is normative because it is not describing some given fact as it is, it’s prescribing or suggesting something as a personal opinion or judgment of an individual. Normative propositions are believed to be expressions of subjective feelings that are closed to further argumentation, whether in public or in the person’s own mind. Normative Statements are value-judgments which reveal the relative importance a person places on some given fact. Since positive propositions deal with facts, one can test them against real world data, while normative propositions cannot be tested because they miss the key element of ‘objectivity’. It is due to this impossibility of reality testing that one finds so many differences on normative questions. This dualism between ‘is’ and ‘ought’ is supposed to separate science from ethics and the objective from the subjective. The Normative Essence of Economics Let us now take up the important question whether this sharp distinction between the two areas of sciences is possible, whether scientists, especially in the area of social sciences, can work independent of norms and values. To see the relationship between positive and normative propositions in a rather non-technical way, think of the statement ‘the world should be made free of atomic bombs because they are capable of mass destruction in human lives’. This statement is actually made up of two types of statements, an ought-statement (the world should be made free of atomic bombs) and an is-statement (they are capable of mass destruction in human lives). The later statement is presented as a justification for one’s recommendation of a world free of atomic bombs. Is it a valid argument? Is it logically valid to justify an ought-statement (recommendation) with an is-statement (facts)? The answer is no, because no logical link exists between these two types of statements. No normative conclusion can be validly deduced from a set of solely positive propositions without making at least one normative proposition. We need at least one normative statement in the premises to deduce another normative conclusion. In order to see how could the fact that an atomic bomb is capable of mass destruction in human lives be used to justify that it should not be made, the structure of argument should go as:

Premise 1: Because mass destruction in human lives should not be carried out Premise 2: Atomic bombs are capable of such mass destruction Conclusion: Therefore, the world should be made free of them’ You can see that an-ought statement was used in premise 1 to support another ought-statement in the conclusion. To take an example from economics, consider the policy recommendation ‘government should reduce money supply to decrease inflation’. This recommendation is based upon a widely accepted proposition in economics that there is a positive relationship between money supply and inflation. Can this empirical fact that money supply and inflation are positively related justify this policy recommendation? Again the answer is ‘No’. The argument must contain one ought statement as follows: Premise 1: Because the welfare of humans should be increased Premise 2: and inflation causes this welfare to decrease Conclusion: Therefore it should be reduced by decreasing money supply Given this relationship, now a further question arises: ‘what is the justification for increasing the welfare of human beings?’ To defend this ought-proposition (that welfare should be increased) you would advance another ought-statement as its justification. But you can sense that this will involve an infinite regress because in order to defend an ought-statement, another one of the same type will be required. And this goes on until you reach an ought-statement for which you have no justification but accept it as a belief, a metaphysically given truth. It is this set of belief (presupposition) which forms the basis of positive economic analysis. All positive research in social sciences is undertaken within a presumed framework of normative beliefs. This relationship becomes evident when we consider the fact that all social sciences address the question ‘how should society be organized, irrespective of revealed knowledge’. Social scientists study the ‘laws’ governing the behavior of individuals and social institutions of a society that prioritizes maximization of freedom as its ultimate objective. It is due to this anti-religious character of all social sciences that the question ‘whether an individual will go to hell or heaven (the most important question for a religious individual and society) as a result of living in a particular way’ is assumed away by social scientists while conceptualizing the problem of ‘how should society be organized?’. The question whether society should be organized for the maximization of freedom (capital accumulation) or for the service of God is not addressed at all because maximization of freedom (capital accumulation) is believed to be a self-evident metaphysical truth, a truth that is unchallengeable and closed to all further arguments. The fact that economics presupposes maximization of freedom (utility / profit / capital accumulation) as its ultimate end in itself disqualifies it to be a positive science once and for all. This normative character of economics is evident from its justification of scarcity, utility maximization and competitive individualism as the fabric of society. Similarly, when we rely on an economist to tell us how allocation decisions should be made to achieve efficiency, we ask him a normative question. The positive analysis of how to achieve efficient-resource-allocation-process presumes the normative concepts of scarcity and efficiency (freedom / utility maximization). Thus, it is not possible for an economist to maintain that he is merely studying the techniques of adapting limited means to multiple ends without taking account of the source and justifications of these ends in the first place. It is the problem of allocating scarce resources among competing ends that is advanced as the central problem of economics. However, the objective function (maximization of freedom, utility, profit the rate of capital accumulation) is taken as given. This objective is of course an objective set by Enlightenment philosophy. Economics does not justify its systemic objectives but suggests solutions for the problem of allocating scarce resources among unlimited wants so as to satisfy maximum human desires, irrespective of the justification of this social objective itself.

1.3: ‘What is Economics For?’: The Agenda of Capitalism The previous section has shown that economics, like all sciences, is necessarily normative. Its positive investigative methodology is based on normative (un-proven and un-provable) presuppositions formulated by the Enlightenment philosophers (especially Locke, Smith, Hume, Kant and Say). Economics seeks to re-mould individual and social behavior so that the ideals of the Enlightenment philosophers are realized. So a fundamental question arises at this stage: what economics can and cannot do? In other words, what is its scope? Remember that economics: cannot answer the question why scarcity should be presumed cannot answer the question why maximization of utility / profit / capital accumulation (efficiency) should be the objective for the organization of individual and social life can answer the question what should be done to ensure maximization of profit, utility and capital accumulation can answer the question what should not be done if we want utility, profit and the rate of capital accumulation to be maximized Thus economics is necessarily a normative and prescriptive discipline. It justifies and seeks to provide resources for the emergence and functioning of a particular: Individuality Rationality / knowledge system Society State, and World order The purpose of all these should be the maximization of utility, profit and the rate of capital accumulation. Economics says that the individual should be self-interested. The knowledge system should show him how he can pursue his self-interest at least cost to himself and to the society. Society should function as a market, enabling firms and consumers to contract freely based on their self-interest. States should guarantee contract, manage money markets and provide support for correcting ‘market failures’. The global order should facilitate free trade and investment flows across national frontiers and regulate international relations to ensure the maximization of global utility / profit. This idealized economic vision of individual, society and state is summarized in Figure 1.5. This diagram shows the theoretical model that economics is meant to explain and justify. One cannot properly understand economic theory by abstracting from its specific purpose—it is a tool for providing justification for the above social order. Figure 1.5: Economics advocates this Capitalist Way of LifeIndividual Maximizes Utility Society that is a sum total of exchange relationshipsA democratic government which should provide only an economic framework for efficient transactionsLeads to a model ofThis justifies Figure 1.5: Economics advocates this Capitalist Way of Life Individual Maximizes Utility Society that is a sum total of exchange relationships A democratic government which should provide only an economic framework for efficient transactions Leads to a model of This justifies Economics and Politics: Link between Theory and Practice Today we see politicians and bureaucrats in most part handing over the world to economists to make it a better place to live in—a world with ever increasing possibilities of capital accumulation. This subjugation of countries’ fate in the hands of economists is not because economists have won some public election, rather it is due to the belief that economic theory is sound and considers a big picture in understanding how the objective of capital accumulation can be carried out most effectively. It is believed that economists know how capitalist societies work and how they can be made to work even better. Thus:

when government opposes minimum wage laws, it is because economics says that such laws increase unemployment debates on reducing or eliminating tariffs on imported items are raised because economics says that free trade provides more opportunities for utility / profit maximization when government goes for privatization policy, it is because economics says that free private ownership of resources is more efficient Economists believe that changes, such as the above ones, in existing social set-up will make this world a better place because these changes will make the real world look more like their hypothetical world of figure 1.5—a world order based on Enlightenment ideals which it seeks to endorse. Figure 1.6 shows the formal relationship between social theory and practice. The objective of theory in social sciences is to provide (1) an idealized conception of society that ought to be achieved, such as the one described in figure 1.5, and (2) policy recommendations that are helpful in achieving this preferred world order. Since the actually existing societies are never in accordance with the preferred one, the policy recommendations derived from a particular theory are applied to actual societies in order to transform them to the desired one. Hence we can identify two domains in this diagram: Domain of theory: is concerned with the derivation of desired social order and policies (movement represented by solid arrows towards boxes 1 and 2) Domain of practice: is concerned with the application of policies for transformation of actual societies into the desired one (movement represented by the dashed arrows) Figure 1.6: Relationship between theory and practice in social sciencesSocial Science Theory(2)Policies(1)Desired picture of societyActual SocietiesJustifiesJustifiesApplied onTransformation Figure 1.6: Relationship between theory and practice in social sciences Social Science Theory (2) Policies (1) Desired picture of society Actual Societies Justifies Justifies Applied on Transformation The relationship thus shows that economics cannot be studied in isolation from politics, both are linked with each other like mind-body relation—the body (politics) obeys the commands passed on by mind (economics). This should once again confirms that economics (and in fact all social theory project) is essentially a moral, and not a positive, science. It is obvious that the way of life which economics seeks to rationalize is the capitalist way of life. It is capitalist individuality, capitalist society and capitalist state organization which economics regards as natural and rational. It develops theories to illustrate what pure and perfect capitalist individuality, society and state looks like. It measures actually existing individual behavior, social organization and state policies on a scale on which 100 percent marks are given to the behavior patterns, institutional structures and state policies which conform fully to capitalist ideals. Economics suggests strategies for enabling individuals, societies and states to achieve capitalist ideals.

Economics is therefore very useful both for justifying capitalist behavior and organization at the micro and macro level and for managing capitalist households, firms, markets and governments. There are many schools (or sects) of economic thought—classical, neoclassical, Keynesian, post-Keynesian, Marxist, institutionalist, behavioralist, new classical, new Keynesian etc (for their introduction, see the last chapter of this book). Among them the most useful school in terms of its ability to justify capitalist behavior and organization and in terms of its ability to produce a portfolio of policies for managing capitalist individualities, markets and government is the neoclassical school which emerged in the 1870s and which continues to dominate the economics profession today. In this book, we will focus and concentrate on neoclassical economic analysis and attempt to assess its usefulness both for justifying and managing capitalism. 1.4: Micro-Macro Distinction We have defined microeconomics as the study of competitive behavior and in this sense the founding father of economics Adam Smith was a microeconomist as he was profoundly concerned with the analysis of competitive behavior. The title of his famous book however is An Enquiry into the Nature and Causes of the Wealth of Nation and the analysis in this book concentrated on aggregates—especially on the behavior of classes. Smith’s political theory was more clearly focused on individual behavior but this is contained in his Lectures on Jurisprudence—a book economists never happen to read. Smith’s theory of value was also class based and largely ignored the role of the individual producer and consumer in the determination of price (see chapter 2). This emphasis on aggregates (especially class) was maintained by all major classical economists—Ricardo, Malthus, Marx, J.S. Mill—and microeconomics proper was born as a consequence of the ‘marginalist revolution’ of the 1870s. The crucial move in this respect was the abandonment of the labor theory of value and its replacement by utility theory of value. This allowed the neo classical economists to abandon the notion of class and to focus attention on the individual consumer and producer as market participants. Understanding the theory of value is therefore crucial for understanding microeconomics. We will discuss this theory briefly in chapter 2 and in detail in chapters 15 and 16 which also seeks to show you why textbooks such as Lipsey, Mc-Connell and Samuelson rarely mention value despite the crucial importance of this concept in the economic paradigm. Microeconomics analyzes the (competitive) behavior of individual units—households and firms—while macroeconomics is concerned with an analysis of the aggregates of these units, most importantly the national economy. But as capitalism has developed, this distinction between units and aggregates has become obscure. More than 60 percent of all babies born in Denmark in 2004 were bastards and adultery has become a universal practice throughout Europe and America. Does it make any sense to speak of ‘households’ as consuming units in these circumstances? What is the meaning of ‘consumer sovereignty’ when consumer preferences are routinely over determined by the trillion dollar advertising, promotion and media industries in America. What sense is there in treating Pfizer as an economic unit (a firm) and the Congo as an aggregate (a national economy) when Pfizer’s annual sales exceed Congo’s GDP by about 30,000 percent. Does Pfizer have no “fiscal policy” despite its extensive transfer pricing? Whose management of money supply and credit has greater impact on world interest rates, the State Bank of Pakistan, a Chase Manhattan, Halliburton and Mercedes not waging war in Iraq and Afghanistan?

The last chapter of this book will try to show that macroeconomics has collapsed into microeconomics. Capitalism creates a single, unique individuality expressed in the form of the human person, the corporation, civil society and republic government (capitalism is a ruthless, relentless totaliser). It allows nothing to stop the process of eternal profit-maximization, neither the human person, nor social institutions and nor the processes and procedures of government. Modern macroeconomics has microeconomic roots. The objective function of capitalist units (households and firms) and capitalist aggregates of these units (governments) is the same. They both seek the maximization of utility / profit. When we study microeconomics we study the general principles on the basis of which value is determined within capitalist order. Value is the organizing principle of capitalist order. Let us now turn to a brief introduction of capitalism and the analysis of value. Key Concepts Competition is a process which involves rivalry among multiple individuals who are struggling against each other to obtain the same scarce resource Dynamic efficiency is to achieve the most from given scarce initial resources over time to maintain permanent pressure of scarcity. It also refers to the generation of new resources through innovation Economic (wo)man is an abstract rational economic agent whose self is subordinated to his (her) infinite desires Efficiency means producing maximum output from given inputs or resources Hypothesis is a proposition which affirms or denies some fact Microeconomics a branch of economics concerned with the description of competitive process: its functioning, consequences and legitimacy. It also provides a theoretical foundation for legitimizing the motive of self-interest as the corner stone of society Opportunity cost of a particular choice is the satisfaction that would have been derived from the next best alternative foregone; in other words, it is the value of forgone activities in making a certain choice or decision Paradigm refers to some metaphysical beliefs regarding the behaviour of subject which form the conceptual framework (hard core) of any scientific discipline through which the world is viewed. It also involves some standard experimental and theoretical techniques to apply the fundamental laws to a variety of situations in order to match paradigm with nature Resource is anything that can satisfy a human want Scarcity is a subjective phenomenon which refers to the degree by which people’s desire for something exceeds its availability Self-interest is the essence of rationality of an economic man. It is the ability of an economic man to rank his preferences as per his personal desires Social sciences work out the laws governing the behavior of individuals and social institutions of a society that prioritizes maximization of freedom as its ultimate objective Static efficiency is getting the most in terms of human satisfaction from given resources (also called Pareto efficiency)

Chapter Summary Economics answers the question: how scarce resources can be allocated efficiently. Economics is thus absent in all societies where wants do not exceed available resources Scarcity is a subjective—not an objective—phenomenon. It depends on people’s wants and desires. If wants are unlimited resources must always be infinitely scarce Scarcity can be abolished only through the limitation of wants and in no other way Capitalist individuality is necessary for the existence of scarcity Only capitalist individuality experiences scarcity because it forgets death and the afterlife and seeks maximum satisfaction of unlimited wants in this life through continuing capital accumulation Scarcity implies choice among alternative options for satisfying unlimited wants. The exercise of choice necessarily involves costs (the giving up of the satisfaction of one desire for the satisfaction of another). Hence the exercise of choice involves the allocation of resources among alternative uses Economists argue that resources should be so allocated that utility and profits are maximized. Efficiency is defined as producing maximum utility and profit from given resources Competition is the method used for identifying policies for maximizing efficiency (i.e. profits and utility). Through the competition process those not interested in and / or not capable of maximizing utility and profit can be weeded out Competitive behavior is not sanctioned by societies which reject economic rationality—i.e. the individual’s unqualified commitment to self-interested utility / profit maximization The scope of microeconomics is the description of the process of competition among individuals and firms. It analyses and legitimizes competitive behavior and evaluates the consequences of competitive organization of markets Competition commits the microeconomic agent to economic rationality; hence all market participants have the same objective function—the maximization of utility / profit as an end in itself If continuing utility / profit maximization is an end in itself then only those conceptions of utility and those uses of profits can be regarded as valuable by economics which can contribute to continuing utility / profit maximization Economics—like all other sciences—assumes that knowledge can be obtained only by seeking the mastery over nature for the satisfaction of unlimited desires through the pushing back of scarcity frontier. Such “true knowledge must be validated by experience” However presumptions such as “all men are self interested” cannot be subjected to the test of experience—we can only test whether one man or a group of men are self-interested. Such presumptions are however necessary for developing testable (falsifiable) hypotheses. Such presumptions provide the (non falsifiable) premises of testable hypotheses. Only those premises provide valid presumptions which enable human to achieve the purpose for which such “knowledge” is being acquired—i.e. mastery over nature for the maximum satisfaction of unlimited wants

Testable / falsifiable hypotheses can be derived from valid premises. Only hypotheses and policies generated by them can be validated by experience. Neither premises (all men are self interested) nor objectives (maximize profits / utility) can be subjected to the test of human experience. The theory is thus a prediction derived from the (non falsifiable) premises for the achievement of a (non falsifiable) objective Economic theory applies only when agents—individuals and societies—behave in accordance with its valid premises and seek to achieve its objectives. The behavior of unselfish men and societies not concerned with profit / utility maximization cannot be explained by economics Economics is a paradigm. It begins from presumptions not from observation. These presumptions reflect the world view of economics. General laws predicting human behavior (the “laws” of supply and demand) are derived from these presumptions. These “laws” provide a conceptual framework for the collection and organization of data which can then be subjected to the tests of experiences. Finally policies are developed for changing individual and social behavior so that it confirms to the economics world view as reflected in its presumptions Economics is essentially normative because its positive statements are necessarily derived from and justified by its normative (unfalsifiable) presuppositions. The positive content of economic analysis is thus subordinated to its unjustified commitment to utility / profit maximization as the only end in itself of both individuals and societies. Scarcity and efficiency are both essentially normative concepts implying an unjustified commitment to capital accumulation as the only end in itself Economics advocates that individual life, knowledge systems, societies, government and world order should all be dedicated to the maximization of utility, profit and the rate of capital accumulation The way of life which organizes individual life, societies, governments and world order to maximize utility, profit and capital accumulation is capitalism. Economics therefore justifies capitalism and provides instruments for governing capitalist individuals, societies, states and capitalist global order Economics justifies capitalism by justifying and enabling (a) Self-interested individuality (b) competitive markets (c) market friendly states (d) a uni-polar world order. Economics regards capitalist order as natural and rational Fig 1.5 and 1.6 show that policies derived from a particular conception of ideal capitalist individuality, society and government are used to create and sustain behavior patterns which correspond to the capitalist ideals of economic theory. The economic paradigm generates policies which are implemented to transform individuals and societies into ideal capitalist individuals and ideal capitalist societies Economics regards capitalist individually, society and government as natural and rational. Every other type of individuality, society and state is regarded as un-natural and irrational. Economics measures individual and social behavior on the basis of its conception of natural and rational behavior and economic policies are instruments for transforming existing non-capitalist individuality and society into capitalist individuality and society

Review Questions Evaluate Robbin’s definition of economics. Is it really universal? Why was there no economics before the eighteenth century? How can scarcity be abolished? “Only capitalist societies experience scarcity”. Do you agree? What is capitalist individuality? “Scarcity necessarily implies choice”. Why? What is opportunity cost? Why is the resource allocation problem not faced with respect to the use of air? “The economic problem is not allocation, it is the efficient allocation” Discuss. Define efficiency. How is it measured? What is the relationship of competition to efficiency and what is competitive individuality? Is competitive behavior acceptable in non capitalist societies? If not why? What is the scope of microeconomics? What is the objective function of all microeconomics agents? How must utility be defined and what must be done with profits given the commitment to never ending utility / profit maximization as an end in itself. Distinguish “humanity” from “mankind”. Which premises are valid and which are not valid premises for the construction of testable scientific hypothesis. Give examples of both of these. Describe “falsification” theory Describe the structure of a typical economic theory Why can economic theory not explain the behavior of “irrational” men and societies? What is economic rationality? “Economics is a paradigm”. Explain. What is the fundamental iman of the economist? Distinguish positive and normative sciences. “Economics is essentially a normative science. It’s positive analysis is necessarily based on a particular set of norms”. Do you agree? How can you show that “All social sciences reject revealed knowledge”? “Scarcity and efficiency are normative concepts”. Discuss. What can’t economics do? And what can it do? “Economic theory is not produced from the real world; the real world is shaped by economic theory”. Discuss. What is the role of economists? “The distinction between microeconomics and macroeconomics has become obsolete”. Briefly explain. Chapter 2 INTRODUCTION TO CAPITALISM AND THEORY OF VALUE A proper understanding of economic theory requires knowledge of the capitalist system as a whole. Students of economics must understand the norms and values under which a capitalist system functions, its regulatory processes and its transaction structures. Without a clear understanding of what capitalist societies are, how capitalist governments govern, and how capitalist markets function economic practitioners are ill prepared to understand the social and economic context within which economic theory is to function. They cannot appreciate what is constant and what is variable in capitalist order. They cannot correctly interpret changes in regulatory regimes and in the ‘rules of the game’. Further, they cannot understand the inherent (insurmountable) limits of the capitalist organization of economy, society and state. It seems appropriate therefore to begin this book with a description of the central features of a capitalist economy in section one. We will then briefly try to outline the theory of value and show how each theory of value is associated with a distinct school of thought in economics. This will also show to the students that economics as an academic discipline is specific to capitalism and despite their internal analytical conflicts; all economic schools of thought are primordially occupied with understanding the nature of capitalist life world and making it possible.

2.1: The Capitalist System Capitalism as a system emerged in the fourteenth or fifteenth century in Italian City states of Naples, Venice and Florence. By the end of the twentieth century, it was prevalent in Britain, America, France, Germany and Japan. By the end of twentieth century, many scholars were arguing that capitalism had become global, while others expressed the view that we were already in a post-global age. It is important to note that capitalism’s growth from city-state to national and global dominance has been continuously resisted. The most famous and effective resistance so far has been mounted by the communist regimes of the USSR and China which tried to replace market capitalism by state capitalism. The Islamic governments of Afghanistan, Chechnya, Iran and Sudan have also sought to distance themselves from capitalist norms, values and practices. 2.1.1: Capitalist Norms and Values It is these norms and values which distinguish capitalism generically from other systems. The key capitalist value is freedom; that is why capitalism is often described as a free society. The individual in capitalist society is committed to freedom. Freedom is self-determination; the right to do what one pleases, as long as this does not interfere with the right of other members of society to do as they please. Capitalism claims to recognize no criteria for evaluating the worth of personal choices. He who chooses to run a madrassah is entitled to the same right and respect as he who chooses to manage a bar. The only unworthy act is to restrict the freedom of the individual. Capitalism recognizes the shortage of material resources as the most important constraint on freedom. Society must be organized to maximize the potential for producing and consuming goods. An increase in goods and services is a pre-requisite for increasing freedom. A person’s ability to do whatever he wants in capitalist society is ultimately defined and limited by the size of his income and wealth (i.e. the relative exchange value of physical and financial assets he possesses). Therefore two very important values promoted by capitalism are acquisitiveness (greed or avarice) and competition (envy or covetousness). Everyone must be induced to desire more and more resources. Everyone in capitalist society possesses this insatiable desire for more resources hence they must compete against each other and derive pleasure from competition. Acquisitiveness and competition are necessary means for a continuous increase in resources. This continuous increase in resources available for production and consumption becomes an end in itself in capitalist society. A capitalist society accumulates and evaluates all activities in terms of their contribution to accumulation. The fact that valuation typically takes place in financial markets illustrates the crucially important role that finance plays in the capital accumulation process. There is of course nothing natural or inevitable about regarding acquisitiveness and competition as individual and social norms. Avarice and covetousness were sins in Christianity and the Christian social system sought to promote the virtues of poverty and charity. For over a thousand years, the European economy was embedded in social practices which sought to promote these Christian values. As Weber and Tawney have shown it was the rejection of these values which led to the emergence of capitalism. This implies that a rejection of the values of acquisitiveness and competition would lead to the down fall of capitalism.

2.1.2: Capitalist Regulation This shows that contrary to the claims of neo and new classical economists, e.g. Hayek, capitalism has a history. Capitalist markets invariably emerge from non-capitalist social formations. This is true even of the United States where, for example Jaynes has documented the legislative acts and policy measures adopted to create a labor market after the abolition of slavery in the decades after the Civil War. The US government after 1865 enforced a legal political system that effectively dis-enfranchised the blacks, reduced their economic power and shaped the labor market. There was little ‘spontaneity’ in the development of capital labor relations in the American South in the second half of the nineteenth century. In the twenty-first century legislative and policy-making measures adopted by the World Trade Organization (WTO) are similarly constructing technology markets by universalizing the US patent system. Once again there is nothing spontaneous, automatic or natural about the processes of legitimization which reduce the access of developing countries to the new technologies. Capitalist markets and capitalist property forms are historical constructions in the specific sense that laws and practices are required for their emergence and their sustenance. Outcomes, of course, need not have been as intended but a certain easily definable ethos (objectives) motivated the actions which led to the development of capitalist property. Historically constructed markets cannot be viewed as natural outcomes of myriad unrelated events or attributed to the natural evolution of technology. This illustrates the fact that capitalism requires regulation. The politically legitimized source of this regulation has traditionally been the liberal and / or nationalist state and its agencies. But firms, labor unions and multilateral agencies such as the IMF and the WTO also undertake regulation. Regulatory systems have their origin in national and local history. The form and intensity of regulation continue to change over time. This brings us to the important point that capitalism exists in several national versions. The history and customs prevalent in a country determine both the pattern of capitalist regulation and the structuring of capitalist transactions. Reading an American textbook to understand economic management in Pakistan misguides local students. The American textbook presumes that American history, and regulatory and transaction structures that are based upon it are universal and therefore rational. This is an absurd assumption, for Pakistan is not America and Pakistani capitalism is not just an underdeveloped form of American capitalism. It is capitalism nevertheless and therefore it is quite legitimate to speak of certain generic similarities between Pakistani and American capitalism. Regulations in both Pakistan and America must first of all involve the legitimation (both moral as well as legal) of capitalist property—i.e. corporatations. The control of this property is in the hands of technically skilled managerial elite (who are not the formal owners of the assets they manage). The enforcement of capitalist contracts is premised upon the formal equality and the factual inequality of contractees etc. It is the duty of every capitalist state, American, Pakistani, Saudi Arabian, to preserve these essential elements of the capitalist system. Each state has to define the scope of capitalist property, the balance of powers between capital owners and managers, the legal form of capitalist contracts etc. on the basis of its own history and traditions.

It is thus useful to speak of a mode of regulation: which is a set of mediations in a (capitalist) civil society. Specifically these mediations must ensure: Systemic dominance of the desire to accumulate through the promotion of the values of acquisitiveness and competition Continued expectation of increased access to resources for accumulation (consumer / investor confidence) Ensuring of compatibility between claims and obligations for continuing accumulation. Ensuring these requires the regulator to persuade everyone to prefer accumulation, sustain consumer / investor confidence in order to develop efficiency in markets and avoid or mitigate capitalist crisis. Firms and banks play an important part in the regulatory process. They persuade the public to participate as efficient contributors to accumulation. They structure rules of payment and flows of goods and financial relationships. They create a hierarchy relating stake holders with claims on and obligations to the collectively produced added values. These structures (laws, rules, ordering of rights and duties in enterprises and in markets) require political legitimation; something the state alone can provide on the basis of a socially dominant ideology (liberalism and / or nationalism and / or social democracy). The political nature of this mediation process is a reflection of the underlying tension between capitalism’s need to accumulate and its need to legitimize accumulation. The Role of Economic Theory Economics is an off-shoot of what is today called ‘Social Theory’ developed in order to rationalize and conceptualize the capitalist way of life. The capitalist way of life emerged out of the Enlightenment movement which sought to promote new standards of morality—standards that originated from the ideal of freedom. The Enlightenment scholars were pre-occupied with the justification of newly developing (capitalist) social structures in Europe during the eighteenth century. These thinkers pretended to model their thoughts on the then prevailing empiricist methodology of physics. They deceived themselves into the opinion that moral laws and natural human sentiments could be discovered merely by employing empirical research methods. According to them, objective social patterns emerge unintendedly from the rational (i.e. freedom oriented) behavior of individuals. Adam Smith was one of the leading exponents of this idea as presented in his ‘invisible hand’ doctrine. Smith converted the principle of ‘unintended consequence’ into an analytical tool by showing that the market economy is a self-regulating mechanism—a mechanism that is beyond the control of the individual actors. This Smithian project of justifying and sustaining capitalist order has remained the sole objective of all economic schools of thought that we introduce in this chapter and in the last one. Economic theory cannot be appreciated properly by abstracting it from its true historical background and its role in harnessing capitalism. The next section will show how the development of economic theory is generically related to the development of capitalism.

2.2: Theories of Capitalism and Value Most microeconomics textbooks do not include a separate chapter on value. Macroeconomics textbooks never mention ‘value’ at all. This might seem strange, for determining the worth (value) of a good or an act is surely the main function that economic theory performs. Figure 2.1: The Skelton of Economic disciplineAdam Smith (1776)Labor commanded theory of valueEmbodied labor theory of valueRicardo (1817)Abstract Labor Theory of Value (1848)Cost of production Theory of Value (1960)Marginalist / Utility Theory of Value (1874) Figure 2.1: The Skelton of Economic discipline Adam Smith (1776) Labor commanded theory of value Embodied labor theory of value Ricardo (1817) Abstract Labor Theory of Value (1848) Cost of production Theory of Value (1960) Marginalist / Utility Theory of Value (1874) a But understanding the concept of ‘value’ gives us an invaluable insight, on the one hand, into the nature and functions of economics both as a science and as a social practice and, on the other hand, into the nature of disagreement among economists. We will see that underneath the apparently conflicting schools of thought in economics is their disagreement on what determines the ‘value’ of an activity. We begin this section by seeking to develop a working definition of ‘value’ in section 1. The skeleton of the remaining chapter is summarized in figure 2.1. We will make some adjustments and comments on this diagram after completing our discussions from sections 2 through 6. The final section provides reasons for concentrating on neoclassical theories in the analysis of consumption, production, distribution and the theory of economic policy in the rest of the book. 2.2.1: What is Value? In chapter 1 we had tried to show that it is nonsensical to make a distinction between ‘normative’ and ‘positive’ economics. Take a standard text book—say Mc Connell and Brue’s Economics now in its seventeenth edition. It’s glossary says that: “normative economics (is) focused on which goals and policies should be implemented.” Positive economics on the other hand is “the analysis of facts and data to establish scientific generalizations about economic behavior” In order to see to what degree this distinction is meaningful consider Abdullah Zhaghzai—an orthodox and practicing Muslim. Abdullah is a shepherd living in the mountains 15 miles north of Pirbaba, a small town in our Sarhad (recently named Khyber Pukhtoonkhwah) province. Suppose Khyber Bank decides to lower its loan interest rate. What “scientific generalization” can we draw about Abdullah’s behavior? Don’t you think that the ‘observed generalizations’ or ‘behavior patterns’ depend on the “goals and policies (Abdullah thinks) should be implemented”? If Abdullah’s goal is to maximize profits he may rush to Khyber Bank’s branch in Pirbaba to take out a loan. If, on the other hand, Abdullah is a Taliban supporter he may plant a bomb in the Khyber Bank branch to frustrate its attempt to expand interest-based business in his local town.

The point is that “scientific generalizations” about “economic behavior” without reference to norms—norms both of the observer (the economist) and the observed (Abdullah Zhaghazai)—are not possible. These normative assumptions underlying “the analysis of facts to yield generalization about behavior” (i.e “positive economics”) are concealed in a specific conception of ‘economic rationality’. According to economics, Abdullah acts ‘rationally’ when he borrows from Khyber bank in response to a fall in the loan interest rate but ‘irrationally’ when he tries to blow it up. Economics cannot analyze such ‘irrational’ behavior. Thus a conception of how Abdullah ought to behave necessarily underlies the economic analysis of his observed behavior. Economists therefore seek to unearth the ‘rational’ basis of ‘irrational’ behavior—they would claim that may be the risk involved in blowing up the Khyber bank branch is negligible and Mulla Omar is paying Abdullah much more than any gain he could make by borrowing at the reduced interest rate. If so Abdullah is acting ‘rationally’ for by blowing up Khyber Bank he is maximizing his income / profit / welfare. Thus the basic presumption is that for Abdullah value resides in income / profit / welfare. What the rational individual values above all is, what Adam Smith and David Hume called, “wealth”. The origins of economics lie in the Scottish Enlightenment (an intellectual movement which achieved its greatest influence in the late eighteenth and early nineteenth century) and the distinguishing feature of this school of thought was its replacement of virtue by welfare as the purpose of both individual and social existence. Christianity of course did not recognize value (intrinsic worth) in wealth, indeed a historically strongly entrenched Christian tradition identified wealth (and specially its accumulation) with evil. For orthodox Christians value resided in acts earning God’s favor and in the leading of a virtuous life. It is a significant fact that the Middle Age and early modern period Christian theologians never identified value with price. Value resided not in the market but in the life of the monastery and the Church. Both David Hume and Adam Smith were passionate opponents of the Christian way of life. Adam Smith (1723-1790) was a horrible man who beat his wife black and blue because she attended matins (a Christian prayer offered at the time of our tahajjud). Smith and Hume argued that seeking virtue led to wars of religion and turmoil. Men should seek not virtue but wealth, maximize pleasure, minimize pain and a life spent in the continuous and harmonious pursuit of wealth and pleasure was the only valuable life. Both Smith and Hume defined rationality as the pursuit of material self interest and argued that ‘the law of nature’ compelled / conditioned men to organize their life on the basis of the principle of net pleasure maximization. Value lay in wealth and in wealth alone. The greater the wealth an individual or a society possessed the greater its value. Virtues were simply instruments enabling everyone in society to harmoniously pursue his material interest. The market was not subordinate to religion or to the political sphere which articulated a transcendental principle of value. Value emerged in the market through capitalist contracts and through them alone. As Smith emphasizes in his famous book The Theory of Moral Sentiments, the moral order must be strictly subordinated to the market whose reproduction it makes possible. The market grants people the experience of not being directly governed by representatives of either God or kings. These thinkers saw the extension of markets into increasing areas of life as revolutionary, liberating humanity from traditional value systems.

Increasing value is thus synonymous with increasing the wealth of nations, through the mutually sustaining processes of expansion of the division of labor on the one hand and of the market on the other. Value therefore resides in the commodities—and the components of the commodities—exchanged in the market. The analysis of the components of the price of a commodity thus became central to the determination of value. 2.2.2: Smith: Labor Commanded or Labor Input Theory of Value? Smith’s analysis of the components of prices of a commodity is notoriously ambiguous. At points Smith seems to be arguing that profits and rent are deductions from the product of labor which alone bestows value on the commodity exchanged in the market. At other points (both in The Wealth of Nations and obliquely in the Lectures on Jurisprudence) he seems to be arguing that profit and rent do not constitute such deductions from the product of labor but represent the contribution made by capital and land to the value of the commodity. In this perception profits, rent and wages were the components of the value of a commodity. The consensus reported in the economics profession is that Smith abandoned the theory which says that labor is the only component of the value of a commodity—the theory which is often known as the embodied labor theory of value—and adopted the view that labor commanded is the most convenient measure of value. According to labor theory of value, the value of a commodity is equal to the direct labor time needed to make a commodity. For example, if it takes 2 labor hours to produce 1kg wheat and 4 labor hours to produce 1 kg sugar, then it means that 1kg sugar will be equal to 2kg wheat in exchange. In contrast, labor commanded theory of value says that the exchange value of a commodity is determined by the amount of labor time that could be purchased by selling a commodity. For instance, if by selling 1kg sugar I can purchase 2 labor hours (i.e. I can hire a labor for two hours) in the market, and by selling 1kg wheat can purchase 1 labor hour, this means that the rate of exchange between sugar and wheat will equal 1kg sugar = 2kg wheat. If it is the case that the value of a commodity is not the number of labor hours spent in its production but the number of labor hours that could be commanded (obtained) by its price, then it means that profit (capital) and rent (land) also contributes to the value of a commodity. According to this notion, the value or price of a commodity is given by the sum of profits, rent and wages: price = wages + profit + rent where profits and rents are not the the deductions from wages but independent value-adding factors. Clearly, the price of the commodity would exceed the value of labor hours consumed in its production (i.e. wages) by the amount of value contributed by capital and land to the value of the commodity (i.e. the sum of profits and rents). Labor time component thus serves as an accounting devise in Smith’s system and is only one component of its value.

Smith’s conception of the determinants of value (‘real price’) allows him to show that accumulation and expansion of the division of labor and of the market is in most people’s interest. He tries to show how price mechanism guides individuals to allocate resources to the greatest social benefit. He distinguishes between two types of prices: natural price and market price. ‘The natural price is the central price to which the prices of all commodities are continually gravitating’ due to the dynamic forces of demand and supply. But Smith was less concerned in showing how prices are fixed than in answering his critics who claimed that markets left free to generate their own produced prices were unstable and therefore allocate resources arbitrarily. Smith is one of the earliest theorists of capitalist society. He sees it as comprising of three great classes; “owners of stock”—i.e. capitalists—landowners and wage earners. There is no conflict between individual aspiration and class affiliation. Everyone gains from the continuous accumulation of “stock” (capital) but Smith does not have a coherent theory of history. He cannot tell us why society’s division in the three great classes, each seeking to maximize its material interest is justified. He has no social account of the formation of wages, rent and profit. He has to fall back upon the “law of nature” to validate rent, profit and wages. Wages are “naturally” determined by subsistence requirements, rent by the productivity of land and profit by the productivity of labor set in motion by “stock”. The ultimate justification of Smith’s conception of value and of capitalist society is that these conceptions of value and of capitalist society accord with nature. Capitalism, according to Smith, is the “Order of Nature”. The explanation of profit and rent within a labor commanded theory of value had to wait around 100 years for the development of marginalist or neoclassical theory of value. But we will come back to this theory of value after discussing Ricardo and Marx—so that the chronological order of theoretical development is maintained. 2.2.3: From Smith to Ricardo: The Embodied Labor Theory of Value David Ricardo (1772-1823), the immediate follower of Smith, was worried by Smith’s inadequate justification of capitalism as a natural order; especially the inadequacy of Smith’s explanation of the determination of value and of the formation of rent, profit and wages. Ricardo returned to the labor embodied theory of value accordion to which the value of a commodity corresponds to the amount of labor time taken to produce it. Smith was puzzled by the implication of labor theory of value that labor did not receive the full product of his work. Ricardo argued that a consistent labor input theory of value was possible and it is in this sense that he was developing one half of Smith’s contradictory theory of value. In his formulation of labor input theory of value, he included both direct as well as indirect labor. The former refers to the labor employed for a specific time and paid a wage while the later is the raw materials and tools also produced by labor time in the past. He dismissed the labor commanded (or utility) theory of value by asserting that in industrial society, most of the commodities are reproducible—i.e. they are produced again and again by labor. Therefore, the relative scarcity and value of most commodities is not some accidental phenomenon, rather produced by labor input. For Ricardo the distinction between the use value of a commodity in consumption and its value in production was an important one. He was primarily concerned with the distribution of income between rent, profits and wages and the effects of changes in size of population and, to him, the above distinction provided the basis for explaining the distribution between wages, profit and rent.

Ricardo on Wages Wages, rent and profit in the Ricardian system could be seen as proportionate shares of a fixed sum of value. In his analysis, wages are determined by the subsistence level—i.e. it is equal to the labor time required to produce commodities necessary for the support of the laborer and his family. He agreed with Malthus in arguing that increases in the wage rate induce laborers to produce more children as they can now support larger families. But this increase in labor supply as a result reduces wages to the subsistence level. Thus Ricardo’s wage-rate analysis is somewhat similar to Smith’s, but as far the determination of profit and rent is concerned he differs with Smith. Profit and Rent in the Ricardian System Ricardo’s analysis of prevailing rates of profit depended on the assumption of ‘natural rate of profit’ or surplus generated from the agricultural sector. If Ricardo, continuing with the labor input theory of value, had to avoid the puzzle that profit was not the result of exploitation (labor being paid less than its full product), then he had to show that profit was the product of nature. Hence he emphasized the importance of the agricultural sector. Ricardo’s theory presents the origin of rent in the technical fact that different plots of land have different degrees of fertility, so that the more fertile plots pay their owners differential gains, with respect to the productivity of that (less fertile) plot of land which happens to be at the margin between cultivated and non-cultivated lands. To him, no rent accrues on the least productive land and rent rises with productivity as more fertile lands are cultivated. It thus becomes crucial to identify this “marginal” land— i.e., that land which is the least productive but nevertheless must be cultivated in order to satisfy the total demand for agricultural produce [see the numerical example in the appendix to this chapter to enhance your understanding of his theory]. This means that in any given situation, there will be: a ‘marginal’ plot of land—the plot at the margin or the last cultivated plot—which by definition yields no rent extra-marginal plots of land—uncultivated because they are not fertile enough—and infra-marginal plots of land, which, besides being cultivated, also yield their owners certain amount of rents; these being the difference between the productivities of the (more fertile) plots of land and the productivity of the marginal land, which, though cultivated, brings no rent. On the basis of this formulation, therefore, it is rent—in logical order—that is distributed first out of the national product to the land-owners. Once rent has been distributed, what remains is to be subdivided between wages and profits. Now, in a natural-law dominated intellectual environment, impressed by the (then emerging) Malthusian theory of population as explained above, Ricardo (and the classical economists in general) was convinced that there exists a “natural” wage, just above subsistence, representing a family income at which the (average) population is induced neither to grow nor to diminish (stationary population). Once this (natural) wage has been distributed to the workers, the “residual” represents the profits of the capitalists-entrepreneurs. Profits therefore depend on wages and rents.

Ricardo’s theory of rent thus endocrines his theory of value and price. The value of a commodity is determined by the amount of labor embodied in the product of the marginal (or least fertile) land. This value will be shared between the capitalist and the laborers. Alternatively put, in Ricardo view “the value of the commodity (is determined) by the quantity of labor that will suffice for their production under the most unfavorable circumstances” and rent is determined by the difference between this value determining quantity of labor and the lesser quantity of labor used for producing commodities of equivalent value on progressively more fertile lands. Ricardo’s embodied theory of labor emphasizes the determining rule of the productivity of labor in establishing the size of the product produced by a capitalist society and available for distribution among its three major classes. Ricardo’s theory thus separates production and distribution but Ricardo remained concerned with the impact of changes in the relative shares of capitalists, landlord and laborers on production and on the accumulation of capital. Ricardian Politics Ricardo, a Jewish stock market gambler, lived at the time of the Napoleonic wars of England with France in Europe, America and India (recall Haider Ali and Tipu Sultan). During that period, government expenditures rose rapidly which were largely financed through rising national debt and high taxations. In order to finance its debts, the government passed the Bank Restriction Act in 1797 which allowed the circulation of paper money not fully backed by gold. Prices were increasing rapidly during this period and it was the problems created by this inflation and the financing of government’s debt that Ricardo first addressed. All this put pressure on production and less and less fertile lands had to be brought into cultivation thus raising rent and wages (due to the rise in the price of corn). Both rent and wage constituted ‘costs of production’ from the perspective of the capitalist and hence an increase in rent and wages would lead to a fall in the rate of profit. By determining value in terms of the productivity of labor on marginal land, Ricardo emphasized that the ultimate source of the growth in accumulation was the growth in the marginal productivity of labor—the productivity of labor using the least fertile resources, i.e. those capable of yielding a product just sufficient to meet the costs of subsistence of the labor employed and (what we now call) ‘normal’ profits. Policies should concentrate on measures which raise labor productivity and reduce ‘the costs of production’—rent and wages. Based upon his theory of income distribution Ricardo went on to develop his theory of crisis, but its details are not a part of our concern in this chapter. Ricardo also advocated free trade. He maintained that the only way in which the decline in the rate of profit due to rising cost of production could be postponed is by importing cheap food. Therefore Ricardo advocated the abolition of the:

‘Corn Laws’—which prohibited the import of food grain thus raising rent. On the basis of his labor theory of value, Ricardo argued that cheap imports of wage foods (corn) could lower the labor time embodied in the subsistence wage and thus allow the rate of profit to rise Poor Laws—state guaranteed (pitiable) minimum subsistence income for paupers—thus reducing the burden of national debt as well as decreasing population growth. He argued that the Poor laws did not make the poor rich but the rich poor The abolition of the Corn Laws (in the early 19th century) was an important step in the consolidation of capitalist rule in England. Ricardo, a Jewish gambler, saw the old English land owning class as the principle opponent of capitalist accumulation. In his analysis, landlords were the unproductive class in terms of creative (capitalist) value. “The interest of the landowner is always opposed to the interest of every other class in the community” wrote Ricardo in his Principles (published first in 1818). Ricardo advocated the conversion of land into capitalist property so that rent income should not be “wasted” but spent productively. By imposing high taxes on rent the capitalist state was the main instrument for converting land (and peasant labor) into capitalist property. In this, Ricardo followed Smith who had also insisted that rent should be the principle source of taxation. The transition in the theory of value—from Smith’s labor commanded as a numeraire to Ricardo’s “value as embodied labor”—is important in that it provided an ideological / theoretical justification for capitalist rule. That is why it displaced not only Petty and Smith’s vaguer formulations in Britain but also that of Say and Sismondi on the Continent. Ricardo rigorously established the natural/technical/rational/ahistorical and therefore non-contingent and necessary domination of capitalist order through his theory/ideology. Capitalist rule institutionalizes the continuing and never ending growth of labor productivity. Accelerated perpetual capital accumulation is merely a bi-directional correlate of labor productivity growth and the labor theory of value was a natural / rational / necessary processes. According to classical political economists, including Ricardo, not ordering life (both of private and public) to perpetuate labor productively growth and eternal capital accumulation is to go against both nature and reason. Christianity, on the other hand, had held that organizing society to achieve perpetual accumulation was going against the commands of God. Labor Input Theory after Ricardo While developing his theory of value and income distribution, Ricardo faced a serious problem that he could not solve. The problem was that relative prices do not in fact correspond to amounts of labor embodied in the commodities—the assertion that exchange value originates from labor time put into a commodity is not validated by the existence of money prices which corresponded to the ratio of labor inputs. Moreover, the prices of commodities also change due to changes in the distribution of income. If it is the case that relative prices also change due to changes in income distribution, but labor inputs remain unchanged, how can Ricardo maintain that labor inputs alone determine the rate of exchange (value) between commodities? The basic essence of this value-price problem is faced by all schools of thought (including neoclassical economics, see discussion on the famous Cambridge Capital Controversy in chapter 16). The solution to this problem requires that:

either the rate of profit is zero—which means that we assume long run stagnation in the economy, or only one commodity is produced and consumed in the economy But, as is clear, both these assumptions are unrealistic. Ricardo’s inability to resolve the value-price problem provided the foundations for two rival theories of value, both inheriting the labor input theory of value: (1) abstract labor theory of value by Marx and (2) cost of production theory of value (by Sraffa and others). Both of these trends shared discontent, though of varying degree, about the desirability and future of market capitalism as they saw in its development the seeds of stagnation, exploitation and crisis. Market capitalism—the idea that markets are the most harmonious way of reconciling individuals’ self-interest to the interest of all—faced criticism right from the time of its development. Ricardo was one of its critics as he saw capitalist order prone to crisis and composed of conflicting classes—those of landlords, stock holders and laborer. But, as Marx argued below, he did not accept (or could not work out) the full implications of his analysis. Many others like Veblen, Keynes, Robinson, Sraffa etc, followed him in this trend. Although these economists are denied the ‘socialist label’ but they were all concerned over the principal problem of distribution in capitalist society. In the upcoming section we spell out the Marxists attempt to resolve the conflict embedded in capitalist order. The cost of production theory of value will be explained after outlining the neoclassical response to Marxists’ critique of capitalism. 2.2.4: From Ricardo to Marx: The Abstract Labor Theory of Value Ricardo’s theory of value was soon recognized as an inadequate justification of profit. One of its major weaknesses (apart from value-price problem) was that if embodied labor is the sole source of value, why should capitalists (and landlords) appropriate a part of its product? Ricardo said some vague things about profits being a reward for ‘waiting’ but these apologies did not fit into his system (these ideas were developed in “theories of interest” by Tausig and Fisher much later). Ricardo saw no need for defending profits on moral grounds. British social order was securely capitalist by the early 1820’s, the landlords were reconciled to capitalist dominance and no one had the power to challenge it. Ricardo and his followers assumed that capitalist property was as natural as the weather and the topography—for a maturing industrializing economy “there was no alternative” in Ricardo’s view. Regarding capitalist property to be sacred (as Ricardo said it should be) was a command of reason to these classical thinkers. Recognition of incoherence’s in the labor theory of value led to divergent responses, as pointed out above. One direction was taken by Marx who tried to extend labor input theory and ‘class-based’ classical analysis to its logical conclusion. Historically, Ricardo’s lack of confidence in the market system (as outlined in his theory of crises) co-existed with the development of socialism as a set of ideas to understand capitalist society and politics. The positive evaluation of market capitalism ‘as a system of harmonious living’ was put under criticism by various schools of thought on moral grounds. Reasons for this negative assessment of capitalism included (i) rapid increase in the income inequalities in society, (ii) the adverse effects on the lives of the masses of factory workers and (iii) increased repression required to maintain the new factory discipline (see chapter 9 for details). Marx linked these (utopian) socialist critiques of market capitalism with the valuation in the market.

Marx’s Rejection of Profit Marx assumes that the primary objective and expression of human existence is the act of production. The realization of this objective takes forms of two sets of relationships: technical and social relations of production. The former relates to the act of converting the material environment into products for consumption while the later refers to the division between the owners/controllers of the means of production and workers. It is this division of social relationships that determines the distribution of economic surplus between the ruling class and the workers. According to Marx, value arises in these social relationships. In Marx’s conception, labor is the substance (value equivalence) of the commodity. Value is ‘labor for others’; labor so far as it is socially recognized within a division of labor, labor whose social character has been abstracted from the activity of the laborer. This socially necessary abstracted labor confronts the laborers as ‘private property’. This abstracted socially necessary labor is homogenized though measurement in time units. To return to Ricardo, how long it is socially necessary to produce one bushel of corn on marginal land is the value of corn; the price every laborer must pay for subsistence. The value of corn is thus an expression of the ‘social relation of production’—the relations between those who produce corn and those who earn profit because they control the land on which it is produced. According to Marx labor is alienated from itself—separated from the product it creates —through the capitalist organization of production and exchange. Capitalist organization of production and exchange (Hegel’s ‘civil society’) makes the realization of ‘true’ human needs impossible because of this alienation of labor. If labor is the substance of wealth (the source of its value) then wealth created by the expenditure of a particular labor must be appropriated by the laborer, who labored for producing that wealth. There is no moral justification for the appropriation of this wealth by capitalists in the form of what Marx called “private property”. The justification of this so called “private property” was first presented by John Locke—writing in the late seventeenth century—to justify the mass slaughter of the Red Indians in America and the wholesale looting of that continent by Europeans. Locke used this justification as an element in his broader advocacy of the need for the secularization of society. Smith and Ricardo offered no separate justification for ‘private property’ but accepted it as a natural foundation of the expanded division of labor. To Marx, ‘private property’ allows the capitalist not only to possess but also to use that commodity for the subjugation and exploitation of labor. In Marx (but not in Hegel) such ‘objectified’ labor is alienated labor. If the embodied labor theory of value is accepted there is no justification for accepting ‘capitalist’ social relationships—expressed in the universalized wage form and profit rate—as natural and rational phenomena.

The Nature of Marx’s Economics and Politics Marx thought (especially in The Economic and Philosophical Manuscripts) that he was developing a moral critique of capitalism through his reformulation of Ricardo’s embodied labor theory of value. Marx had a great respect for Ricardo for the fact that he discovered the weaknesses in Smith’s analysis of value and price—that is why Marx called Ricardo a scientific political economist. But Marx rejected his ahistorical approach towards understanding capitalist society. The differentiating aspect of Marx was to reject the assumption that the problem of valuation could be addressed by treating some aspect of human activity as given; e.g. taste or technology. For him, the starting point was not the individual, but the means of production and the conflict over the control of surplus value among different classes. For Marx social structure is never static [Marx and Engels (1967)]. He presented a materialist account of history which asserts that the material environment in every society is shaped by that society’s dominant “mode of production” [the way people get together to produce means of livelihood and control and allocate the resulting surplus product] of commodities that individuals wish to use. This formulates the basis for historical materialism or economic determinism—the view that the way we think and live is determined by prevailing material structures of production, distribution and exchange. Marx writes that “the mode of production of material life conditions the social, political and intellectual life process in general. It is not the consciousness of men that determines their being, but, on the contrary, their being that determines their consciousness”. One historically specific determined form of social relationships is commodity exchange—a system through which people relate to each other through markets using money. This particular form became dominant after the rise of capitalism where the majority of the people sell their ability to work to those who own and control the means of production. Social life can only be studied in terms of the relationships between the forces and relations of production and the internal conflicting forces within this relationship. Marx outlined a theory of history by which the relations of production correspond to a definite stage of development of the material productive forces. But then, after further development of those forces of production, a conflict arises between them and the existing relations of production. These relations had formerly helped the development of the productive forces, but now they start fettering further progress. Revolution then occurs, but only after all the productive forces in the old society that can develop, have developed. This conflict in capitalism between private appropriation and social production is revealed in the theory of falling rate of profit, that gives rise to capital-labor conflict. Marx claimed that labor has the capacity to produce more use value than its exchange value and the difference between the two is called exploitation, but disguised as profit by capitalist. Therefore, the source of profits, according to Marx, under capitalism is value added by workers but not paid out in wages. Once the wage is covered, the capitalist, owners of the means of production, always have an incentive to force workers to work longer and harder than the workers are themselves likely to do. The capitalist has to compete with other capitalist to stay in competition by improving the product and cutting down the cost of production. But this attempt to increase labor productivity and thereby raise profit creates a tendency for the profitability of capital as a whole to fall. This further puts pressures by capitalist on labor force to increase profitability, a move that creates competitive instability and furthers class struggle. Therefore, classes struggle for power, the control over the means of production, and this is fundamental to market capitalism and therefore capitalism is always in a danger of destroying itself in a way which lays the foundation of a new social order. Class conflict is rooted in the essential structure of capitalism as a system: “Those who own the means of production and those who perform wage labor are bound together but have significantly different needs about the intensity of production and the distribution of its proceeds”.

To Marx humanity is destined to freedom, but its struggle towards this goal has been prevented by the presence of scarcity which has forced humanity to compulsive toil—the necessity to work just for survival. However, with the emergence of the capitalis mode of production, people have become productive enough to produce abundance for the first time in history. But here Marx finds a dilemma: ‘though humanity has created means of production that provide enough for all people to be free, yet the economic system used to industrialize production distributes its bounty to a few wealthy people, thus artificially perpetuating the enslavement of the masses’. In other words, what nature had denied people for centuries was now being withheld from them by their fellow men. Though Marx appreciated market capitalism for its role in the enhancement of productivity, but he despised it for its oppression and exploitation of workers. Class conflict is thus fundamental to capitalism and it cannot be resolved by the actions of the state (as believed by the social democrats outlined below). On the contrary, the state itself reflects the imbalance of class forces and always works in favor of the dominant class interests. Marx defines progress in terms of ever greater control by humans over their environment through the development of the technical relations (or forces) of production. But this control over the environment will become possible when people can control their social relationships and hence eliminate their class conflicts. To Marx, the elimination of class conflict requires revolutionary change in social relationships. He believes that workers can be brought together into revolutionary associations which ultimately overthrow the bourgeoisie state. 2.2.5: From Labor Commanded to Utility Theory of Value: The Marginalist Revolution or Rejoinder? Marxist’s attack against market capitalist social relationships raised serious concerns. The missing link between identifying markets as the primary focus of capitalist activity and the justifying of free markets as the means to prosperity and justice was developed by a number of writers after Marx. Behind the technical jargons was their desire to show that market capitalism is a classless society fundamentally characterized by harmony and progress. The school of thought that championed this classless-theoretical framework is known as Marginalism or Neoclassical Economics. Nature of Marginalist / Utility Theory of Value Despite Smith’s recognition of labor commanded theory of value—i.e. value of a good is measured by the amount what people are willing to pay for a good and what wage rate people are willing to work—he primarily focused on the analysis of production activity and not on consumption. But a theoretical framework which starts from what people are willing to pay or are prepared to accept for a commodity requires a theory of valuation of commodities in use or consumption. As stated by Cole, Cameron and Edward, ‘the logical outcome of this trend is to stress individual choices within a framework of markets regulated by competition, with the valuation of commodities determined by the particular subjective tastes of the individuals’.

In Britain, writers like Bentham (1748-1832), had given some credibility to the idea that value arose from consumption, and not from production. But Bentham rested his analysis on the debatable assumption that consumer satisfaction can be measured in numbers (cardinally). Bentham concluded that since all human beings have a roughly equal capacity to derive utility (pleasure) from consumption, therefore equality in consumption is desirable for the greatest happiness of the greatest number. This conclusion of Bentham is an embarrassment to the marginalist school of thought. Many economists [e.g. Baptiste Say (1767-1832) and Nassau Senior (1790-1864)] continued with the labor commanded theory of value, but Smith’s project of reconciling individual interest with that of society was fully realized in 1870’s. This time it was expressed in mathematical terms gaining both credibility and scientific aura of social neutrality. Whether it was due to the international exchange of knowledge or the wide spread of socialist challenge, William Jevons (1835-1882) in Britain, Carl Menger (1840-1921) in Austria and Leon Walras (1834-1910) in Switzerland all produced their independent books in 1874 yet bearing a striking similarity. The trio were more influenced by Hume and Bentham than by Smith and Ricardo and adopted utilitarianism—the view that the rational individual maximizes his pleasure and minimizes his pain and society should seek the maximization of total net pleasure—as a basic creed. These neoclassical economists were the first genuine microeconomists as they relegated the question of overall economic growth and of distribution of aggregate output to relative unimportance and price determination became the central core for their theories. For all of these three, commodities have value because they are wanted, and wanted because they have utility for individuals. Marginalists base their analysis on the presumption of universal scarcity. Abdullah has next to nothing but he is supposed to want everything. The richest man in the world also has unlimited wants and comparatively limited resources. Both Abdullah and this richest man seek to maximize their total individual utility by exchanging the goods they have for the goods they want (and can afford). If Abdullah can satisfy wants without giving anything in return (e.g. air or the breath taking view of sunset on mountain crests) then such things hare no value and no price. Commodities only have value in conditions of scarcity. A picture by Picasso accidentally falling out of a traveler’s luggage will have no value in the Zhaghazi settlement but may sell for $1 million in a New York auction. Thus value is bestowed upon commodities by those who want them. Non-scarce goods have no value and scarcity is created by wants the utility derived from each additional unit of a commodity (i.e. marginal utility) declines as more of that is consumed. it is the intensity of want for this additional unit of a good that measures its value (that is why the name comes ‘marginalism’, see chapter 7 for details). Price corresponds to the marginal utility (and not the total utility) gained by Abdullah from the consumption of a commodity. These prices are unique in the sense that demand and supply of a commodity can be equated and the market cleared only at these prices the ‘just price’ or ‘equitable price’ is the price which expresses the values (preferences) and the rationality (self-interestedness) of free and autonomous individuals prices generated through capitalist transactional structures ensured the optimal allocation of resources. Prices—and money in which they were necessarily expressed—emerge naturally from the pursuit of self-interest by autonomous individuals and express the rationality of this self-interestedness and of capitalist order in general.

Walras made an attempt to prove Smith’s indivisible hand doctrine through an algebraic model of the economy. In this model, every market was represented by a single equation which when simultaneously solved gave equilibrium prices and quantities for all the commodities. However, there was a problem in Walras model: if every individual’s decision to buy and sell was dependent upon the decision of everyone else, how does the individual find out what everyone else is doing in the economy? Thus, the solution of his model required an all-knowing and all-seeing auctioneer who keeps on adjusting prices until demand equals supply (see chapter 12 for the details of this ‘auctioneer’). Walras maintained that his hypothetical mathematical model of the market economy can be applied to any number of goods and markets to work out their competitive equilibrium prices and quantities. This is called general equilibrium model. However, Menger did not agree with the possibility of having perfect information for every individual in a market economy and he therefore did not develop a general equilibrium model of the economy—although he believed that autonomous price movements would equilibrate demand and supply. It is since the 1870s that the labor commanded theory of value has got its powerful expression not only in the academic circles of economics but also in the state policy making of many capitalist countries. Despite a number of differences in analytical details, one can outline some general similarities in such analysis. Nature of Neoclassical Economics The starting point of this school of thought is the individual endowed with innate tastes and talents. Both Abdullah’s preferences and the resources with which he enters the market are predetermined. They cannot be the subject of neoclassical analysis. Neoclassical analysis cannot answer questions such as “what should Abdullah’s preferences be?” What resources should he have before he enters the market? These—how Abdullah gets the resources he has and how his preferences are formed—are “hidden abodes” for neoclassical economics. The individual calculates the outcomes of his actions so as to maximize his personal utility. The taste of this individual determines his preferences among alternative consumption patterns while his talent determines his ability to fulfill his infinite desires through productive activity. His decision to consume and talents to produce is coordinated by a special talent called entrepreneurship—the mechanism through which productive inputs are combined to satisfy consumer desires. The owners of inputs receive a reward determined by their contribution in the production of utility for the consumers. Prices, of both goods and services, are thus derived from the preferences of free and autonomous individuals. Value is assigned to goods and factors subjectively by free choosers. The value of a good or ‘factor’ represents not the ‘socially necessary cost’ for its production but the extent to which it contributes (on the margin) to the fulfillment of the (given) preferences of a group of consumers.

The objective of economic activity in neoclassical economics is to maximize the utility of individuals from consumption activity. These economists believe that the free markets reconcile the interest of the individual (personal utility) to the broader social interest (social utility or utility of everyone else). There is thus no fundamental conflict of interests within society. The state policy that follows from this analytical tool box is: the creation of an environment which allows maximum freedom for individual consumption decisions the removal of coercion from the market place, and the enforcement of voluntary capitalist contracts between individuals Before moving any further, we can legitimately ask a question at this stage: why did people wait for so long to discover this “desirable” way of organizing economic activities? If free markets are the key to human welfare, then human history up to 1850 A.D. looks to be a waste of time. The answer to this question does not rest in the inadequacy of human thinking; rather it lies in the general change in thinking, known as the Enlightenment, which took place in Europe and North America during the eighteenth century (see chapter 1 for details about the Enlightenment movement). This intellectual movement emphasized ‘freedom’ as the ultimate goal and the individual as the ‘decisive entity’ in society. Intellectuals started to worry what about we should do on the earth now, rather than what we might do to reach heaven in the future. This Enlightenment infused shift in thought in favor of individual liberty made its way in the vision of Adam Smith, the unanimously accepted founder of modern economics. It is also important to stress that the founders of neoclassicism were not concerned with the determination of the actual prices that ruled in the markets of their time. Walras said nothing about the determinants of house prices in nineteenth century Paris. They were presenting a “pure” theory of price in the most general and abstract terms. They were not asking how are prices determined in actually existing capitalist markets. They were asking how are prices determined when capitalism is pure; i.e. when there is perfect ‘knowledge’, perfect self-interestedness (i.e. “rationality”) and perfect-freedom to do what one pleases to do. They were thus not asking the positive question “how prices are determined” but the normative question “how prices ought to be determined”. They were measuring actually existing capitalism against “pure” capitalism and assuming that this “pure” capitalism is (or at least ought to be) every man’s ideal. If Abdullah does not accept this “pure” capitalism as his ideal he is inhuman, unnatural, irrational, ignorant perhaps insane. The purpose of their policy is to move actually existing capitalism towards “pure” capitalism. 2.2.6: From Labor Input to the Cost of Production Theory of Value: Emergence of Social Democracy As explained above, the development of capitalism has co-existed with a profound pessimism which also gave economics the label of the ‘dismal science’. This pessimism appeared in the writings of Ricardo, and more rigorously in Marx. One tradition in economics that combines insights from the radical revolutionary Marxists and the conservative neoclassicals is social democracy. Their theoretical foundations can be traced back to what is named as ‘cost of production’ theory of value mainly influenced by the writings of Ricardo.

The hallmarks of the cost of production theory of value are: their central concern with the production, the resulting distribution of output between the factors of production and the belief that market forces left to their own will lead to inefficiency and, at worst, stagnation Their starting point, unlike neoclassicals, is the analysis of the material environment and technology available to produce a given output. Available technology determines the division of labor and the pattern of exchange in the economy. The prices of output are determined by the costs of production. But the cost of production is determined not only by technical factors (e.g. quantity of labor time and raw material used in the production) but by the distribution of the output between wages and profits. The resulting division of output will depend upon the relative bargaining strengths of the various interest groups within capitalist society which may lead to conflict. For the cost of production theorists, though technological changes in production could be so crucial to the society in general, yet there may be sectional opposition to the introduction of new technology because it hurts the interests of that segment in capitalist society. For example, the introduction of machines may be viewed as profit-maximizing endeavor form the point of capitalists but a potential source of unemployment from the point of view of the workers. The precise outcome depends upon the bargaining power of the two groups to negotiate with each other. The puzzling question then is that if the gains from technological improvements cannot be realized through the anonymous market forces, then how can society as a whole benefit from new technology? For cost of production theorists, the answer lies in pluralist politics through which competing groups could reach compromise, and in neutral bureaucracy seeking to remove obstacles to technical progress by establishing appropriate institutional frameworks for mediating conflicts and promoting class collaboration through the establishment of a ‘corporatist state’. Nature of Social Democrat Politics Social democrats lay stress on positive government action for sustaining welfare enhancement rather than just protecting basic human rights. Their conception of justice is ‘to favor the creation of conditions in which people have real opportunities of judging the kind of lives they would like to lead’ and to focus ‘particularly on people’s capability to choose the lives they have reason to value’ according to Sen. The social democrats, in general, believe in the functionality of the market economy as the effective means for allocating resources and attaining development. However, these economists disagree with the view that valuation determined in the market is always desirable and efficient. They criticize the market mechanism on several grounds. Two aspects of their position can be highlighted: they condemn the free market system for the existence of large corporations which implies that the decisions about who is to be employed and at what wage are not the outcomes of anonymous market forces alone. Rather, these decisions are products of the power struggles in which people are discriminated against. Thus, assistance to the unemployed and the low paid citizens through the state budget also directly counts as ‘developmental’ since it assists people to lead freer lives

distributional inequity and disparity are central to the social democratic market critique. According to them, since markets can’t remove poverty and income inequalities, and all citizens have the right to rising material subsistence, therefore the state is responsible for redistributing resources towards the deprived segments of society. Poverty to them is not simply the lack of income. It is deprivation of basic capabilities which prevents people from participating as citizens in capitalist order and as consumers, employees and entrepreneurs in the markets. Based on this, they see the active role of an agency that is not subject to market forces in resource allocation—i.e. state which is essential for maintaining capitalist order. The hall mark of social democrats is the identification of marginalized groups and their restoration within capitalist order. Thus social democracy is an effort to find justice within capitalism—i.e. to minimize its inherent inequalities. Their focus is on the freedom generated by commodities, rather than on commodities seen on their own’ because people cannot be free if they do not have the resources to do what they like to do. Table 2.2 summarizes major features of the three schools of thought that we have introduced in this chapter. Table 2.2: Summary of Economic Schools of thought School of thought Source of Value Resulting Political Ideals Role of the State Utility theory of value OR Neoclassical Economics / Marginalism Relative scarcity or utility Emphasis on consumption activity Value determined by exchange process Market Capitalism Self-regulating anonymous markets achieve the best result for all economic agents Ensure free functioning of the market by enforcing capitalist law and order Minimum state intervention in the market Socialist OR Abstract Labor Theory of Value Social process of production resulting from both technical and class relationships of power to appropriate surplus value Value is determined by socially necessary labor time embodied in commodities Emphasis on production activities State capitalism Abolition of the market Public-ownership of resources to make a classless society by overcoming scarcity Resource allocation through central planning Cost of Production / Recardian / Keynesian / Sraffian OR Social Democrats Technical relations of production or physical real cost Value is determined by commodities destroyed during production Emphasis on production activities Nothing specific, but Social Democracy is consistent with it Active regulations of markets Welfare state 2.3: Where Do We Go From Here? Though learning any single theory of economics / value is bad enough as it does not provide complete insight into the development of economic discipline, yet we will be focusing on neoclassical (or what was called the utility) theory of value for most of the part in this book due to several reasons. First, the word ‘economics’ usually stands alone for ‘neoclassical economics’ in Pakistan, and, since this book is intended for students in Pakistan therefore we will be elaborating and evaluating neoclassical school of thought. Secondly, the utility theory of value provides a more coherent justification of capitalist order than does the labor theory of value. This justification has gained relevance and importance as capitalist individuation has destroyed non-capitalist communities and the class structures from which it has emerged and as capitalist rationalities have displaced other (especially religious) rationalities in most spheres of individual and social existence. Like classical political economy, neoclassical economics is also an instrument of governance and its theory of value provides a criteria for measuring actually existing capitalism with ‘pure’, ‘perfect’ and ‘ideal’ capitalism—it is this aspect of neoclassical economics which makes a collapse of its ‘positive’ claims inevitable. Most neoclassical pioneers—Jevons, Walras, Wicksell, Marshall, Pigou, Weiser—suggested reforms for moving actually existing capitalisms of their times towards ‘pure and perfect’ capitalism. European Social Democracy was born at least partly as a consequence of these reform suggestions and many of the defects of late nineteenth century capitalist orders were remedied by the implementation of these reforms suggested by neoclassical economics.

Neoclassical economics retains its permanence both because it is to date the most coherent and profound justifications of capitalist order and because it provides several theoretical discourses from which appropriate instruments of capitalist governance can be crafted. Both the theoretical justification for capitalist order and the practical policies advocated by neoclassical economists are based on its theory of value. In the rest of this book (with the exception of the last chapter) we will try to evaluate neoclassical theories of consumption, production, distribution and its theory of economic policy. These evaluations will try to identify the strengths and weaknesses of neoclassical theories both as justifications of capitalist order and as basis for undertaking reforms required for addressing capitalist policy incoherence and contradictions (especially in Pakistan). In the final chapter we will examine some other approaches and schools which seek to justify and reform capitalist order with regard to the organization of production, consumption and exchange at the micro level. That chapter will seek to understand why these schools have generally failed to supplant neoclassical economics as capitalism’s orthodox ideology, apology and theory of policy. Chapter Summary The central capitalist value is freedom. Freedom is self-determination––the right to do what one pleases in a manner which does not prevent others from doing what they please Capitalist ideology claims to recognize no external criteria for the evaluation of personal choices Free individuals are (a) acquisitive and (b) competitive. Capitalist order is based on the promotion of these two traits and emotions Competitive and acquisitive societies accumulate for the sake of accumulation. All activities are valued (in financial markets) in terms of their contribution to accumulation. Without accumulation freedom cannot expand for the greatest constraint on freedom–––the ability to do what everyone wishes to do––is the lack of economic resources Acceptance of acquisitiveness and competition as social values is neither natural nor inevitable. Christian society regarded competition and acquisitiveness as sins and social evils Capitalist markets and capitalist property is not natural but historical–––created by the acts of policy of a capitalist state and sustained by state regulation. Different capitalist states regulate capitalist markets in different ways based on the history and traditions of that country All national regulation systems must (a) legitimate capitalist (i.e. corporate) property, (b) ensure the enforcement of transaction contracts premised on the formal equality and actual inequality of contractures Non-state agencies, such as firms and banks and international public and private sector, also play an important role in capitalist regulation All schools of economic theory justify capitalist order as natural and rational on the basis of the view that economic “laws” can be observed on the basis of empirical observation of human behavior and the operation of these “laws”—that when men seek accumulation through competition—ensures that the greatest good of the greatest number is automatically achieved. This is Adam Smith’s theory of the “invisible hand”

Economics is essentially a moral and normative science because its analysis of observed facts and behaviors is necessarily based on what behavior ought to be. If actually observed behavior is not what economists believe what it ought to be, then such behavior is regarded as “irrational” According to the economists value resides in wealth not in virtue. Rationality is the continuous pursuit of an individual’s material self-interest. Value is produced through capitalist contracts which seek maximization of pleasure and the minimization of pain Value necessarily is embodied in commodities produced for the fulfillment of capitalist contract. Therefore, estimating values requires an analysis of the components of the prices of commodities exchanged in the market According to Smith the labor that can be commanded by the price of a commodity in the market is a correct measure of its value–––not the labor time that is used into the making of a commodity. According to the labor commanded theory of value, the value and price of commodity is equal to the wages, rent and profit paid for its production Smith sees capitalist society divided into three main classes––“holders of stock”, laborers and landlords. According to him all classes gain from a continuing accumulation of capital (“stock”). Capital is “the order of nature” according to Smith Ricardo advocated the embodied labor theory of value––i.e. the exchange value of a commodity by the relative labor time that goes into its production. The value created (alone) by that labor is distributed among wages, rent and profit. In the Ricardian conception value is determined by the amount of labor embodied in the product of marginal land. This value will be shared between wages, rent and profit. Rent will be determined by differential in productivity of different qualities of lands. Wages will be determined by the level of subsistence and profits share from value will be determined by rent and wages By showing that the growth of value was based entirely on the growth of labor productivity, Ricardo tried to demonstrate the inevitability of accepting capital accumulation as an end in itself. Capitalism was a natural and rational system because it alone facilitated never ending capital accumulation and therefore continuous increase in labor productivity However, Ricardo’s value theory was unsatisfactory in that it could not be shown that relative prices in fact correspond to labor embodied in the exchanged commodities. Moreover, prices change with changes in the pattern of income distribution even when labor inputs remain unchanged If money prices do not correspond of labor embodied, the pattern of income distribution generated by the market cannot be shown to correspond to any capitalist principles of equity. Ricardo, thus, could not show that market capitalism was a just system To Marx value is produced by labor alone within capitalist society through the network of class relations. Market capitalism is exploitative according to Marx because it allows ‘the private property’ owning class to appropriate ‘surplus’ value produced by laborers who are thus ‘alienated’ from the products of their labor.

Marginalists reject the Marxist view that market capitalism is exploitative and argue that market order is classless and capable of generating just outcomes Neoclassical economists argued that value emerges in consumption, not in production Neoclassical economists were utilitarians. They argued that the ethical basis for evaluating the justice of outcomes was the ‘greatest happiness principle’. Society should seek those transactional arrangements which yield greatest net social utility (pleasure) The main assumptions underlying neoclassical analysis are as follows: Scarcity is universal. Wants are always unlimited and resources always and necessarily scarce. Commodities derive value from relative scarcity Utility derived decreases as the consumption of good increases. Price corresponds to marginal utility Equilibrium prices (= marginal utility) equate demand and supply and “clear” the market. These “equilibrium” prices are “just prices” These just prices emerge automatically from the pursuit of autonomous self-interested actions of individuals and express the rationality of self-interestedness and of the capitalist order in general The preferences of individuals who enter the market are given. Neoclassical economics cannot answer the question. “What should these preferences be” The resources which an individual brings to the market are also given. Neoclassical economics has nothing to say about them The owners of inputs receive incomes which is proportional to the contribution of these inputs to production of utility for consumer. These incomes are just because they measure the relative contributions of each input to consumer utility The value of a good and input is thus only determined by “free choosers”. Capitalist markets enable all preferences to be expressed and valued in terms of their contribution to social utility and hence every one gains from free market transactions. Capitalist society is not built into conflicting classes but is harmonious and benevolent According to neoclassical economists state policy allow free functioning of markets and the enforcement of capitalist contracts Neoclassical economics is concerned to show not how prices are actually formed in capitalist markets but with how they ought to be formed. They provide a theory to measure / assess actually existing price structures against “pure” price structures if capitalist markets were absolutely perfect Social demonstrates, inspired by Keynes and Sraffa, argue that production of value and its distribution is affected both by technological form and by the relative bargaining strength of conflicting classes–––especially those earning profit and those earning wages. Institutionalizing the basis of continuous negotiation both in the market (collective bargaining) and in the state provide a basis for reconciling the interests of labor and capital for sustaining optimum output-price configurations Social demonstrates advocate state intervention to offset market generated inequalities. This they regard as essential for effective capitalist governance

For summary of the characteristics of the major economic schools, see Table 2.2 Review Questions Why is an understanding of capitalism necessary for a student of economics? Define “freedom”. Is the claim that ‘in capitalist order there are no external criteria for evaluating personal choices’ correct? “Accumulation is an end in itself in capitalism”. Comment Do you agree that competition and acquisitiveness are natural values which all societies have to adopt sooner or later? Why does one country’s capitalist system differ from that of another? What are the essential functions a capitalist regulatory regime must perform and what are its objectives? What role do firms and banks play in capitalist regulations? How does Adam Smith justify capitalist order? What is economic rationality? What is the difference between the ‘embodied’ and the ‘commanded’ labor theories of value? Compare and contrast the theory of value and distribution propounded by Smith with that of Ricardo. Assess the relationship between Ricardo’s theories of distribution and his politics. Show how Ricardo attempts to establish the rationality of capitalist order. Assess the strengths and weaknesses of Ricardo’s theory of value. Define the Marxist conceptions of ‘value’ and ‘labor’ and distinguish it from the corresponding Ricardian conceptions. Explain and evaluate Marx’s “conceptions of ‘alienation’ and ‘exploitation’. Outline the main features of utilitarianism. Were Smith or Ricardo utilitarian thinkers? What are the assumption underlying neoclassical economics? What justification does Marginalist Economics present for capitalist order? What is the neoclassical argument for saying that the pattern of income distribution which emerges in the market is just? Why do neoclassical economists regard capitalist markets and society as harmonious and not conflicting? What according to the neoclassical economists should be the objectives of state policy? “Neoclassical price theory provides conclusive proof that neoclassical economics is purely normative and not at all positive.” Discuss. Outline the theory underlying the Social Democrats understanding of how capitalist markets function. Assess the social democratic critique of the market and the policies they advocate. P A R T T W O Markets Liberal framework of analysis Chapter 3: Basics of Demand and SupplyChapter 4: Markets and Price ControlsChapter 5: Elasticity Chapter 3: Basics of Demand and Supply Chapter 4: Markets and Price Controls Chapter 5: Elasticity Chapter 3 BASICS OF DEMAND AND SUPPLY If you are asked to identify a single answer that could be an appropriate one to almost all economic questions; then you should say ‘demand and supply’. It has been said that a parrot could be converted to an economist if trained to answer ‘it is a question of demand and supply’ to every economic question—and there is truth in this notion. The model of demand and supply is the mantra invoked to address all aspects of the capitalist economy ranging from consumption, to production to distribution of income and wealth. Sections 1 and 2 of this chapter lay down the foundations of demand-supply analysis. Section 3 then explains how the basic model of demand and supply operates in a single (competitive) market.

3.1: Demand We begin the study of markets by exploring the behavior of consumers—the logic behind this behavior is discussed in chapters 6 to 8. When economists talk about demand, they refer to the amount of a commodity that a consumer is willing and able to purchase. But talking about the level of demand is not very useful; rather economists try to explore the factors that can change the demand for a commodity from one level to another. Let us discuss these factors in turn. 3.1.1: Determinants of Demand Determinants of demand are factors that affect a consumer’s decision regarding ‘what amount of a commodity to purchase’ with his income. One could identify a long list of such factors, but economics isolates the ones it regards as the most important. To understand how many factors can affect the demand for a commodity, suppose you are standing at a chicken shop in your local market and you are intending to purchase some kgs of chicken. You ask about its rates from the shop keeper and he offers you a price of Rs 100/kg. At this price, you decide to purchase, say, 4 kgs. After a few weeks when you go to the market, you find that the price has increased to Rs 180/kg. You deem this price to be too high to purchase any amount on that day and postpone your decision to purchase chicken and wait for the price to fall. Economists believe that demand for a commodity is most significantly affected by changes in its own price. But ‘own price’ is only one out of many factors that can affect the demand for a commodity. Suppose that the price of chicken remains the same, Rs 100/kg, but beef becomes very cheap, say, from Rs 240/kg to Rs 160/kg. This might encourage the consumer to purchase less chicken (say 2 kgs instead of 4) and more beef because the demand for beef and chicken are interrelated in the sense that they can be used in place of each other. To take another example, decrease in the price of mobile chip connections increases the demand for mobile phones, (as in Pakistan in 2006). So, economists argue that changes in related goods prices can also affect demand decision of a consumer. According to economic theory income also affects demand. Will you still be purchasing the same amount of chicken if you lose your job, or if you receive a permanent boast in your income? Obviously, if you are a ‘consumer’ (see chapter 6 for detailed discussion on ‘who a consumer is’), then income changes will influence your decision of how much chicken to purchase. So income is considered by economists to be another important factor that affects the demand for a commodity. Similarly, a consumer’s taste with regard to a particular commodity is expected to make an important impact on his demand decision; i.e. if you are a Muslim, you will not consider purchasing pork no matter how low its price is or how rich you are (but the economists view that you would be acting irrationally when you make such a decision). There is a great debate among economists about where consumer taste comes from. One group believes that it is innate or inborn while the other considers that it is determined by the society in which an individual lives. Leaving this debate aside, we can identify one very common factor operating in a capitalist society that is used to affect the demand decision of individuals for a commodity; and that is advertisement. All capitalist firms devote a huge amount of their budgets on advertisement to create a taste for their products by altering consumers’ purchasing habits. Thus, in capitalist society taste is largely affected by advertisement. Since changes in taste can affect demand for a commodity, therefore advertisement is related to demand through taste.

It is conventional in economics text books to mention prices of commodities, income of consumers and taste as the major determinants of demand. But this is not an exhaustive list of all factors that have an effect on demand for a commodity. Expectations about future prices of commodities and income also have an effect on consumers’ demand decision. Most importantly, it is critical to note that demand for all types of goods cannot exist independent of the institutional, social and legal structure of a society. To understand this idea, consider what will happen to the demand for automobiles if government introduces a law of ‘maximum 20 Km/Hour speed limit’ on all city roads. Clearly, this will change people’s choices radically not only in terms of automobiles used and mode of traveling, but also in their choice of residence, in their use of time, and in the design of towns, cities and roads. Similarly, the demand for loanable funds by the general public crucially depends upon the existence of commercial banks and state financial policies. It is important to note that this theory of demand applies only to capitalist market economies. Phyllis Deane’s research on medieval England and Agleitta’s research on 11th to 14th century France have shown that changes in demand for staples and many other traded commodities did not respond to changes in prices or income. Changes in demand were merely a consequence of changes in population or of upheavals caused by war. Prices remained stable for long stretches of time—rising at the rate of half a percent per annum on average for several centuries during the European Middle Ages. As Agleitta notes there was not major difference in consumption patterns between the lords and the serfs in medieval. In France consumption levels were determined by customs and conventions, and not by changes in prices of goods or income. Economists would say that consumers were not “rational” before the seventeenth century almost everywhere in the world. It is only in capitalist society that men become rational, say the economists, and they become so by maximizing utility; that is by consuming more and more and more and more. We can summarize the theory of demand in capitalist society in a compact expression called the demand function written as: or (3.1) where stands for the amount or quantity of x demanded. This is a typical demand function which says that demand for any commodity, say x, in general depends upon the price of x, price of all other related goods that can affect the demand for x, the amount of income the consumer has and his (advertisement determined) taste. Thus, we have identified the major determinants of demand in capitalist society. Let us take each of these factors one by one and examine the nature of their relation to demand. In other words we seek to find out ‘whether demand will increase or decrease due to change in these factors’. To begin with let us take own price first. Own Price and Demand How would the capitalist consumer react if price of a commodity, say chicken, increases? It is expected that he will reduce its demand (for reasons, wait till chapter 8). This negative relationship between price of a commodity and its demand is known as the law of demand. Table 3.1 uses hypothetical data to explain this law:

Table 3.1: Own Price and Demand Price of x (Rs) Amount of x Demanded by Nomi (Kgs) A 40 4 B 30 6 C 20 8 D 10 10 This table says that as the price of x falls from Rs 40 to Rs 30, Nomi (the capitalist consumer) tends to increase his demand for it from 4 to 6 kgs. The same decreasing pattern of demand holds as further reduced price is offered to Nomi, such as Rs 20 and Rs 10. These numbers clearly indicate that as the price of x is increasing, its demand is decreasing. This is exactly what is meant by the negative relationship between price and demand—both of them move in the opposite direction. We can draw all price-quantity combinations of table 3.1 in a price-quantity graph or space. These points are drawn in Figure 3.1 which plots price on the vertical axis and quantity on the horizontal axis. For example, point A represents a price-quantity combination (4, 40) containing a quantity of 4 kgs of x and a price of Rs 40. The same holds for point B showing a combination (6, 30), C showing (8, 20) and so on. If we join all these points, we obtain a straight line termed the demand curve, here demand curve of commodity x, Dx. This shows the amount of a particular commodity, say x, a consumer is ready to purchase at different prices. For example, a consumer is willing to purchase 4 kgs of x when he is offered a price of Rs 40 and 6 kgs at a price of Rs 30. Figure 3.1: The Demand Curve0410D (10, 10)6840B (6, 30)C (8, 20)A (4, 0)Dx302010xPrice Figure 3.1: The Demand Curve 0 4 10 D (10, 10) 6 8 40 B (6, 30) C (8, 20) A (4, 0) Dx 30 20 10 x Price The Slope of the demand curve The slope of a curve is defined as change in the dependent variable divided by the change in the independent variable. The slope of the demand curve is thus defined as: (3.2) where the symbol ‘Δ’ (delta) indicates change in the relevant variable. Since price and demand have a negative relationship, the slope of the demand curve must also be negative; i.e. changes in both variables move in the opposite directions. Note that expression (3.2) measures the inverse of the slope of the demand curve. For clarity of this idea, see FYI Box 3.1. FYI: B O X 3.1 A Precautionary Note on the Slope of the Demand Curve Keep one thing about the slope of the demand curve in mind. It is customary that the slope of a curve is expressed as rise over the run—change in the variable on the vertical axis divided by the change in the variable on the horizontal axis. For the demand curve in figure 3.1, the slope expression will be: (3.1.1) However, this tradition is not followed in case of the demand curves. Economists normally note the slope of the demand curve by the inverse of expression (3.1.1) as (3.1.2) It is for this reason that the demand curve is called the inverse demand curve. The reason for adopting this expression for the slope of the demand curve is that while developing consumer theory, economists consider quantity demanded of some commodity as a function of its price, that is what should be the price of a commodity for the consumer to choose a particular level of quantity (it is the price which determines the quantity demanded). On the other hand, the expression (3.1.1) gives us price as a function of quantity; i.e. what should be the quantity demanded of a commodity for a particular price to prevail in the market. Therefore, we use expression (3.1.2) for stating the slope of the demand curve.

You might be thinking that instead of using this messy inverse expression, why don’t economists draw demand curves with price on the horizontal axis and quantity demanded on the vertical? You will have to wait for the answer to this question until we reach the market level analysis. There you will see that the supply curve of a firm is its marginal cost curve, and we have cost and price of a firm on the vertical axis because cost is a function of quantity. Therefore we draw the demand curve with price on the vertical axis so that we may reach an equilibrium state on the same graph. Don’t worry if you don’t understand this reasoning, you will do so when we reach chapter 11. Let us see how the slope of the demand curve is measured. As we said above, there was nothing special about the numbers we assumed in table 3.1. Figure 3.2 plots a negatively sloped demand curve with another set of values of prices and quantities demanded. Figure 3.2: Slope of the Demand CurveQa = 10Qb = 20Pb = 2BPa = 4ADxΔPx = -2ΔQx = 10x Figure 3.2: Slope of the Demand Curve Qa = 10 Qb = 20 Pb = 2 B Pa = 4 A Dx ΔPx = -2 ΔQx = 10 x Price Price Consider movement from point A to B. Recall that change in a variable is given by the difference between its new and previous values. For example, while moving from point A to B, price decreases from Rs 4 to Rs 2. Thus change in price from A to B is given by: (3.3) Similarly, change in quantity is given by: (3.4) Dividing (3.4) by (3.3) we obtain: (3.5) This expression says that for each one rupee increase in the price of x, its demand decreases by five units. Thus, the rate of change in the quantity demanded for x with respect to price is 5 (for more on slope, see chapter 4). The negative sign behind this number indicates the negative relationship between price and quantity demanded. Since it is a straight line, the slope must be the same at all points along this demand curve. Income and Demand According to expression (3.2), income is also an important determinant of demand. So, now pose yourself a question: ‘what will happen to the demand for a commodity if Nomi’s income increases?’ The first answer that strikes the mind is that in capitalist society it will increase; i.e. an increase in income leads to an increase in the capitalist consumer’s demand. Goods whose demand increases (or decreases) due to increase (or decrease) in consumer income are termed normal goods. Thus we have: (3.6) The expression (3.6) will be positive only if both and ΔM move in the same direction. There are several commodities whose demand goes up with income in capitalist society such as better clothing, housing equipment, cars etc. But not all goods can be ‘normal’ for a consumer, say Nomi. A capitalist consumer can always identify a set of commodities the demand for which does not increase as income goes up, rather it decreases. Consider the demand for hawai chappal. If Nomi is poor, he might use it, but as he grows rich he will not increase its demand; rather he will switch to Peshawari chappal and become ashamed of wearing hawai and his demand for hawai will fall. Or think of the demand for bicycles. As Nomi grows richer, he purchases first a motor cycle and then an automobile. He discards his bicycle. Goods whose demand decreases as the income of a capitalist consumer increases are called inferior goods giving us the relationship.

(3.7) Remember that there is nothing intrinsic to commodities that make them normal or inferior. A commodity could well be normal for one individual or society and inferior to another. The Prophet (SAW) continued to wear footware like hawai chappals even after the conquest of Khyber when a great deal of wealth was acquired by the Muslims. If Bill Gates considers Khaddar cloth inferior, it does not mean that there is something ‘wrong with’ Khaddar cloth; rather it merely reflects the attitude of Gates for this commodity. It is quite possible that the same cloth is a normal good for Farooq, and it may be a ‘superior good’ for Abdullah Zhaghazai because it helps him uplift his spirituality by adopting zuhd. The point here is that within neoclassical economics, there is no criterion to evaluate the ‘normality’ or ‘abnormality’ of goods and activities beyond ‘human desires; i.e. it says that the value of goods and activities comes from the wants of individuals. If a society agrees to accept wearing string biking as ‘normal’ practice, it will become a normal good while hijab and naqab will be regarded as ‘inferior’ goods. If prostitution and homosexuality are viewed as acceptable by a capitalist society, it becomes a ‘normal good’ according to neoclassical economics. This fact is a perfect example of the marginalist theory of value we discussed in the last chapter. According to that theory, the value of a commodity or an activity lies in the eyes of the beholder. The answer to the question whether a commodity is normal or inferior varies from individual to individual and one capitalist society to another in the marginalist or neoclassical economic perspective. Note that it is not a logical necessity—the opposite of which involves a contradiction—to assume that demand for some commodities must increase with increase in the income of an individual, as is assumed by economics. This assumption holds for an individual who lives in this world in order to maximize utility. A person not committed to utility maximization will not follow this general pattern of increasing demand with increasing income. For example, it is possible that Farooq may not wish to improve his standard of living at all as he becomes richer because he and his family have adopted faqr. He will give away all excess income, say, for the cause of Jihad, or he may give khairat (charity) to a Madrasah. Despite the fact that Hadrat Usman-e-Ghani (RA) was quite a wealthy person, he lived a life of faqr and zuhd. His riches did not appear in the form of better housing equipments or clothing; rather they took the form of spending in Ghazawat, helping needy and poor Muslims etc. The point to note is that there is no logically necessary relationship between increasing demand for commodities and individuals’ income. It depends upon the objectives which individuals pursue in their lives. If we do assume that there is a positive relationship between the demand for a commodity and income, as it is the case for Gates, the question arises: ‘how can this effect be studied on a demand curve drawn in a price-commodity space?’ First note that the demand curves given in figure 3.1 and 3.2 can be plotted keeping income of the capitalist consumer constant. To ensure that demand decreases as price of the commodity increases, we must keep income fixed when price rises. If income of the consumer is also allowed to increase when price is increased, there can be no guarantee that demand will decrease in response to increase in price for normal goods. This is because increasing price and income will have opposite effects on the demand for a commodity—demand will decrease due to increased price while it will increase due to increase in income. So, income must remain fixed at all points of a demand curve, such as A, B, C and D of figure 3.1. This fact is shown in figure 3.3 where the demand curve DxO (1000) is drawn for income Rs 1,000; i.e. the capitalist consumer is ready to purchase these amounts of commodity x when his income is Rs 1,000 per month. This point is key to understanding the effect of income on the demand curve.

If income is held fixed along a demand curve, what happens to the demand curve when income goes up? One way of analyzing the effect of income on demand could be to use an income-commodity space, such as in figure 3.4. This diagram plots demand for x against the income of the consumer, M. If x is a normal good in a capitalist society, say chicken, then increasing income from Rs 1,000 to Rs 1,500 will increase the demand from 4 to 8 kgs per month. Figure 3.3: Income and the demand curve in price-commodity space4106840DxO (M = 1000)302010DBC A12Dx1 (M = 1500)A1B1C10xPrice Figure 3.3: Income and the demand curve in price-commodity space 4 10 6 8 40 DxO (M = 1000) 30 20 10 D B C A 12 Dx1 (M = 1500) A1 B1 C1 0 x Price Though such a graph gives some additional information, it is not very useful for economists’ purpose, as will be clear in the third section of this chapter. Economists want to study the effect of income on demand in a price-commodity space. But how can this be done? Consider figure 3.3 again. Point A gives us the information that when Nomi’s income is Rs 1,000, he is willing to purchase 4 kgs of x at a price Rs 40/kgs. What if his income goes up to Rs 1,500 while the price of x remains the same, Rs 40? Since his purchasing power has increased and x is assumed to be a normal good, he will increase his demand for x and start purchasing, say, 8 kgs as suggested by figure 3.4. Where will this point be located in figure 3.3? If you are considering point C, then you are wrong because this point does indicate 8 units of x, but at a price of Rs 20 per kg. Figure 3.4: Income and Demand in income-commodity spacexa = 4Bxb = 8AMa = 1000Ma = 1500Mx0 Figure 3.4: Income and Demand in income-commodity space xa = 4 B xb = 8 A Ma = 1000 Ma = 1500 M x 0 Remember that price is held fixed at Rs 40 per kg when income is increased. So, the point corresponding to 8 units of x at price Rs 40 is A1, exactly to the right of point A. According to this point, Nomi is willing to purchase 8 kgs at the price of Rs 40 when his income has increased to Rs 1500. Now ask ‘how much x will he purchase if price is Rs 30 per kg while income is increased to Rs 1,500?’ When his income was Rs 1,000, he purchased 6 kgs at price Rs 30. But after increase in his income, he will increase his demand and will purchase, say, 10 kgs. This gives us point B1. We can repeat the same process for all points on the demand curve. If we join all these points, we obtain another demand curve Dx1 (1500) corresponding to income level Rs 1,500. This demand curve records information about Nomi’s purchasing decision of x at different price levels when his income is assumed to be Rs 1,500 instead of Rs 1,000 per month. Thus, we find that if the income of a capitalist consumer increases, then the whole demand curve shifts out right wards if x is a normal good indicating that demand for x has increased at all price levels due to the increase in income. Another way to understand this shifting is to consider the case of two consumers, one Nomi with income level Rs 1,000 and another Moni (another capitalist consumer) with Rs 1,500. The person having higher income level will demand more units of x no matter what its price is. For example, at price Rs 40, Nomi is willing to purchase 4 kgs while Moni is ready to buy 8 kgs because his income is greater than that of Nomi. The same goes for all price levels. Visualizing figure 3.3 from this angle, demand curve DxO (1000) stands for Nomi while Dx1 (1500) for Moni. The larger the income of a capitalist consumer, the farther will be the demand curve from the origin for normal goods. This is what is meant by the shifting of the demand curve.

The demand for all goods does not rise due to increase in income as explained above. If x is an ‘inferior’ commodity, then its demand will decrease due to increase in income. This means that the demand curve will actually shift inwards and towards the left and not outwards for inferior commodities indicating the fact that demand has decreased for all price levels. Figure 3.5: Income and Demand for ‘Inferior’ GoodsDx1 (1500)BADxo (1000)106Pricexinferior020 Figure 3.5: Income and Demand for ‘Inferior’ Goods Dx1 (1500) B A Dxo (1000) 10 6 Price xinferior 0 20 This is shown in figure 3.5 which shows that as income increases from Rs 1,000 to 1,500, demand for x falls at all price levels. One such price level is shown in the diagram. Finally, note that it is merely conventional that the relationship between demand for a commodity and its own price drawn in a price-commodity space is called a demand curve. In fact the relationship between demand and income when drawn in income-commodity space such as in figure 3.4 could also be termed as the demand curve—and there will be no effect of changing this terminology technically. But as we will see, such a graph is useless for analyzing the behavior of capitalist markets. Related Goods’ Prices and Demand We can also study the effects of changes in the price of one commodity on the demand for another. This is called the cross price effect; i.e. what happens to the demand for x if the price of y changes. We have said above in expression (3.1) that prices of related goods can also affect demand for a commodity. The direction of the relationship between demand for commodity x and price of commodity y depends upon the nature of the relationship between these two commodities; i.e. whether they are substitutes or complements to each other. Substitutes are goods that can be used in place of each other because they serve more or less the same purpose in the eyes of a capitalist consumer, such as beef and chicken for households or oil and CNG for automobile users. Technically speaking, two goods are said to be substitutes if demand for one increases due to increase in the price of another commodity. For example, increase in the price of petrol has increased the demand for CNG and LPG gases over the last few years in Pakistan. Thus, we have: (3.8) In other words, the cross price effect is positive in the case of substitute goods. Two goods are said to be complementary to each other if they are used more or less together, such as mobile phones and mobile chip connections or jam and bread. In case of complementary goods, cross price effect is negative indicating the fact that demand for one commodity increases when price of another decreases. For instance, a dramatic fall in mobile connection charges from Rs 3,000 to almost Rs 200 and mobile call service charges from Rs 12 to Rs 2 per minute has led to a revolutionary increase in the demand for mobile phones over the last decade in Pakistan. Thus we have the relation: (3.9) The effects of changes in price of commodity y on the demand for x can also be studied in a price-commodity space much the same as the effect of income on demand. If two goods are substitutes, then increase in the price of y will increase the demand for x and the demand curve will shift outward as drawn in figure 3.6. Note very carefully that we have price of x, Px, on the vertical axis and not price of y. Secondly, the level of income is held fixed along both demand curves at Mo level (say Rs 1,000 per month). However, the price of y, Py, is different for both curves. When Py = Pyo, say Rs 10, per kg we have demand curve DxO (Mo, Pyo) which shows demand for commodity x at different prices of x when the income of the consumer and the price of y are held fixed at Mo and Pyo levels respectively. When Py increases to Rs Py1, say Rs 15, the demand curve shifts to Dx1 (Mo, Py1) reflecting the consumer’s willingness to purchase x at different prices of x when income and price of y remains fixed at Mo and Py1 levels. Again, it is important to note that income and related goods prices remain fixed along any single demand curve.

Figure 3.6: Effect of increase in price of a substitute on demand curveABDx1 (Mo, Py1)x1xoPoDxO (Mo, Pyo)Price0x Figure 3.6: Effect of increase in price of a substitute on demand curve A B Dx1 (Mo, Py1) x1 xo Po DxO (Mo, Pyo) Price 0 x On the other hand, if two goods are complements, then increase in the price of y will decrease the demand for x and the demand curve will shift inward (try to draw a diagram yourself for this case). Read carefully FYI Box 3.2 to avoid an important conceptual mistake. FYI: B O X 3.2 A Precautionary Note on the Law of Demand Suppose that you want to test the law of demand for, say, milk whether or not a rise in price of milk reduces its quantity demanded. How would you do this? You might collect the data on the price of milk over time and the quantity demanded for it. You will observe that the money price of milk has been rising since August 1947 and its consumption is also increasing. Does this observation refute the law of demand (or that individuals maximize utility subject to income constraint)? The answer is no, because the data and assumptions are not realistic. A careful statement of the law of demand says that it is the changes in relative prices, not absolute money prices, which produce law of demand. In addition to that, the income of the individual as well as prices of related goods are also held constant. If you want to test any hypothesis in the real world, you must take into account its assumptions because assumptions are the conditions under which that law or hypothesis is true. Taste and Demand The only remaining factor in the expression (3.1) is taste denoted by T. Now it should be a straight forward matter to see how changes in consumer taste towards a commodity can affect its demand. If it is very cold weather, Nomi might prefer to consume more dry fruits than he does in summer even if their prices and his income remain more or less the same. Alternatively, if it is hot summer day, he might go to an ice cream parlor or have Lassi. The effect of changes in taste on the demand curve is much the same as that of changes in income and related goods prices. The demand curve will shift outward if taste becomes more favorable for a commodity and vice versa. Remember that a single demand curve is drawn keeping income, prices of related goods and taste constant. Thus, a correct statement of the ‘law of demand’ is as follows, ‘own price and demand for a commodity are negatively related keeping other things constant’. These ‘other things’ include prices of related goods, income and taste of a capitalist consumer within capitalist society. Taste and Advertisement Economists pretend that the taste of an individual is innate or inborn. According to this idea, all individuals are born with infinitely insatiable desires and infinite appetite to fulfill these desires. The reason behind economists making this absurd assumption is explored in chapter 7 and 8. But note here that taste or preferences of individuals do not exist independent of the values of the society he is born into. One of the major factors that shape the taste of individuals in capitalist societies is advertisement which is a tool to create and maintain new and higher levels of desire. Firms such as Pepsi and Coca Cola spend billion of dollars per month for this objective. When Pepsi or Coca Cola advertises its product, it is not providing information to customers as their products are already well known even in Sindh villages, rather they try to create new tastes and enhance consumerism within society (see chapter 9 for detailed discussion on it). This fact is revealed by the attractive types of slogans used by these companies such as ‘dil hay to mango aur’ and ‘khana mangay coca cola’, etc. The role of advertisement in the market will be discussed in Application Box 3.4 below.

3.1.2: From Individual to Market Demand Economists are interested in analyzing individual behavior so as to know and shape the collective behavior of all individuals in capitalist society. Thus John Hicks; a Nobel prize winning economist says, “Economics is not, in the end, much interested in the behavior of single individuals. Its concern is with the behavior of groups. A study of individual demand is only a means to the study of market demand”. One of the fundamental objectives of economics is to study the behavior of a capitalist society; i.e. to uncover the regularities that ought to be working behind its processes so that appropriate policies can be derived in order to keep it working efficiently. It is believed by neoclassical economists that the behavior in capitalist society is reflected in an aggregation of the behavior of its members. If we convert this into a mathematical equation, it can be stated as: Behavior of America = Behavior of Mr. Gates + Behaviour of Mrs. Gates + … + Behavior of all American citizens In general, Behavior of capitalist society = Sum of the behavior of all capitalist Individuals In other words, if one is interested to know how capitalist society should operate, he must know how a capitalist individual must behave in a capitalist society. Whatever has been said about demand so far holds for a single capitalist consumer—how the consumption decision of Nomi responds to changes in prices and income etc. Given this consumption behavior of a capitalist, rational individual; the next problem is to find the consumption behavior of capitalist society as reflected in the market. If we accept the neoclassical belief that market behavior ought to be the sum of individual behavior, then market demand for a commodity will simply be the sum of all individual consumers’ demand for a commodity. Let us begin with a two-consumer-one commodity model, a ‘2×1’ model (two consumers, say Nomi and Moni, and one commodity, say x). Consider table 3.2 which shows the demand decision of Nomi and Moni for commodity x at different price levels. At price Rs 10, Moni is willing to purchase two units of x. On the other hand, Nomi opts not to purchase any amount of x at this price, may be because he is poor. These differences in demand can result either from the differences in the income of the two individuals or differences in their taste. Adding the demand for x of the two individuals, the market demand at price Rs 10 is, thus, two units. Similarly, market demand at price Rs 8 is four units. When x is offered at Rs 6, Moni chooses to buy 6 units while Nomi buys 3 units. Adding their demands at price Rs 6 gives 9 units of x. The same holds at point D and E. Thus we find that market demand is merely the sum of all individuals’ demand at a particular price. Table 3.2: Deriving Market Demand from Individuals’ Demand Price of x (Rs) Amount of x (kg) Demanded by Moni Amount of x (kg) Demanded by Nomi Market Demand (Kg) A 10 2 + 0 = 2 B 8 4 +

0 = 4 C 6 6 + 3 = 9 D 4 8 + 6 = 14 E 2 10 + 9 = 19 Let us represent the demand functions of each individual for x as: (3.10) (3.11) Note two things: both individuals are assumed to face the same prices at a time and each person’s demand depends on his own income and taste and not that of the other. The total demand for x is then given by the sum of the amounts demanded by the two individuals. Mathematically, Market Demand for x = xM + xN = + Market Demand for (3.12) where “F” shows the market demand function for x. Note that the market demand depends on the income levels of both the individuals. This idea is shown graphically in figure 3.7 segmented into three panels. The first two panels draw the demand curves for commodity x of the two consumers. The market demand curve for x can be obtained by adding these demand curves horizontally. The panel (c) shows the market demand for x at different price levels. For example, at price Ps and above, market demand is zero since neither Nomi nor Moni is willing to purchase any amount of x at these prices. Now let’s pick the price level P1 (Rs 10) and see how much of x each individual is willing to purchase at this price. From Table 3.2, we can see that Moni is willing to buy 2 kgs of x while Nomi is not ready to purchase any amount at this price. Point A is one point on the market demand curve corresponding to point a of panel (a). The same holds at point B. The slope of the market demand curve will be equal to that of Moni’s demand curve above the price where Nomi enters the market, P2. This is so because above this price level, Nomi does not purchase any amount of x and therefore the market demand is equal to Moni’s demand in this price region. Now think of price P3 and repeat the same process. At this price level, Nomi also participates in the market by purchasing 3 kgs of x. The market demand is 9 (= 6 + 3). This gives us another point C on the market demand curve which is a horizontal summation of points cm and cn. Repeating this process at all prices and adding the demand curve of all individuals horizontally will give us the market demand curve, DM. Figure 3.7: Deriving the Market Demand CurveabqAP1 (10)P1P1P2 (8)P2P2cfBDNDMbfPsP3 (6)cqP3 P3 C2446633Ps24600302469xMxNxM + xNPxPxPx(a) Moni(b) Nomi(c) Market Figure 3.7: Deriving the Market Demand Curve a bq A P1 (10) P1 P1 P2 (8) P2 P2 cf B DN DM bf Ps P3 (6) cq P3 P3 C 2 4 4 6 6 3 3 Ps 2 4 6 0 0 3 0 2 4 6 9 xM xN xM + xN Px Px Px (a) Moni (b) Nomi (c) Market 2 2 This result can easily be generalized to n-individuals in the capitalist economy. The key to derive the market demand curve is that we add horizontally the demand for a commodity by all individuals at any given price level. The general formulation for the market demand function for x turns out to be: Market Demand for x = = F (Px, Py, {Mi}) = f m (Px, Py, MM) + f n (Px, Py, MN) = f i (Px, Py, {Mi}) (3.13) Note that there is a kink in the market demand curve at the price where Nomi enters the market, P2 in figure 3.7. With two individuals entering the market at two different price levels, such as Ps and P2, we have one kink in the market demand curve, such as at point B. Using this logic, if we have three individuals who enter the market at three different price levels, we will have two kinks in the market demand curve. If there are n-individuals entering the market with very small differences in the market price, the kinks will increase in numbers and move closer to each other and we will, approximately, have a smooth market demand curve, just like the one drawn in panel (c) of figure 3.8. Adding up individual demand curves to produce a smooth market demand curve is quite unrealistic as several neoclassical and orthodox economists have noted. Adding up individual demand curves to yield a relatively smooth market demand curve depends on several unviable—not merely unrealistic—assumptions about tastes, relations between tastes and income and patterns of income distribution. This has led Hal Varian, whose book Microeconomic Analysis is compulsory reading on most American M.S Economics programs, to the conclusion that “unfortunately the aggregate demand curve posses (es) no interesting properties … The neoclassical theory of consumer behavior places no restrictions on aggregate behavior in general”.

Figure 3.8: The smoothness of market demand curve emerging by increasing the number of consumers Px 0 xa + xb + xc xa + xb + xc + xd ∑xiDM Figure 3.8: The smoothness of market demand curve emerging by increasing the number of consumers Px 0 xa + xb + xc xa + xb + xc + xd ∑xi DM bcP1P1P2P2(a) Market demand with three consumers(b) Market demand with four consumers(c) Market demand with n-consumersdbPsaP3 acPs b c P1 P1 P2 P2 (a) Market demand with three consumers (b) Market demand with four consumers (c) Market demand with n-consumers d b Ps a P3 a c Ps It would complicate matters a great deal if we were to show why a smooth market demand curve cannot be derived without making these unviable assumptions (wait for chapter 8). But an important point to note is that economics is not primarily concerned with describing how existing capitalist societies (including markets) actually function. Rather, it is essentially a moral theory prescribing how capitalist societies and markets ought to function. The smooth individual demand curve shows how a rational capitalist consumer ought to behave. All capitalist consumers ought to behave in this same way and you are taught to accept as optimal the social outcome of everyone behaving in this rational way. Allowing everyone to behave in this rational way is an end in itself. Saying that when individuals are induced to act rationally it cannot be shown that social utility will be maximized demonstrates the ultimate irrationality of capitalist rationality. Society cannot be organized to achieve capitalist ends for these ends are inherently unrealizable. The capitalist organization of production and exchange necessarily constrains the maximization of consumption/welfare/freedom. No branch of capitalist epistemology—philosophy, jurisprudence, sociology, political science or economics—has been able to grapple effectively with this paradox. 3.2: Supply Having discussed the idea of demand, let us move on to the other side of the market: supply. Supply is defined as the amount of output that firms or individuals are willing to sell at a positive price. Supply can also be modeled in the form of a supply function, such as: or (3.14) This function says that the sellers’ decision to sell a particular amount of output depends upon the own price of the commodity that they are selling, prices of inputs and technology. Let us briefly discuss the relationship of supply with each of these factors one by one. Own Price and Supply The relationship between the own price of a commodity and its supply is expressed by the so called law of supply. This law says that quantity supplied will be larger at higher market prices and smaller at lower market prices, other things held the same. To demonstrate this idea, consider figure 3.3 which illustrates the meaning of this law. You can see that as the price of x is increasing, so is the amount supplied. The plot of this relationship in price-commodity space is called supply curve.

Figure 3.9: The Supply CurveD40BCA Sx30201046810xSPrice0 Figure 3.9: The Supply Curve D 40 B C A Sx 30 20 10 4 6 8 10 xS Price 0 86104 8 6 10 4 The logic behind the positively sloping supply curve cannot be completely understood without analyzing production and cost structure of a capitalist firm. So you have to wait till chapters 10 and 11 to understand its justification. Loosely speaking, the supply curve is positively sloped due to the assumption of diminishing returns in the production process which results in higher cost of production as output increses. To consider a rough example, suppose a car manufacturing company produces 100 cars per month at a cost of Rs 100,000/car. Suddenly, the demand for cars increases to 500 cars per month. In order to produce 500 cars, more factors of production or inputs must be purchased. And it is possible that the cost of purchasing additional inputs may increase when their demand increases in the market. Higher cost means that the firm can no longer produce a car for Rs 100,000 and hence a higher market price is needed to induce the firm to produce more cars. This justifies the law of supply; i.e. a higher price is required to produce higher output by capitalist firms. Remember that this law does not usually hold in production of most goods in capitalist markets. Most of the times, producers are willing to sell more output at the same price, or even at lower prices. When we reach the theory firm in this book, we will discuss these matters in detail. At this moment, note that the slope of the supply curve is defined as: (3.15) Another way to make some intuitive sense of the positively sloped supply curve is to think of an exchange economy. This is a type of economy where goods already exist in the hands of people and production is no longer taking place. Nomi happens to posses some goods, may be he has inherited them, and does not face the problem of producing them. Suppose that the only thing Nomi inherits from his father is wheat. He needs some other goods as well, such as clothing, housing etc. Now in order to consume goods other than wheat, he needs to sell some amount of wheat for money so that he can purchase other goods. Thus, the only decision he has to make is how much of wheat to consume himself and how much of it to sell in the market in order to purchase other goods. Assume that the market price of wheat is Rs 10/kg while the price of chicken is Rs 20/kg. This means that for every one kg wheat sold in the market, Nomi can earn Rs 10. These Rs 10 can then be used to purchase half a kg of chicken (because 1 kg chicken costs Rs 20). In other words, 1 kg of wheat can be exchanged for half a kg of chicken in the market at these prices. Now assume that the price of wheat increases to Rs 20/kg. This means that by selling one kg of wheat in the market, Nomi can now earn Rs 20 and, hence, can purchase one kg of chicken. Alternatively, after increase in price of wheat, Nomi can exchange 1 kg wheat with 1 kg chicken. Thus, after a rise in the price of wheat, its exchange value increases which mean that more units of other goods can be purchase by selling one unit of wheat. According to neoclassical economics, if Nomi is an economic-man (one who maximizes utility / profit), then he should sell more units of wheat at higher price levels because that will allow him to consume larger amounts of other goods. However, if Nomi is not an economic-man, then there is no guarantee that he will exchange more wheat for chicken even if its price keeps increasing in the market. In general, the law of supply is not a universal law that holds for all individuals and all societies and at all times it operates only in capitalist markets.

Input Prices and Supply Just as the position of the demand curve changes—i.e. the demand curve shifts—when a factor (such as income) other than the own price of a commodity changes, similarly the supply curve also shifts out or in due to changes in inputs prices and technology. For example, if prices of inputs increase from Wo to W1, then the cost of producing the same level of output increases. If the market price at which that commodity is sold remains unchanged, firms will produce less amount of that commodity and, hence, supply will decrease. The effect of such an increase in input prices will be to shift the supply curve inward as shown in figure 3.10. Much has been said on the meaning of ‘shifting’ in our discussion on demand, read that section again. Algebraically, this relationship is shown as: (3.16) which says that there is an inverse relationship between input prices and supply of a commodity. Technology and Supply Another factor that can shift the supply curve is technology. More will be said on the issue of technology in chapter 9; here it is sufficient to note that in economics technology is conventionally defined as ‘the method of producing output from inputs’ or ‘a way of converting inputs into output’. Not only inputs but also a specific method is required to produce something. You can think of inputs as ingredients of a food-recipe while technology as its ‘method’ of cooking; i.e. which ingredient to use in what combination and proportions. If a new technique allows a firm, say Microsoft, to produce more output with the same amount of inputs, then economists says that technology has improved. Figure 3.10: The impact of change in input prices on SupplyBA Sx (Wo)30Sx (W1)048xPrice Figure 3.10: The impact of change in input prices on Supply B A Sx (Wo) 30 Sx (W1) 0 4 8 x Price The effect of improved technology is to lower the cost of production and, hence, to increase supply. So, there is a positive relationship between supply and technology “improvement”. (3.17) The effect of improvement in technology is to shift the supply curve outward. Just reverse the direction of the arrow in figure 3.10 to see this effect. Other Determinants of Supply One can think of a number of other factors that can affect the supply of a commodity. Some of them are: Prices of Related Goods: If production of two goods requires the same type of resources, then a change in the price of one commodity can cause a shift in the supply curve of another related commodity. For example, consider the production of wheat and grapes both of which require a particular piece of land for their production. Once a piece of land has been used for cultivating wheat, it cannot be used for producing grapes at the same time. Think of Carter who inherits two acres land from his father which he uses for producing wheat initially. Now assume that the price of wine increases in the US market because most people have become drunkards in America. The production of wine requires grapes as ingredients, but grapes can be produced in larger quantity only if land reserved for producing wheat is diverted to the production of grapes. Therefore, Carter as a capitalist farmer will decide to produce more grapes than wheat in order to maximize profit. The supply of wheat will fall, hence shifting its supply curve inward. Note that if the farmer is not an ‘economic-man’ and does not organize production for maximizing profit, then production of wheat will not fall no matter how high the price of wine goes up in the market because the farmer will continue to produce wheat on his land to sustain his society. See Application Box 3.1 to see the result of capitalist response to price changes in the eighteenth century.

A P P L I C A T I O N B O X 3.1 Famine in France During the French Revolution Several authors have noted that a major cause of the French revolution (which occurred in 1789) was the famine experienced by the landless rural poor. The success of French colonialism during the eighteenth century led to the inflow of immense quantities of gold and silver into France. This wealth was used by a new class of capitalist farmer to acquire large landholdings from the decaying nobility and to dispossess the peasants. At about the same time there was a dramatic increase in the demand for wine in France—mainly for domestic consumption but also for export—leading the capitalist farmers to drastically reduce the production of wheat and increase the production of grapes. The production of wheat declined so catastrophically that in the 1780s, bread became a luxury commodity and there was wide spread famine and malnutrition throughout rural France. This was a major cause of the peasant uprisings and revolts which played a crucial part in the French revolution. Expectations: Supplier’s expectation about future conditions of the market relating to their goods can also shift the supply curve. For example, suppose that suppliers of LPG gas are anticipating that the government is going to enact a law according to which LPG prices will be fixed at some higher level. If they are profit-maximisers, they will withhold LPG gas today in order to sell it in the future at the anticipated higher price. Therefore, the supply curve will shift inward today. Application Box 3.2 shows the same type of mentality on the part of fruit-suppliers in Pakistan before the month of Ramadan. A P P L I C A T I O N B O X 3.2 Fruit Supply before Ramadan Ramadan is a month reserved exclusively for Ibadaah and earning reward from Allah Almighty. But the devilish economic-man sees it as a potential source of profit-maximization. It is known that a week or two before Ramadan, many farm owners withhold the supply of fruits from markets so that when demand for fruits increases during Ramadan, they can sell fruits at higher prices. Remember that such a price increase of fruits is not a ‘natural’ outcome; it is artificially created by the lust of suppliers for more profit. If this evil desire is removed from individuals by Tazkia, prices will not rise. Economic theory accepts hoarding as natural for it is a capitalistically rational response to anticipated price changes. If economic-man does not hoard as a response to expected price raise he will be behaving irrationally from the point of view of economic theory. Discoveries: The supply curve of natural resources shifts to the right if new resources are discovered because this is expected to lower the cost of production. Weather: Because of dry weather or flood, supply curve of, say, wheat will shift to the left. Similarly, a good harvest of wheat can shift its curve outwards. One can, easily, think of many other factors that can affect the supply of a commodity and add them to this list. We now briefly discuss the concept of market supply.

3.2.2: From Individual to Market Supply Section 3.1.2 gave a detailed description of how to derive the market demand by adding individual demand curves. We also saw that it is in fact impossible to derive the market demand curve in this way in real capitalist markets (or indeed justify such a derivation logically) and that the concept of the market demand curve is an ideological devise to illustrate capitalist rationality. The same procedure can be applied to obtain the market supply curve which shows the supply of a commodity made by all firms at different price levels. This is illustrated in Table 3.4 which presents the supply decision of two firms at different price levels. The resulting diagram is shown in figure 3.11 that draws the sum of supply by the two firms. Note again that we have one kink in the market supply curve with two sellers. Table 3.4: Deriving Market Supply from Individual Firms’s Supply Function Price of x Amount of x Supplied by Coco Cola Amount of x Supplied by Pepsi Cola Market Supply A 5 0 + 0 = 0 B 10 4 + 0 = 4 C 20 6 + 2 = 8 D 30 8 + 4 = 12 E 40 10 + 6 = 16 As the number of firms are increased, kinks tend to increase and become closer and closer to each other. If there are many sellers, we will have a smooth market supply curve. Mathematically, Market Supply of x = xc + xp = + Market Supply of (3.18) where “F” shows the market supply function of x. Figure 3.11: Market supply with two firmsD30BCASc + Sp201054628446812xM0Price Figure 3.11: Market supply with two firms D 30 B C A Sc + Sp 20 10 5 4 6 2 8 4 4 6 8 12 xM 0 Price A lot has so far been said about demand and supply, it is now time to put the ‘two-blades of the scissors’—demand and supply—together to understand how markets ‘ought’ to work according to economic theory. 3.3: The Market And Equilibrium We have outlined the behavior of two agents operating in the market—i.e. the consumption behavior of consumers and production behavior of firms. This enables us to understand how markets ought to work and how, as a result of this process, prices ought to be determined according to economic theory. Consider figure 3.12. Think of an auction where individuals have come with their belongings so as to exchange them with that of others. The problem for the auctioneer is to determine prices of all goods that individuals hold so that they can be exchanged. Obviously, exchange of goods cannot take place without knowing the rate at which goods can be exchanged. To begin with, suppose that the auctioneer announces a price of Rs 15 (= Po) for the auction to start for good x. He asks participants to tell him who is willing to sell how many units and who is willing to demand how many units at this price. It so happens that the amount demanders are willing to purchase turns out to be exactly the same as the amount sellers are willing to sell at this price. Let it be 8 (may be 8 hundred or thousand etc.) units denoted by xo in figure 3.12. Point e where demand and supply curves intersect is said to be the equilibrium point. But its meaning can be fully understood only when we see how this equilibrium point is reached from a disequilibrium position.

Figure 3.12: Market EquilibriumSoDoePo = 15xo = 8xPrice0 Figure 3.12: Market Equilibrium So Do e Po = 15 xo = 8 x Price 0 15 = Po 15 = Po Market with Excess Demand Consider figure 3.13 now. Suppose that the auctioneer announces a price Rs 10 for the auction to start. At this price, demand is 14 while supply is 6 units. In other words, demand for this commodity is greater than its supply at this price. This situation is known as excess-demand or shortage in the market. How should this gap between demand and supply be filled? What should the auctioneer do to eliminate excess-demand? Economists believe that this situation cannot persist for long because it leaves some demanders unsatisfied. This is because at this price, people are ready to purchase this commodity but the only problem is that there is nothing to purchase. Figure 3.13: Market with excess demand10SoDo15Excess Demand614x0Price Figure 3.13: Market with excess demand 10 So Do 15 Excess Demand 6 14 x 0 Price Excess demand Excess demand Economically rational buyers will be willing to pay a higher price for this commodity. Also profit-maximizing suppliers can ask for a higher price for this commodity as they know that they can sell this commodity at a higher price without losing their customers. The auctioneer therefore raises the price of this commodity from Rs 10 towards Rs 15. Does this resolve the problem? Yes, because when the price is increased, rational consumers reduce their purchases, quantity demanded falls. On the other hand, due to increase in price, quantity supplied increases because rational firms are profit maximizers. Increased price stimulates more supply simply because selling one unit of a commodity at a higher price means higher profit. Since demand is decreasing while supply is increasing after increase in price, the gap between demand and supply will decrease. Where should this process of increase in price stop? Obviously, at point where demand is equal to supply. The process is explained in figure 3.14. Excess DemandPriceD Suntil D = SFigure 3.14: Process of equating demand and supply in case of excess demand Excess Demand Price D S until D = S Figure 3.14: Process of equating demand and supply in case of excess demand Market with Excess Supply Now think of the opposite possibility in figure 3.15. Obviously, there is no way that the auctioneer can know in advance at which price the problem of excess demand will be eliminated. Suppose that in order to resolve the situation of excess demand in figure 3.13, he announces a new price, say, Rs 20 per unit. But at this price the problem of excess-supply or surplus emerges. To see this, note that at this price, quantity supplied is 10 units while demand is only 4 units. This means that supply is greater than demand at this price. Again, this situation cannot prevail according to economic theory for very long because it leaves sellers with goods piling up on their shelves without anyone to purchase them. The only way firms can sell their commodities is by accepting a lower price for their commodities. Reducing price, say towards Rs 15, is expected to induce more customers to purchase this commodity [because they are utility maximizers].

Figure 3.15: Market with excess supply20SoDoExcess Supply154010xPx Figure 3.15: Market with excess supply 20 So Do Excess Supply 15 4 0 10 x Px On the other hand, some sellers refuse to sell their goods if offered a price of Rs 15 and leave the market: quantity supplied should fall. This is shown in figure 3.16. Excess SupplyPriceD Suntil D = SFigure 3.16: Process of equating demand and supply in case of excess supply Excess Supply Price D S until D = S Figure 3.16: Process of equating demand and supply in case of excess supply Market in Equilibrium Thus we see that: in the case of excess demand price is expected to increase, which as a result, is expected to eliminates excess demand from the market, and in case of excess supply price is expected to decrease, which is expected to eliminate excess supply. In both the situations, the direction of change in price ensures that excess demand and excess supply is eliminated from the market so that demand equals supply. Figure 3.12 shows this end point of the auctioneering process: price will stop changing where demand is equal to supply, as at point e where demand and supply curves intersect. This is equilibrium. Equilibrium is defined as a ‘position where there is no further tendency for change’. Point e is called the equilibrium point because demand and supply are expected not to change from this point, once attained, until something else happens (to be discussed below). Price Po is said to be the equilibrium price because there is no tendency for price to change from this level. At this price level, demanders are expected to be willing to purchase exactly what firms are expected to be willing to sell: price will neither increase nor decrease because demand is equal to supply. Similarly, quantity xo is said to be the equilibrium quantity sold because neither consumers nor sellers will want to revise their purchase or sale decisions. This expected tendency of price to increase or decrease in the case of excess demand and excess supply until the market clears is called the market or price mechanism. 3.4: Changes in Equilibrium: How Markets Allocate Resources? The previous section demonstrated that equilibrium in the market is determined where demand and supply are equalized. Once such an equilibrium point is established, nothing can change this point until the factors that determined this point undergo some change. What factors are responsible for the existence of the equilibrium? Obviously, it was determined by ‘demand and supply’. As long as the position of the demand and the supply curves remain the same as in figure 3.12, equilibrium price and quantity will also remain unchanged. This equilibrium point can change only if either demand or supply curves or both curves change their positions. Let us first analyze how changes in demand can affect the equilibrium price and quantity sold. 3.4.1: Changes in Demand What factors can cause the position of the demand curve to change? To see this, consider the demand function (3.1) of commodity x again:

(3.1) We discussed in section (3.1.1) that the demand curve will shift either outwards or inwards if any factor other than the own price (Px) of a commodity undergoes some change. For example, if the income of an individual increases, then demand for a normal good will increase and the demand curve will shift outward (see figure 3.3). Similarly, changes in related goods prices and taste can also shift the demand curve. In other words, the position of the demand curve changes due to changes in these factors. Demand can change in two directions due to changes in these variables: it can increase as well as decrease. Let us consider these positions one by one. Increase in Demand Consider figure 3.17a where initial price and quantity sold are Po (say Rs 5) and xo, determined by the intersection of the demand curve Do and the supply curve So. Now assume that demand for this commodity increases after increase in the consumer’s income. As a result, the demand curve shifts outward to D1 as shown in this diagram. Figure 3.17a: Effect of increase in demand on marketSoDoExcess Demand5 = PoD17 = P1efgxox1xPrice0 Figure 3.17a: Effect of increase in demand on market So Do Excess Demand 5 = Po D1 7 = P1 e f g xo x1 x Price 0 Figure 3.17b: Effect of increase in demand on marketxox1xPrice0SoExcess Demand5 = PoD17 = P1efg Figure 3.17b: Effect of increase in demand on market xo x1 x Price 0 So Excess Demand 5 = Po D1 7 = P1 e f g After shift in demand curve, Po is not the equilibrium price because demand is now greater than supply at this price. To see this clearly, look at figure 3.17b which plots the same diagram omitting the demand curve Do. Remember that once the demand curve has shifted out, the original demand curve is not applicable and the relevant demand curve is the new one, here D1. We can clearly see that on this new demand curve, quantity demanded is xd whereas quantity supplied is the same xo. The difference between xd and xo or the distance ef measures excess demand in the market at this price which is very similar to the one drawn in figure 3.13. The same process of increase in price as outlined in figure 3.14 will begin once excess demand appears in the market and the new equilibrium is attained at point g in figure 3.1.7a. Price will stop increasing when demand and supply are equal at P1 (= Rs 7). The process is shown by figure 3.18. Figure 3.18: Process of equating demand and supply after increase in demandPriceD Suntil D = SIf D Excess Demand at initial price Figure 3.18: Process of equating demand and supply after increase in demand Price D S until D = S If D Excess Demand at initial price Comparing the old and new equilibrium points e and g, we can see that market price has increased to P1 while quantity sold has increased to x1. Thus, economists conclude the following: Proposition 3.1: If demand for a commodity increases, market price and quantity sold should increase, given standard demand and supply curves We will say more about this proposition while evaluating capitalist government price control policies. Here, see Application Box 3.3 which highlights that if the logic of this proposition is followed, then it involves some perplexing implications and moral dilemmas when evaluated with respect to the well accepted moral values of all non-capitalist societies. Also study Application Box 3.4 to see the role of advertisement within the framework of market equilibrium (the box notionally shows the effects of advertisement on market price, the role of advertisement comes into play in imperfectly competitive markets, see chapter 14).

A P P L I C A T I O N B O X 3.3 Are Increases in Prices Due to the Azad Kashmir Earthquake Justified? SoDo100=PoD1200=P1emgmom1Pm0Let us agree with whatever is stated in proposition 3.1. Assume that the market for medicines (or tents) is characterized by a negatively sloped demand curve and positively sloped supply curve as drawn below. Now consider the situation after the Azad Kashmir earth quack struck on 8th October 2005. This immediately and heavily increased the demand for many basic necessities in those areas including medicines and tents (for shelter). The effect is to shift the demand curve outwards. The logic of the market mechanism as expressed in proposition 3.1 requires prices of medicines (or tents) to increase from Rs 100 to Rs 200 in this situation. Viewed from the Islamic perspective however, the practice of increasing prices in this situation is callous hard heartedness and exploitation of people. However, if medicine companies or tent sellers increase prices of their products, capitalist ethics regards this increase in price as ‘just’ and ‘fair’. Capitalist ethics sees nothing wrong about this practice and considers it to be the right of producers to increase prices in such situations. So Do 100=Po D1 200=P1 e m g mo m1 Pm 0 Remember that the logic of the market mechanism works only when we assume that individuals are ‘economic-men’ (one who seeks to maximize utility / profit). Raising prices after the earth quake is just and fair if men are economic men and act “rationally”. However, if Pakistanis are not economic men, they will not raise the price of medicines instead they will reduce their prices. When Madina was hit by a famine and the trading stock containing food-stuff of Hadrat Usman (RA) reached the city, some Jews tried to offer him four times the price of his food-grain. But Hazrat Usman (RA) refused to sell it to anyone and distributed it free. Similarly, during the earth quake, thousands of individuals donated all their many belongings to the victims without even thinking of the opportunity to make profit. It is important to note that the market mechanism is not something impersonal like the gravitational force that can exist without human motives; rather it is guided by the spiritual condition of an individual. Only utility and profit maximizing individuals respond to the market mechanism. Pious Muslims make price decision on the basis of quite different considerations, the most important of which is the desire to serve and obey Allah. A P P L I C A T I O N B O X 3.4 Role of Advertisement in the Market SoDo 10 =PoD1 12 =P1emg1000Pm01500Consider this figure where demand and supply curves are intersecting at point e with price of Rs 10 prevailing in the market and quantity sold equal to 1,000/month. Note that the supply curve is drawn very flat (for reasons, wait till chapter 5 and 11). Assume that the board of directors of the company are not happy with the current performance of the company and ask the marketing department to do something in order to improve sales. They set them the targeted sale level of 1500/per month. The only way the targeted sale can be attained is by increasing the demand from Do to D1 via advertisement. The advertisement department devises an attractive advertisement campaign to befool the people into belief that ‘this product will make a real difference in their lives’. That is how advertisement is used to manipulate markets. Once demand increase to D1, the company cannot sit idle, rather it will have to be active in order to maintain this high level of demand because, otherwise, some other competitor of this company will snatch away its customers. This explains why companies participate in advertisement-wars against each other in capitalist markets. The proportion of advertisement expenditures in total expenditure of firm always keeps on increasing.

So Do 10 =Po D1 12 =P1 e m g 1000 Pm 0 1500 Another way to see the contribution of advertisement is to recognize its role in maintaining a particular high price level. For example, if the company wants to maintain a price of Rs 12/unit for its product, then demand must be at D1, otherwise price will decrease. Fall in Demand Here the demand curve shifts inward. Consider the market for chickens, as shown in figure 3.19. Do and So are initial demand and supply curves respectively which intersect at point e. This means that Rs 90/kg is the market price of chicken at which co (say 2 tons/day) chicken is sold in Karachi. Now assume that rumors of ‘bird-flue virus epidemic hitting poultry chickens’ spreads throughout the city. This drastically decreases the demand for chicken in the city from Do to D1. After fall in demand, Po is no longer the equilibrium price because quantity supplied is now greater than quantity demanded (to see this clearly, draw this diagram on a page with pencil and omit demand curve Do as we did it in figure 3.17b. Once you omit Do, the diagram will be very similar to figure 3.15). In other words, there is now excess supply at this price in the market equal to distance he. Again, the market mechanism in case of excess supply as outlined in figure 3.16 set in to equilibrate demand and supply at point k. At this point, the price of chicken has gone down to P1 (Rs 50/kg) whereas quantity sold has also decreased to c1. Comparing the old and new equilibrium points, we can derive proposition 3.2: Figure 3.19: Effect of fall in demand on marketSoD1Excess Supply50 = P1Do90 = P0ehkcoc1ChickenPrice0 Figure 3.19: Effect of fall in demand on market So D1 Excess Supply 50 = P1 Do 90 = P0 e h k co c1 Chicken Price 0 Proposition 3.2: If demand for a commodity falls, market price and quantity sold both decrease, given standard demand and supply curves 3.4.2: Changes in Supply As changes in demand can affect market outcomes, so can changes in supply. Let us now take its changes one by one. Increase in Supply Consider figure 3.20 where again demand and supply curves intersect at point e initially. This time, it is the supply curve that shifts to the right from So to S1, say due to a fall in input prices or improved technology. As a result, there will be excess supply equal to em at the initial equilibrium price Po (again to see this clearly, draw this diagram on a page and omit the supply curve So. The resulting diagram will be very similar to figure 3.15). Once again, the market mechanism (figure 3.16) will set in to equilibrate demand and supply and new equilibrium is attained at point n where demand and supply curves intersect. The process is shown in figure 3.21 and the effects of increase in supply on market outcome are summarized in Proposition 3.3. Also see Application Box 3.5. Figure 3.20: Effect of increase in supply on marketSoS1Excess Supply20 = P1Do30 = P0emnx1xox0Price Figure 3.20: Effect of increase in supply on market So S1 Excess Supply 20 = P1 Do 30 = P0 e m n x1 xo x 0 Price Figure 3.21: Process of equating demand and supply after increase in supplyExcess Supply at initial pricePriceD Suntil D = SIf S

Figure 3.21: Process of equating demand and supply after increase in supply Excess Supply at initial price Price D S until D = S If S Proposition 3.3: If supply of a commodity increases, market price falls while quantity sold increase, given standard demand and supply curves A P P L I C A T I O N B O X 3.5 Constant Fall in IT Products’ Prices eabSoS1P1DoP0S2P2PitIToIT1IT2ITIt has been observed that prices of computer related products; such as processors, motherboard, RAM, monitor; have been decreasing constantly over time. This can be explained in the light of Proposition 3.3 using standard demand-supply diagram. Suppose that the diagram here shows the market for IT products with Do and So initial demand and supply curves. Over time, computer technology has been constantly improving which means that the supply curve is shifting rightward over time. As a result, prices are decreasing from Po to P1 to P2 and so on. e a b So S1 P1 Do P0 S2 P2 Pit ITo IT1 IT2 IT Fall in Supply The last possibility is that the supply curve shifts inward reflecting a fall in supply. This case is shown in figure 3.22. Proposition 3.4 summarizes the outcome of fall in supply on the market (work out the explanation of this diagram yourself). Figure 3.22: Effect of fall in supply on marketS1SoExcess Demand30 = PoDo40 = P1zyexox1x0Px Figure 3.22: Effect of fall in supply on market S1 So Excess Demand 30 = Po Do 40 = P1 z y e xo x1 x 0 Px Proposition 3.4: If supply of a commodity falls, market price increases while quantity sold decreases, given standard demand and supply curves Read Application Box 3.6 to see this proposition in practice. A P P L I C A T I O N B O X 3.6 Understanding The 2006 Sugar Crises 4025DSBASsoSs1PSugSugar10.80Let us explore the sugar crises that hit Pakistan in early 2006. To analyze this situation, we develop a basic demand-supply model. The standard negatively sloped demand curve and positively sloped supply curve of the sugar market are used to model this situation. Their intersection determines the equilibrium price of sugar at Rs 25/kg at which, say, 1 million kg of sugar is sold per month. Now suppose that the supply of sugar decreases because of hoarding made possible by the corruption of sugar seths (mill owners) who are duly supported by the Musharraf government. The supply-curve shifts backwards, as shown by the dotted line. Such a situation will have an adverse effect on consumers as the “equilibrium” price of sugar rises to, say, Rs 40/kg while quantity sold is 0.8 million per month. Consumers are purchasing less sugar at a higher price. We will see in chapter 5 on elasticity that this situation will make sugar seths better off by increasing their profit margin. 40 25 DS B A Sso Ss1 PSug Sugar 1 0.8 0 We can compactly summarize the results obtained in this section in Table 3.5. Table 3.5: Summary of Demand-Supply Results If Market price Quantity sold 1 Demand increases Increases Increases 2 Demand decreases Decreases Decreases 3 Supply increases Decreases Increases 4 Supply decreases Increases Decreases The procedure to analyze any given situation within the ideal—not actual—capitalist market can be outlined as follows:

Draw the standard demand-and-supply curves and identify an initial equilibrium price and quantity sold at the point of their intersection Given the situation to be analyzed, determine: which side of the market (demand or supply) will be affected by the given situation, and in which direction (i.e. whether demand or supply will increase or decrease) Once you have shifted the curve in the appropriate direction, identify the problem (of excess demand or excess supply) at initial market price Follow the logic of the price mechanism to determine new equilibrium point (i.e. price increases in case of excess demand and price falls in case of excess supply) Compare old and new equilibrium prices and quantity sold. 3.4.3: Simultaneous Changes in Demand and Supply We have so far analyzed the situations in which only one of the two curves changed at a time, i.e. either the demand or supply increased or decreased. We can extend this demand-supply framework to model the situations when both demand and supply change at a time. No major change is brought about by this extension except that now both the curves will shift at a time. Here we discuss one of the many possible combinations. Increase in Demand and Fall in Supply Consider figure 3.23 where initial demand and supply curves of chicken intersect at point e with market price Po and quantity sold co. Now suppose that it is the peak wedding-season in Karachi which runs usually from November till February. During this season, demand for chicken increases due to its large consumption in marriage and Valima ceremonies. This means that the demand curve shifts outward to D1. Further assume that bird-flue virus also hits the country during the same season and a lot of chickens are immediately disposed off which shifts the supply curve inward to S1. Figure 3.23: Effect of simultaneous changes on market (I)So90 = PoDo160 = P2gfeD1S1120 = P10c1coxcPc Figure 3.23: Effect of simultaneous changes on market (I) So 90 = Po Do 160 = P2 g f e D1 S1 120 = P1 0 c1 co xc Pc If you delete the initial demand and supply curves Do and So, you can clearly see that now there is excess demand at the initial price. To determine the new equilibrium point, just see where the new demand and supply curves are intersecting i.e at point g. At this point, price has increased to P1 while quantity sold is the same. Why is it that quantity sold remains the same? To see the reason, look at table 3.5 again. According to this table, if demand increases and supply falls, the market price will increase for both the reasons, as indicated by the two arrows. So, the effect of both changes on price is on the same direction. However, the effect on quantity sold of these two changes is in opposite direction, as shown by the table. To see this in the graph, note that if supply had not decreased after increase in demand, then the new equilibrium would have been at point f with P1 price and c1 quantity sold. But reduction in supply pulls quantity sold back towards co. The diagram is drawn such that demand and supply curves are shifted in equal amount so that rise in quantity sold due to increased demand is exactly off set by fall in quantity sold due to reduction in supply.

However, there is no reason to assume that both the curves will shift in equal proportion. If the demand curve shifts out by more than the inward shifting supply curve, then price as well as quantity sold will rise, as drawn in figure 3.24. You can think of a number of combinations regarding simultaneous increase or decrease in demand and supply (we leave this as practice). Figure 3.24: Effect of simultaneous changes on market (II)So90 = PoDo140 = P3geD1S1xcxox10Px Figure 3.24: Effect of simultaneous changes on market (II) So 90 = Po Do 140 = P3 g e D1 S1 xc xo x1 0 Px 3.5: Why Economists Insist on Equilibrium? When one draws the market demand and supply curves for any real world market for a commodity—onion or computer hardware or motor cycles—they would look like the one in figure 3.25. The market demand curves shown in economics textbooks not only don’t exist, but also they cannot exist. Adding up “well behaved” individual demand and supply curves never yields “well behaved” market curves for the reasons we will discuss in detail in the course of book (see chapters 8, 11, 12 and 13). Some of those reasons include the facts that every change in price affects income distribution, consumers have different tastes (Motorcycles may be a normal good for Nomi but an inferior good for Farooq and a luxury good for Abul Bashar), most producers face constant returns to input, some firms enjoy increasing returns to scale, all commodity markets are integrated through finance etc. Market supply and demand cannot behave properly. Why then do economic text books continue to pretend that both market supply and demand slope smoothly: one upward and the other downward? Figure 3.25: Real world market demand and supply curvesSoDox0Px Figure 3.25: Real world market demand and supply curves So Do x 0 Px They do this for ideological reasons. They want you to believe that capitalism is a rational system. It is not a rational system at all. From the time of Adam Smith apologists for capitalism have argued that when one person (the butcher and the baker according to Smith) seeks to maximize his utility / profit, social utility / profit is automatically and necessarily maximized—the invisible hand argument. Capitalism is, in this view, a naturally benevolent system and it is rational to allow the butcher to pursue his self interest and not to interfere with his production and pricing decision. This is nonsense. The capitalist butcher is greedy (accumulative) and jealous (competitive). He exploits his customers, his employees and all those who are in his supply chain whenever he is able to do so. Capitalist society or civil society is inherently conflicting and as Figure 3.25 shows there are many possible equilibrium outcomes in the market, each benefiting one set of individuals at the expense of other individuals. There is no unique equilibrium price or equilibrium quantity demanded and supplied. But Samuelson and Mankiw cannot admit this, for admitting this is accepting that capitalism is not a rational system. When individuals are led to maximize their own utility and profit, social utility and profit is not maximized. That is why capitalist state must step into limit capitalist exploitation and capitalist injustice. Figure 3.25 shows that capitalism is an inherently unstable, vicious, crises prone system in which every equilibrium level is constantly being undermined by continuing conflict and struggle among greedy (accumulative) and jealous (competitive) individuals. Equilibriums are produced either by chance or by force and prices have a tendency to move away from—not towards—these arbitrary equilibrium points. If you ever study mathematical chaos theory, you will understand how this happens (of course not a part of this textbook).

Economics pretends that this does not happen because it is capitalism’s ideology. Its main concern is to justify capitalist order not to explain how real world capitalist markets actually function. In other words, the major objective of economics is to prescribe how real world should be forced to function. Key Concepts Change in demand is the shift in demand curve for a good brought about by changes in prices of related goods or income of the individual Change in quantity demanded is the movement along the demand curve due to change in the own-price of a commodity. This is different from change in demand Complements are goods that are used together Cross price effect is change in the demand for one good, say x, due to change in the price of another good, say y Demand curve shows the amount of a particular commodity, say x, a consumer is ready to purchase at different prices Demand function shows the relation between consumption of a commodity and all factors that can change its demand, the prices of all goods and income of a consumer Demand refer to the amount of a commodity that a consumer is willing and able to purchase Determinants of demand are factors that affect a consumer’s decision of ‘how much amount of a commodity to purchase’ with his income Equilibrium is the position where there is no further tendency for change. In the context of market, it refers to the situation when demand is equal to supply Equilibrium price is the price where demand is equal to supply Excess-demand refers to the situation when demand is greater than supply at some positive price level Excess-supply refers to the situation when supply is greater than demand at some positive price level Inferior goods are goods for which there is negative relationship between income and demand Inverse demand curve shows quantity demanded of a commodity as a function of its price Law of demand says that other things held constant, there is inverse relationship between demand and price of a commodity Law of supply says that other things held constant, there is positive relationship between supply and price of a commodity Market demand is the sum of all individuals’ demand at a particular price. Graphically, it is the horizontal summation of individuals’ demand curves at all price levels Market or price mechanism is the tendency for price to change until market clears Market supply is the sum of supply by all individual firms at different price levels Normal goods are goods for which there is positive relationship between income and demand Own price is the price of a commodity in some monetary terms Substitutes are goods that can be used in place of each other because they serve more or less the same purpose in the eyes of a consumer Supply function simply says that sellers’ decision to sell a particular amount of output depends upon the own price of commodity that they are selling, prices of inputs and technology Supply is the amount of output that individuals are willing to sell at positive price Chapter Summary

“It is a question of demand and supply”. This is the standard answer economics gives to all questions Economists believe that the most significant factor influencing the demand for a commodity is its own price. Other determining factors include price of related goods, income and taste. In capitalist society tastes are very significantly affected by advertisement. Expectation about changes in prices and income also influence demand. Demand also responds to changes in laws and institutions The theory of demand applies only to capitalist societies. The “rational consumer” first appeared in a large number in sixteenth century Europe The Law of Demand holds that in capitalist society, other things remaining unchanged, the demand for a normal good rises as its price falls Since quantity demanded is hypothesized by economic theory to be a function of price the slope of the inverse of the demand curve is estimated The ‘normality’ or ‘inferiority’ of a good is not determined by any intrinsic characteristic of that good. It mostly reflects the desires / tastes of capitalist consumers Demand for a good increases when the price of substitute goods increase and the demand for a good decreases when the price of its compliment good increases Advertising increases demand and creates a taste for new products. It is a means for stimulating desires Economics assumes that adding up the preferences of individuals within capitalist society yields total social preferences. This is the market demand curve. The market demand curve is expected to be smooth and not kinked because an infinite number of consumers are expected to enter the market as price changes minutely Unreliable—not merely unrealistic—assumptions have to be made to derive the smooth downward sloping market demand from individual demand curves. The market demand curves neither in theory nor in real life have the characteristics identified by economic theory as recognized by Varian. Economists pretend that the market demand curve has this shape because they want to show that capitalism is a rational system. The true shape of the market demand curve—in theory and in real life—shows that capitalism is not a rational system The supply function postulates that supply is determined by price, costs of inputs and technology. The Law of Supply holds that other things remaining the same quantity supplied will rise with price The supply curve is supposed to be upward sloping because of the assumed operation of the ‘law’ of diminishing returns which states that costs increase as production increases The Law of Supply applies only to capitalist markets Supply falls when input prices rise and the supply curve shifts inwards. If technology “improves” supply increases. In capitalist society supply is also affected by changes in the price of related goods Normally individual supply curves are horizontal or downward sloping for costs fall with increased production. The “laws” of diminishing returns does not operate Economics believes that disequilibrium conditions cannot persist for long because utility maximizing consumers and profit maximizing firms respond rationally to price signals

The market mechanism is the process of price adjustment in response to excess demand and excess supply Increase (decrease) in demand raises (lowers) equilibrium price and output. Increases (decrease) in supply lowers (raises) equilibrium prices Market demand and market supply curves cannot have the shape economics says they have because adding up individual demand and supply curves “distorts” the shape of market demand and supply curves. This is because individuals have different incomes, different tastes and income distribution keeps changing. Most firms face constant returns and because all product and factor markets are integrated and there are no fixed “factors of production” in the short run Economists insist that adding up individual demand and supply curves yield “well behaved” market demand and supply curves for ideological reasons. Adam Smith developed the ideology that capitalism is a rational system in that when individuals do—and are allowed to—maximize utility and profit total social utility and profits are automatically, unintentionally and necessarily maximized This is nonsense: since the capitalist individual is greedy (accumulative) and jealous (competitive) capitalist society is conflictive and exploitative. There is no single unique equilibrium in the market but there are several possible equilibriums (Figure 3.25) and every individual and firm is struggling to reach and maintain the equilibrium which benefits him most. Social utility / profit cannot be maximized in capitalist markets because capitalist individuals maximize their own utility and profits by exploiting other individuals Review Questions What, according to economic theory, are the determinants of demand? What determines taste in a capitalist society? Why does the theory of demand apply only to capitalist economies? State and explain the demand function and the Law of Demand. Using the following data draw a demand curve. What does it show? Price of x (Rs) Amount of x Demanded 10 10 8 15 6 20 4 25 How is the slope of the demand curve measured? Calculate the slope of demand curve for above data. What is a normal good in capitalist society and what are ‘inferior’ goods? What determines whether a good is considered ‘normal’ or ‘inferior’ in capitalist society? What goods were regarded as inferior by Hazrat Usman? What is the effect on the demand for Coke when the price of Pepsi goes up and what is the effect on the demand for fountain pens when the price of ink goes up in capitalist society? Illustrate your answer using two diagrams. What is the social purpose of advertisements? What is the market demand curve? What assumption has to be made to derive the market demand curve from the demand curves of individual capitalist consumers? Why is the market demand curve kinked in Figure 3.7 and smooth in Figure 3.8? State and explain the supply function and the Law of Supply. How is the inverse of the slope of the supply curve measured? Why does the Law of Supply apply only to capitalist markets? Analyze the impact of changes in input prices and “improvements” of technology on supply. What is the meaning of technological “improvement”?

Analyze the impact of factors other than prices and input costs on supply. Why is this market supply curve kinked with two firms? When can the kinks disappear? What is the meaning of excess demand and excess supply? Define equilibrium. Why according to economic theory do markets tend to move towards equilibrium levels of output and price? What is the “price mechanism”? Using a diagram each, show the impact of (a) increase in demand (b) reduction in supply on equilibrium price and quantity. Was it justified to raise the price of food after the earthquake in Azad Kashmir? Would Hazrat Usman have done this? Why does the ratio of advertisement expenditure to total expenditure keep on rising in capitalist societies? Why can market demand and supply curves never have the shapes economic textbooks say they ought to have? Why do market demand and supply curves never “behave properly”? Why do economists pretend that market demand and supply curves are “well behaved”? Chapter 4 MARKETS AND PRICE CONTROLS The previous chapter discussed how market mechanism operates if left free from all interventions. But markets can move freely only if no private agent has any sort of market power; though ironically capitalism systemically concentrates power in the hands of a few. In this chapter, we see how governments can use their coercive powers to intervene in the market. Economic justification of state intervention is based on the view that sometimes it is not in the interest of capitalist society to let the market mechanism determine price and output levels. In such cases, it is the capitalist government which is supposed to control markets so that capitalist objectives are realized. We explained in chapter one that one of the major objectives of microeconomics is to provide the capitalist state with tools to govern civil (or market) society. This chapter will show you how the demand-supply model tells government what it should do and what it should not do. The capitalist government can intervene in the market in many ways: by limiting entry to the market; e.g. no private firm may be allowed to supply water at the national level by limiting exit from the market; e.g. many airports at remote locations, such as at Gilgit, are going in loss but government wants them to continue operating by controlling quantities sold or purchased, e.g. imposing quotas on purchase of imported goods by controlling prices of goods, e.g. mandating price-ceilings and price floors. The standard demand-supply model can be used to analyze all of these situations. In this chapter, we will examine the effects of only price controlling policies by capitalist governments on market outcomes. Let us discuss price ceiling first. 4.1: Price-Ceiling Some goods are so essential to life that it becomes difficult to leave their price determination at the market mechanism even in capitalist society. Suppose, for example, that the market price of atta (flour) after hoarding becomes Rs 50/kg and the capitalist government feels that this price is too high for consumers to buy atta. So it decides to control its price through a policy of price-ceiling. The price ceiling fixes the maximum price of a commodity that can be legally charged by sellers. Such a price is necessarily set below its current market equilibrium price. To see how it works, consider figure 4.1 which reproduces the sugar market example from Application Box 3.6. In this diagram, the price of sugar rises from Rs 25 to Rs 50 / Kilo after reduction in its supply due to hoarding by sugar mill seths (the initial supply curve Sso is drawn small because it has no role to play after the shift in the supply curve to Ss1). However, the government feels this price to be too high. So it opts to ceil the sugar price, say, at its initial price of Rs 25, Pmax. This is the maximum price that can be charged after the imposition of this ceiling and no firm can legally charge any price higher than this maximum price set by the government. Since the objective of government to ceil the price of sugar is to keep its price at a level at which it can be affordable to most consumers, therefore it is set below the current equilibrium price.

What will be the effect of this price-control over demand and supply? To see this, note that at price Rs 25 = Pmax, supply of sugar is 0.3 thousand tons while its demand is 1 thousand tons. Clearly, there is excess-demand or shortage of sugar in the market. This shortage develops because once price is reduced from Rs 50 (where demand and supply are equal) to Rs 25, quantity demanded increases as more consumers enter the market (recall the negative relationship between price and demand from chapter 3). On the other hand, a fall in price causes profit-maximizing sellers to reduce quantity sold (recall the positive relationship between price and supply from chapter 3). Thus, the immediate effect of the imposition of price ceiling is to produce excess-demand in the market. However, Application Box 4.1 shows that this effect is specific only to a capitalist society—a society formed by economic-men. Figure 4.1: Effects of Price CeilingPSug5025 = PmaxDSBASsoSs1Sugar10.80Price CeilingC0.3Market price is too high, soShortage Figure 4.1: Effects of Price Ceiling PSug 50 25 = Pmax DS B A Sso Ss1 Sugar 1 0.8 0 Price Ceiling C 0.3 Market price is too high, so Shortage A P P L I C A T I O N B O X 4.1 Rent Control after 9/11 Suppose that the Taliban launch a successful counter attack on the ongoing American terrorism against Muslims. In frustration, the American government deports all Muslims from America. Because many of those deported from America do not have permanent residences in Pakistan and yet they are rich, they prefer to spend their lives in Islamabad living on rent. This raises the demand for rental houses in Islamabad. The market for rental houses in Islamabad is shown in the diagram below. Note that the supply curve is drawn vertical here because the number of houses available for rent is fixed in the short-run and, therefore, it is very difficult to increase its supply even if its price is high. So, say 20000 houses are available for rent. The initial demand curve is Do and the initial market rental rate for an average house is, say, Rs 4000/month. After increase in demand for rental houses due to immigrants from the US, the demand curve shifts to D1. There will be excess demand for rental houses equal to 10000 (= 30000 - 20000) at the initial rent. So, rents will increase as immigrants compete for rental houses with existing residents by offering higher rents to house owners; and at the new equilibrium, rent is say Rs 8000/month in this market (see point c). SoDo4000 = PmaxD18000aRHb20000Prh030000cSuppose that the government is concerned about this rent rise and considers it unsatisfactory because it creates problems for local rental-residents in Islamabad. So, the P.M. decides to fix rental rates at this initial level of Rs 4000. He places price ceiling on rents. The effect of this policy will be to create shortage in the market for rental houses as more houses are demanded (30,000) by people at this maximum price than are available (20,000). By trying to overcome one market problem (i.e. high rents), the capitalist government has created another (i.e. excess-demand).

So Do 4000 = Pmax D1 8000 a RH b 20000 Prh 0 30000 c Let us now assume that Pakistan is an Islamic-Jihadi state. The outcome of the attack on the market for rental-houses after immigrants reach Pakistan can be understood in the light of Muwakhat-e-Madina between the Muhajireens of Makkah and Ansars of Madina after the event of Hijra. There developed no rental-house market whatsoever. The reason for the absence of ‘rent’ in that society was the fact that the Ansars were not ‘suppliers’ and they did not see the Muhajireens as their ‘demanders’—i.e. their relationship was not based on utility / profit maximization. Instead, the Ansars accommodated their Muslim brothers by sharing their houses and belongings with them. It is the underlying spirit of ‘demand and supply’ that causes rental rates to increase in such situations. A society that is not committed to the objectives of utility and profit maximization will not face the problem of excess demand. No state policy is required to cope with the issue of high rent rates in non-capitalist society. Non-Price Rationing The immediate result of price-ceiling is excess demand—capitalist demanders want more than suppliers are willing to provide. Such a situation is not sustainable in a world of utility / profit maximizing agents because demanders cannot live without increasing consumption while producers cannot miss out on profit making possibilities. If price is not fixed below current market equilibrium, say, in the rental markets, then the problem of excess-demand will be removed by increase in rents as the market reaches a new equilibrium point, c (figure in Box 4.1). With price-ceiling, house owners do not enjoy the option of (legally) charging rents above Rs 4000 = Pmax and excess demand cannot be translated into higher rents. Price cannot play its role of rationing demand to equal the amount supplied, and therefore the rental house market cannot clear. When price is not allowed to ration demand and make it equal to the quantity supplied in the market, this does not mean that the problem of scarcity has been solved in capitalist society. Removing the option of competition for rupees switches competition to channels other than price. Non price rationing is the use of mechanisms other than price to ration or equate the demand for something with its available supply. Such rationing may be intentional or an unintended response to excess-demand. Long queues: One response to the problem of excess-demand that can be predicted in case of price-ceiling is waiting time in long-queues. For example, suppose that a one-day cricket match is planned between Pakistan and India at the National Stadium, Karachi. The number of seats available is fixed, say 40,000. However, the demand for tickets is higher than the available seats, so there is excess-demand. One way of solving this problem could be to charge a high price for a ticket which will reduce demand. Since such an increase in price is not allowed, people have to wait in long queues to obtain a ticket. But how does this reduce the pressure of excess-demand? Obviously, the waiting time and effort required to obtain tickets in these long queues discourage many people from purchasing tickets and, hence, some demanders go out of the market. This will help reduce the gap between demand and supply (see Application Box 4.2).

A P P L I C A T I O N B O X 4.2 Long Queues at Utility Stores After the sugar crises of 2006 the government tried to reduce public frustration by providing sugar at lower controlled-rates, in specific utility stores. People rushed towards these outlets in order to purchase cheap sugar. This resulted in sugar sacks going empty very shortly, thus creating excess demand. People turned up many hours before the utility stores opening time waiting in long queues. First-Come-First-Served and Lottery: Another way to cope with the problem of excess-demand is to introduce the device of first-come-first-served. You can often see advertisements saying: ‘this offer is for a limited time period’ or ‘only a few seats are available, so be quick to apply’. Another way is to draw a lottery. For example, when the government announces a new residential-scheme, such as Taisar Town in Karachi, the applicants are usually far larger than the available plots; sometimes there are 10,000 applicants per plot. In order to allocate these plots among these potential buyers, government uses the institution of lottery. Where does this excess-demand develop in case of residential plots? If you think that it arises because so many people are homeless in Karachi, then you are wrong. Rather, it arises merely due to the lust for making-profit. It is observed that almost 90% of the applicants for these plots are those who already posses their personal residence and merely want to invest their savings in some lucrative project. Thus, the probability of getting a house in the lottery scheme by the remaining people who do not possess a house and really need it diminishes by a great deal. And this possibility further decreases after the lottery is drawn. To see this, suppose that originally, the price of a 120 yards plot is Rs 100,000 payable in installments. Once the lottery is announced and most of the plots are won by the speculators, the prices of the plots go up sky high, such as to Rs 500,000/120 yards plot which makes it impossible for a poor and needy person to purchase that plot in the second round. Money keeps moving among the few. It is the lust for maximizing-profit which is responsible for the extreme hunger and homelessness in major parts of the world. On the other hand, if society is non-capitalist, providing personal home at affordable prices will no longer be a problem because in such a society, land prices will not increase by much overtime due to the absence of ‘demand for plots for speculation and profiteering’. People will own houses mainly for the purpose of ‘personal residence’ and not for ‘investment’ as in capitalist societies. Quota or Quantity Restrictions and Holidays: Sometimes, the capitalist government may decide to restrict the amount of the commodity that people can purchase at any time to dampen the pressure of excess-demand. For example, if petrol prices are reduced to Rs 40/liter, it may create excess-demand. Government can then issue several coupons labeled with certain amount of oil that one can use per day; e.g. the government may announce that you can have only 4 liters/day. Holidays are another means to control excess-demand for a commodity. For example, the sale of mutton is not allowed on Tuesday and Wednesday throughout Karachi so that some of its demand may be reduced. During summers 2009 and 2010, all large markets of Karachi; such as Tariq Road, Sadar, Clifton, etc. were forced to shut-down by 8:00 P.M. The objective of this time restriction was to deal with the problem of electricity shortage in Karachi city which arose due to the corruption ridden privatization of KESC. However, this involved loss to sellers due to fall in their sales. Again, the problem of short-supply of electricity arises due to the existence of capitalist living styles in which people go for shopping late at night. If this practice is abandoned by the public (as is the case in the country-side), then markets will automatically shut down before Maghrib Prayer and, hence, neither state enforcement will be required in this case nor will it result in sellers’ loss.

Quality Compromise: In some cases, non-price rationing can develop in the form of reduced quality of the services offered at controlled prices. For example, in the case of rental housing, most of the services provided by the house-owner are not explicitly written into the contract. The house owner may agree to provide hot water during winter, but does not state the temperature to be maintained. Help in changing over the utilities from one tenant to the next may be provided or withheld. House owners may reduce the frequency and expense of house maintenance—i.e. the apartment would not be repainted between tenants, cleaning would not be done, major repairs would be put-off. This under-maintenance of the house will gradually reduce the market value of the rent-controlled house to the level of the price ceiling. Thus the quality of life in a rent-controlled house can drop substantially. Read Application Box 4.3 to see how price-controls will affect the quality of Bakra-Mandi during Eid-ul-Adha. A P P L I C A T I O N B O X 4.3 Price-Control in Bakra-Mandi SgDg200 = PmaxPrice Ceiling300cGoatsb15Pg020a10 Bakra-Eid is one of the two major religious events of Muslims. People buy sacrificial animals in order to present them as a token of their submission to the will of Allah Almighty. But the lure of profit-maximization turns this event into a market phenomenon. Prices of animals, especially of goats, keep on rising every year making it difficult for people to participate in this religious event. One response to this phenomenon is the participation in ‘combined-sacrificial animals’, such as that of the cow. Let this diagram represent Bakra-Mandi where the price of an average goat is Rs 300/kg (which means that a 30 kg goat costs around Rs 9,000) and 1.5 million (15 lacks) goats are sold to the public. Frustrated by this high price, people want the government to force sellers to sell goats, say, at Rs 200/kg. Technically speaking, the public is asking for a price ceiling. But how will it affect the goat-market if sellers are profit-maximizers? Clearly, it will create excess-demand equal to the distance cb (= 20 units demanded – 10 units offered for sale). Excess demand develops because as price is reduced to Rs 200/kg, quantity demanded increases as some new customers enter this market while quantity supplied falls as some sellers refuse to sell healthy goats at this price. Sg Dg 200 = Pmax Price Ceiling 300 c Goats b 15 Pg 0 20 a 10 One non-price rationing response to this excess demand will be that sellers might bring only small-sized or unhealthy goats (tedi bakra) for sale in the market and withhold the healthy ones. Pakistan Navi normally offers such controlled-price animals for their employees on the basis of their weights. However, if you visit these controlled-price markets, you will find largely small-sized and low quality animals for sale. Political Influence: Influence, connections and politics can sometimes also help solve the problem of excess-demand. For example, to get admission at NED University, students do not and cannot outbid the other applicant by paying higher tuition fees. Even to be considered at all for admission, you must have superb grades at intermediate level. But grades are not the only instruments with which some people actually compete. Entrance to such universities are sometimes sold by politicians or provided with greater ease to their families and friends. Political influence is sometimes also excreted on the basis of race, national origin or physical beauty of participants to qualify for a particular post.

Remember that these are but only a few ways of allocating resources in case of excess-demand. Their exact form cannot be predicted. It may vary from case to case. However, if the price is held fixed, there must develop some device to reduce the gap between demand and supply, if the people are not willing to do it themselves, in capitalist society irrespective of whether that device is intended or unintended. See Application Box 4.4 for an interesting example of this case. A P P L I C A T I O N B O X 4.4 Handling Food Shortage at Marriage Ceremonies Many times, the actual number of guests in a party exceed the expected or invited guests. Suppose that you have arranged dinner for 200-expected guests at a marriage ceremony. However, 250 guests turn up which results in food-shortage. It is difficult to provide additional food at the spot. One way of overcoming this problem could be to convert this event into a market-exchange by asking guests to pay some price for food which will reduce demand as some guests will refuse to pay anything and will leave the hall (to never come again to any of your future events!). But social norms do not allow such a practice. Another standard way of resolving food-shortage at these events is to ask your close-relatives not to have food at the hall because this problem has occurred on the promise that they will be served later at the home. Another way is to slow-down the supply of food; i.e. to reduce the frequency and hence increase time interval of providing additional food at tables after its initial service. Many people leave and refuse to wait. This reduces some pressure on excess demand for food. 4.1.1: Black-Markets Another aspect of price-ceiling that deserves government attention so as to make this policy work effectively is black-marketing; i.e. the practice of selling a commodity above its legal price. This phenomenon is present in almost all capitalist societies—societies that are composed of utility and profit maximizing individuals. To understand how black-markets work, let us go back to the demand curve again as drawn in figure 4.3 (we discussed this in chapter 3). Any point on this demand curve can be read in two equivalent ways. Consider point A on this curve. One way to read this point is to say that the ‘consumer is willing to purchase 4 units at a price of Rs 9/unit; i.e. at Rs 9/unit, he is ready to purchase 4 units’. However, we can also interpret it as the ‘consumer is willing to pay 9 rupees per unit for 4 units’; i.e. for 4 units, he is ready to pay 9 rupees per unit’. In other words, the height of the demand curve at any quantity measures ‘how much the consumer is willing to pay for that number of units’. For example, for 7 units, the consumer is willing to pay Rs 6/unit (point B). This point is the key to understanding how black-markets work. Now consider figure 4.4 which redraws the market for sugar from figure 4.1. At the controlled-price Rs 25/kg, consumers want to purchase 1 thousand tons of sugar in total. On the other hand, sellers are offering only 0.3 thousand tons of sugar. Hence, the maximum sugar that consumers have available is 0.3 thousand kg which means that some consumers must go without any sugar or have less than what they want to consume (because demand is greater than supply).

Figure 4.3: Interpreting demand curvePx96DxABx7409 Rs/unit for 4 units6 Rs/unit for 7 units Figure 4.3: Interpreting demand curve Px 9 6 Dx A B x 7 4 0 9 Rs/unit for 4 units 6 Rs/unit for 7 units Now ask yourself: how much can consumers be willing to pay for this much sugar? To see this, read-off the price at the demand curve against 0.3 thousand ton quantity at point D which is Rs 65/kg (the height of the demand curve at quantity 0.3). This point says that there are some utility-maximizing consumers who are willing to pay Rs 65/kg for sugar. Such individuals get frustrated waiting in long queues for sugar and eventually getting nothing! Therefore, some sellers may sell some sugar to such individuals outside the market at this high price in order to make additional profits. This creates a black-market for sugar where it is sold above its controlled-price. Thus, Rs 65/kg is the black-market price of sugar. Note that it is not necessary for sellers to charge exactly Rs 65/kg. Any price between Rs 25/kg to 65/kg will work. Rs 65/kg is the maximum black-market price that they can charge. Also note that black-market price is even greater than the equilibrium price of sugar, Rs 50/kg. The black-market phenomenon illustrates another problem that develops due to price-controls. If the capitalist government wants to make this policy effective, it must ensure that the black-market does not develop for the commodity whose price is to be kept under control, because otherwise it will be a self-defeating exercise. Clearly, the objective of the government is to benefit the consumers. However, if sugar is sold in the black-market at even higher than equilibrium prices, then the policy will actually make some consumers worse off. This means that price-ceiling can work effectively only if (1) the product is actually sold out at the controlled-price and (2) black-markets do not develop. Both these conditions require the government to spend a large amount of money for monitoring the effects of price-control. The administrative problems faced by the government of Punjab in providing ‘2-rupee roti’ to the public is an example of difficulties associated with the policy of price-ceiling. Figure 4.4: Demand In the Sugar MarketDPSug5025 = PmaxDSASs1Sugar10.80Price CeilingC0.3Some consumers are ready to pay this price65 = Pblack Figure 4.4: Demand In the Sugar Market D PSug 50 25 = Pmax DS A Ss1 Sugar 1 0.8 0 Price Ceiling C 0.3 Some consumers are ready to pay this price 65 = Pblack 4.1.2: Objectives of Price-Ceiling If price ceiling carries so many rationing-problems with it, then why do the governments of almost all capitalist countries practice such control over prices in case of many commodities? There are several reasons for this, we discuss some of them below. Consumer Affordability As outlined above, the government may set the price of a commodity below its current market equilibrium price in order to make it accessible for most consumers (as is the case for ‘2-rupee roti’). Much has been said about this already.

Price Stability The prices of some commodities are subject to large variations if left to the forces of demand and supply and government, therefore, may wish to smooth out these variations by fixing its price in the interest of both consumers and producers. For example, agricultural products are subject to unplanned variations in supply; due to weather conditions, diseases, etc. output can be greater or less than that which farmers planned to produce. To see how this works, consider figure 4.5 which shows market for wheat, one major agricultural product. Figure 4.5: Output Fluctuations in the Wheat MarketPwh120006000DwBASw1Wheat30250C15SwoSw28000 Figure 4.5: Output Fluctuations in the Wheat Market Pwh 12000 6000 Dw B A Sw1 Wheat 30 25 0 C 15 Swo Sw2 8000 In this diagram, Swo is the planned quantity of wheat by the farmers at the beginning of the year. Farmers would be happy to produce, say, 25 million tons of wheat at Rs 8000 per ton. Suppose dry weather or some disaster hits the country and supply decreases to Sw1. This raises the price of wheat to Rs 1200 per ton. Such a high price might suit farmers but causes distress or even famine among consumers. On the other hand, if the actual supply is Sw2 due to extra ordinarily good weather, then consumers might be delighted to have a price of Rs 6000 per ton but this will leave farmers in an undesirable situation, as some may not be able to cover the cost of their production at this price. One might argue that it would be necessary for the government to try stabilizing prices and incomes. But how can a capitalist government do this? One way to achieve this end is to create a government agency. Suppose that this year, we have the situation shown by the Sw2 supply and with quantity supplied equal to 30 million tons. The agency can purchase the extra 5 millions and store it which will drive price up to Rs 8000/ton. If supply is Sw1 in the subsequent year, the agency can then release 5 million tons from its store so that price can be maintained around the market equilibrium price, Rs 8000/tons. Neoclassical economists emphasize that this policy is not easy to implement because it is difficult to determine the ‘correct’ market price of a product and decide how much of a commodity to purchase or release in any one year. The example shows that if the capitalist-state is committed to stabilize the price of a commodity at or around some desired level, then it must control quantity supplied in order to address the problem of excess-demand. Maintaining Competitive Prices Another reason for fixing prices could be to avoid increase in prices that result from artificial reduction in supply. Consider for example fruit prices during the month of Ramadan. Let us assume that the price of an average quality banana is Rs 15 per dozen one month before Ramadan. In order to increase profit margins during Ramadan, the capitalist-banana producers—those who produce banana for the objective of maximizing-profit and not for fulfilling their religious obligations—withhold its supply from the market for a week or two so that market prices may increase to, say, Rs 25/dozen. The situation will look very similar to figure 4.1. Once prices have increased, they bring the withheld quantity of bananas to the market so that its price remains at Rs 25/dozen. Very often you can see price-controlling authorities announcing that prices of fruit items will be regulated during the month of Ramadan. One way to regulate prices is to set them at their current market level. Apparently, this will destroy the incentive for suppliers to make additional profit by reducing their supply. However, capitalist-producers may offer bribes to capitalist-state-officials in order to make such policy measures ineffective; a phenomenon present in all capitalist societies.

Another situation when government wants to control prices around their market or competitive price levels is during wartimes and disasters. It is likely that profit-maximizing producers may charge higher prices for their products when people are in dare need of them, when the country is involved in wars and there is shortage of a commodity or after a disaster has hit a region. Income Redistribution Another objective of instituting price-ceiling is to control the incomes earned by one segment of society or redistribute it from one segment to another. The European Union’s Common Agricultural Policy is specifically designed to meet this end as is the Japanese subsiderization of domestic food production. The incomes earned by individuals in a capitalist society depend upon the prices of commodities and services they offer for sale. For example, if Farooq rents-out a house, then his income will depend upon the rental-rate; i.e. the higher the rental-rate, the higher will be his income, and vice versa. Similarly, the income earned by the KFC franchiser depends upon how high the price of the KFC burger is. If people abandon consumerism—the practice of finding meaning and value in more and more consumption of branded and famous goods—the price of a KFC burger may go down suddenly to, 40 paisa and its franchiser will find it difficult to run such well-furnished outlets as his revenue will fall dramatically. Therefore, when government puts price-ceiling on some commodity, e.g. on rental-rates, then this will lower the incomes of house-owners in favor of tenants. Standard microeconomic tools can be used to analyze this situation, but this will involve some additional concepts which will be introduced later when we study input markets. 4.2: Price-Floor As price-ceiling is aimed at benefiting consumers, price-floor is designed to help producers. Price-floor is the minimum price that must legally be offered for a commodity. This minimum price is set above the equilibrium market price of a commodity and any transaction of that commodity below this minimum price is illegal. The European Union, Japan, South Korea and the USA use price floors for almost all locally produced agricultural communities. To see how this works, consider figure 4.6 which shows markets for cotton. If the market is left alone, it reaches an equilibrium price of, say, Rs 10/cotton bushel at which 100 units are exchanged as shown at point e. Suppose that cotton producers persuade the government to increase this price because this price is too low to cover their cost of production. The government imposes a price of, say, Rs 14/cotton bushel above the current market equilibrium price. Since no transaction can take place below this price, therefore this is the minimum price for cotton, and is called price-floor. Note that such a price-floor will create excess-supply of the commodity in the market. At this controlled-price, quantity supplied (120) exceeds quantity demanded (80). In an uncontrolled market, forces of demand and supply tend to move price down towards the equilibrium price and hence eliminate surplus. But once price is set above the current equilibrium level, it can no longer fall below this controlled level. This means that the price floor will cause producers to produce more than what buyers are willing to purchase. Farmers may be happy to receive a relatively high price, but will not be happy about their unsold production. Usually, capitalist government steps in to buy the surplus agricultural production. European Union and American governments destroy millions tons of agricultural commodities every year to keep their prices high.

Figure 4.6: Price Floor for CottonbPcot10 = PeDceScCotton1201000Price Floora80Market price is too low, so 14 = Pmin Figure 4.6: Price Floor for Cotton b Pcot 10 = Pe Dc e Sc Cotton 120 100 0 Price Floor a 80 Market price is too low, so 14 = Pmin 50 50 As we saw above the shortages developed due to price-ceiling can lead to some ‘undesirable’ rationing mechanism (we discuss in next section why economists regard them to be ‘undesirable’). Similarly, surpluses develop after price-floor which requires some rationing-mechanism to handle excess supply. Clearly, if production is undertaken for profit-maximization, we can see that some sellers will be unable to sell their products at controlled-price in case of price floor fixing as producers have produced more than what demanders want to purchase. In this scenario, sellers will have to finance rising inventories. This is a very serious problem of production facing mature capitalist economies. See Application Box 4.5 which discusses the heatedly debated case of price floor fixing in economics. Also see FYI Box 4.1 to note a terminological confusion. A P P L I C A T I O N B O X 4.5 The Minimum Wage Law Controversy DLSL100 = waMinimum wage rate125 = wmincLaborLaWage0LcbLbaUnemployment One of the best examples of price-floor fixing is the imposition of minimum wage law in many social democratic capitalist countries. This law dictates a minimum wage that must be paid to labor by an employer. For example in Pakistan, currently the minimum legal wage is Rs 6,000/month. To see how it works, first note that labor services are treated as a commodity like any other commodity, such as potatoes. In other words, you can represent the labor-market by demand for and supply of labor. The demand for labor is made by firms while its supply comes from workers. The demand curve for labor is drawn negatively sloped because there is assumed to be a negative relationship between demand for labor and its price; i.e. the wage rate. As wage rate decreases, firms demand more labor, and vice versa. On the other hand, labor-supply is assumed to increase as wage rate goes up (see chapter 15 for detailed discussion on labor demand and supply). This is shown in this diagram. If the government does not interfere in this market, current market equilibrium wage rate is adjusted to that level where labor supply equals its demand. Here it is at point a where wage rate is, say Rs 100/day and La workers get jobs. DL SL 100 = wa Minimum wage rate 125 = wmin c Labor La Wage 0 Lc b Lb a Unemployment However, suppose the government feels that this wage rate is too low for a person to live, so it decides to impose a minimum wage of Rs 125/day above the market equilibrium wage. The result of this policy is that labor supply (Lc) exceeds labor demand (Lb) at this wage rate. Clearly, the number of individuals who get job is Lb, the amount of labor that firms want to hire, while the remaining (Lb – Lc) go without jobs. So, minimum wage law creates unemployment in capitalist labor markets. Thus, although minimum wage rates increase the incomes of those who have jobs, but they also lower the incomes of those workers who cannot find jobs or who have been laid-off by firms after increase in wage rate (La – Lb workers have lost their jobs after this wage rate policy). There is a heated political debate on the issue of minimum wage law among capitalist economists. Advocates of this policy point out that unskilled labor will not be able even to live without such laws because their market wage would be too low. Opponents believe that minimum wage law is not the best way to fight poverty because it creates unemployment.

FYI: B O X 4.1 Note on Terminologies Students sometimes confuse price-floor and price-ceiling because of their position of placement with respect to the market equilibrium level. For example, students tend to reason like this: ‘since floor is below our feet and ceiling is above our head, therefore price floor should be below equilibrium while price-ceiling should be above’. Note that this interpretation is faulty. The reason behind price-floor being named so is that it is the minimum price while price-ceiling is the maximum price. That is why the former is called floor (because it is the minimum level) while the letter is named ceiling (because it is the maximum level). 4.3: Why Economists Preach Free-Markets? We have spent much time understanding the market process in the previous as well as this chapter. Let us now spend some time trying to understand why economists are in favor of the free market process and against government intervention in the form of price-controls. This can be grasped after we understand the role of price—what buyers pay to the seller in exchange for some commodity—in capitalist economies. Price as Information, Incentive and Allocative Device To neoclassical economists, prices of goods give information to market agents (consumers and sellers). More importantly, they claim that free markets are the best allocators of resources as they correctly represent consumers’ desires in a capitalist society. For example, suppose that American citizens want to have more wine. This will increase the demand for wine in America. If the market is allowed to operate freely, price of wine increases. This increased price is giving information to agents that the profit-margin in the American wine industry has increased relative to other industries. Motivated by this high profit, some firms will shift resources, say, from wheat production to grape production; hence the production or supply of wine will increase in America. Note that this is exactly what the Americans wanted; i.e. to have more wine. Taking another example of how prices allocate resources according to consumers’ preferences by providing information to agents, suppose that British society wants to have more MBAs as compared to IT professionals. How will this desire be signaled to suppliers? Alternatively, who will decide that more MBAs and less IT professionals should be produced now? To economists, the answer is the price mechanism. The idea is that the forces of demand and supply operating in the British labour market will automatically solve this problem. When demand for MBAs increases in Britain, its price (or salary of an MBA) will increase. On the other hand, because demand for IT professionals has decreased, their salary levels would fall. This increase in price or salary of MBA will provide incentive to people of Britain to become MBA professionals instead of IT professionals—students will enter the business schools instead of IT colleges, more universities will start offering MBA program and some may stop offering IT programs because it is not profitable now. Thus, supply of MBAs will increase while that of IT professionals will fall. In other words, resources from the IT specialists producing industry will be shifted to the MBA producing industry and more resources will now be allocated to the MBA producing industry as compared to the IT producing industry—something that the consumers wanted.

These examples show that prices give information to market agents just like traffic-signals in a capitalist society—they guide people about which direction they should move in and when to stop. When a traffic-signal goes red, everyone stops and when it is green every one starts moving in that direction. Similarly, when the price of a commodity, activity or skill is high in a capitalist society, market agents see this as an opportunity to make more profit by engaging in the supply of that particular commodity, activity or skill. 4.3.1: Logic behind Elimination of Price-Controls With this background in mind, let us see why economists hate government intervention in the form of price-control. Distortion in Resource Allocation One reason why economists consider price-controls a social evil is due to its adverse effect on the resource-allocation mechanism in a capitalist society. To them, when individuals are left free to compete with each other, the invisible hand automatically brings supply in line with demand without the need for any central-planning. Moreover, when government sets a price of a commodity other than its equilibrium price, say through price-ceiling, then it ‘distorts’ the allocative processes of the market by providing wrong signals to market agents. For example, in the case of price-ceiling, there develops excess demand due to the existence of a lower than market price. This controlled price has created a mismatch between consumers’ and producers’ calculations by giving wrong signals to them. If the market process is allowed to operate freely; say if consumer desires are left free to play their part in capitalist society, then this excess-demand will be eliminated automatically by the price-mechanism. Excess demand will push price upwards, giving producers an incentive to produce more on the one hand, and discouraging some consumers from participating in this market as the price increases. Similarly, when government creates a price-floor, through e.g. minimum wage laws, it also ‘distorts’ the resource allocation mechanism by giving wrong signals to market agents, resulting in excess-supply. Hence the market mechanism should not be interfered with. Social harmony is assumed to prevail when all individuals are allowed to pursue their own utility and profit maximization. Non-Money Competition There is even a more fundamental reason underlying economists’ opposition to price-controls in a capitalist society. We discussed in this chapter that when price-controls are applied, some non-price rationing mechanism develops to handle the problem of excess-demand or excess-supply. The fundamental problem—the problem which makes price-control an ‘evil’ in the eyes of the economists—with non-price rationing is that it shifts competition from money-prices towards other margins. A capitalist society works when the only thing that individuals want or value is money. To see this note that in a market economy, all features of a commodity can be converted into money. Economic rationality requires individuals to convert even the slightest quality variations in the commodity or service into money by putting a price on it. For example, suppose you own an extra house to rent. According to the economist’s advice, the rent that you should charge must take into account all possible factors, such as: the number of rooms, the size of rooms, services such as electricity, gas connections, condition of wall-color, so on and so forth. Similarly, if you have two extra fans and tube-lights installed in your house, then this feature must also be converted into money by adding some additional rupees into the rental. In brief, each and every feature of a commodity must be priced to make more money because earning more and more money is the only way that allows individuals to buy the commodities they desire. When non-price rationing starts, the medium of exchange shifts to a resource other than money; i.e. people may start using something other than money to buy commodities. For example, political friendship, influence, nobility status, family or religious ties may become media of exchange. The value of these resources induces people to invest their time and effort in acquiring them. And according to economic rationality of maximizing utility / profit, even a minute of one’s time invested in developing these relations or resources represent economic waste for capitalist society because these investments create no new capital—they just represent attempts to invest in redistributing existing wealth. For instance, in non-capitalist societies, people frequently visit their relatives and spend hours with each other discussing merely family ties and issues. Social collectivities, such as the family, are considered highly valuable in these societies because of their important social functions—an individual cannot survive in non-capitalist societies without playing his / her role in these collectivities. On the other hand, from an economic point of view, time and efforts devoted to all such collectivities is merely a waste as it does not produce capital. An economist would be happy to see you investing this time and effort in the labor-market earning some additional money. Economic rationality can see any good in developing such non-market relationships only to the extent they can be brought under the discipline of market rationality to accumulate what economists call human capital—skills acquired by an individual through training, education and social-habituation that allow him to generate more capital by working efficiently in the market. Read Application Box 4.6 to see how production was organized prior to capitalist societies.

A P P L I C A T I O N B O X 4.6 The Organization of Production in Medieval Europe Production was seen to be a religious—not an economic—activity in medieval Europe. Agricultural production was organized around a manor and relations between the lord and the tillers who occupied the land were determined by the ecclesiastical and canon laws formulated by the Church. Almost all families resident in a manorial settlement were related with each other and wage labour was unknown. Production was undertaken primarily for meeting the needs of the community. Prices did not vary over centuries. Manorial communities were mainly self-sufficient. There was comparatively little difference in the life style of the peasants and the lords and the lords and serfs had mutual social obligations determined by custom and religion. Even in the market towns of medieval Europe crafts were controlled by religious orders—every trade had a patron saint. The Church and the town authorities were committed to maintaining a system of just prices which were determined in accordance with the social commitments to satisfy traditionally recognized needs and not on the basis of supply and demands. All interest based transactions were illegal and Jews were punished when found guilty of lending money on interest. Consumption and production levels remained normally stable varying only in times of drought, floods, epidemics and prolonged wars. Economists advocate free-markets because when the market is left free, rationing through price-competition makes money the only thing that people value while developing relations with other; and this is exactly what capitalist society wants—inducing its citizens to care only for money leaving all other identities, such as religious or family identities, aside. According to economics, the ideal society is one where people are competing only for money and this ideal is ensured and becomes socially dominant when resource allocation is left to price or market mechanism. For example; consider again the rental-house market of Islamabad from Application Box 4.1. Since the number of houses available for rent are fewer after the arrival of emigrants, then who should get these houses? The economic answer is: whosoever is willing and able to pay the price; i.e. no characteristic, such as Taqwa of the tenant, other than money price should be considered while renting ones house and anyone not able to pay the money-price should receive this strong message from the market: if you want to have what you want, do something to have more money because only money can buy what you want! Economists idealize free markets because all features other than the amount of money-possessed by an individual are regarded meaningless in market relations that are created among demanders and suppliers. The market does not care who the consumer or producer—Muslim, Kafir, munafiq, muttaqi, fasiq, murtad—is. The only feature required to successfully develop market relations in market or capitalist society is the amount of money you possess—and this is the only barometer that market-mechanism uses to measure and score success. Therefore, the more market-mechanism is free and unhampered by price-controls, the lesser individuals will be worrying about other things than money. Thus, it is not only the competition among individuals that economists love to see in a capitalist society; rather it is competition on a specific margin; i.e. competition for more and more and more money. So, the description of a market or capitalist society merely by the phrase of ‘competitive-society’ is not comprehensive. Its correct description is a ‘money-oriented-competitive-society’ because this expresses the nature and the objective of competition nurtured in this society.

4.3.2: Does Economics Discourage State Intervention? Real world capitalism does not of course function in the manner economics says it should. In mature capitalist markets, all prices are administered prices determined by oligopolistic collision (discussed in Chapter 14) among firms with different levels of market power each committed to maximizing its own profits. There is no ‘invisible hand’ in mature capitalist markets. Therefore there is no likelihood that prices produced through negotiation among a small number of market dominant firms and imposed upon all other consumers and producers are prices which lead to an allocation of resources that maximizes utility and profit in general. The capitalist state therefore has to act in the market as the representative of capital in general. It must ask: are the administered prices the ‘right’ prices? Do they enable the allocation of resources in a manner which facilitates the maximization of capital accumulation throughout the capitalist economy? If not, then the capitalist government must take action to induce the market leading firms to move existing prices towards ‘optimum’ prices; i.e. prices which permit maximization of the rate of capital accumulation throughout the capitalist economy. Economics provides capitalist state policy makers with tools which enable them to: Estimate ‘optimum’ prices—prices which economic theory says would automatically emerge if there was perfect competition in all product and input markets Assess the extent to which existing administered process deviates from these ‘optimum’ prices Develop and operate policies which induce / force market leader-firms to accept these optimum price As capitalism matures markets become more and more monopolistic / oligopolistic—a necessary and unavoidable consequence of capital accumulation. Therefore the need for effective state regulation increases as capitalist markets expand, deepen and become socially dominant. Strong capitalist-markets need stronger and stronger capitalist states. This is the reason why the state expenditures to GDP ratio has kept on rising throughout capitalisms’ history, especially in America, Britain, Germany, France, China, India and other “advanced” and “advancing” capitalist countries. Economics pretends that it is discouraging state intervention in the market. This is a false claim. In reality economics seeks to teach the government to behave like a capitalist individual. This is necessary because (as we shall see in chapters 8, 12, 13, 15 and 16) capitalism is an irrational system. When individual firms seek to maximize their own profit, this cannot automatically result in the maximization of total social profits. When the state acts like a capitalist individual it tries to impose a (non-existing) capitalist rationality on irrationally functioning markets. That it can never do so—as so many economists have been forced to recognize—is due to the fact that capitalism is inherently an irrational and self-contradictory way of life; i.e. it can never achieve the ends it sets itself—the achievement and fulfillment of freedom or infinite wants. We will return to this issue in several later chapters.

Key Concepts Price ceiling is the maximum price of a commodity that can be legally charged for that commodity. Such a price is set below its equilibrium price. Non price rationing is the use of mechanism other than price to ration or equate the demand for something with its available supply Black-market is the practice of selling a commodity above its legal price Price-floor is the minimum price that must legally be offered for a commodity. This minimum price is set above the equilibrium or market price of a commodity Self-interest is an economic hypothesis about human behavior which says that while doing something, an individual must always look for his own objectives or desires; i.e. each activity should be motivated by the expectation of fulfilling one’s own desire Chapter Summary There are no “free markets” in the modern capitalist world, for necessarily some market participants have more power to move the markets than others Capitalist governments seek to influence market outcomes if market functioning impedes the achievement of capitalist objectives Capitalist governments may impose price ceilings to ensure that prices of essential goods–––atta, dal, urban transport–––does not rise so high that a portion of the capitalist working class starves to death The price ceilings set by the capitalist government is necessarily below the market price. It creates excess demand in capitalist markets where firms seek profit maximization and consumers seek utility maximization Price ceilings do not create excess demand in non capitalist market. When the Muhajareen came to Madina after Hijra, rents did not rise because Ansars owning houses were not profit maximisers and the Mahajareen were not utility maximizers Rationing can be used to equate demand and supply. Rationing can be instituted through first come first served arguments or the use of lottery In capitalist society excess demand emerges often as a consequence of speculative behavior—buying something one does not need with the aim of selling it at a higher price later Excess demand also emerges due to the extravagant living style, a typical characteristic of capitalist society. Rationing is a response which reduces demand to cope with supply shortages Non price rationing may also take the form of reduction in the quality of services provided to customers. Rationing can also allocate scarce supply to selected customers on grounds of political preferences Black marketing is the selling of a good above its legally fixed price Administrative costs of implementing price controls and presenting the operation of black markets may be prohibitively high Price controls may be instituted to prevent unplanned variations in price again mainly of essential consumer goods In order to keep prices stable capitalist governments buy essential goods in times of surplus production, stock this production and sell it in years of relative scarcity. The buying and selling necessarily is based on a “target” price that the government wants to keep unchanged relatively stable. Price controls are also enacted to offset tendencies for hoarding

Price controls have an impact on income distribution. If prices of agricultural goods are kept high–––as through the Consumer Agricultural Policy of the European Union (EU)–––this increases the relative income of farmers Price flours have been established by the EU to provide income support for European farmers Maintenance of price floor generates surplus production and increases the cost of financing inventories. Such “over production” due to price floors has become permanent in European, American and Japanese agricultural markets. It is usually the capitalist government which has to bear the cost using tax payer’s money Microeconomics argues that markets should be left uncontrolled because freely determined (equilibrium) prices give the best estimates of consumer preferences and signal what profit maximizing producers should do to benefit from satisfying these preferences Microeconomists say that controlling prices “distorts” the information they provide to capitalist consumers and producers about individual preferences Price controls necessitate rationing and this shifts competition from money to non-money margins. Non monetary competition violates capitalist rationality–––it takes some commodities outside the circuit of capital. Non monetary competition recognizes non capitalist transactions–––e.g. religions activities and family associations––as repositories of values Free markets are a myth. In real world capitalism almost all markets function as oligopolistic and almost all prices are administered. There is no invisible hand in mature capitalist markets Therefore state control of capitalist markets is normal and inheritable in capitalist order. It is exercised to ensure that ‘optimum prices’ are generated in the market–––prices which permit the maximization of aggregate profit and welfare The need for state regulation increases as capitalist markets mature and become more monopolistically and oligopolistically structured State regulation is rarely successful for capitalism is inherently an irrational and conflict ridden system Review Questions Why cannot capitalist markets ever be free? Why do capitalist governments seek to control markets? Why is price control often unnecessary in non-capitalist societies? What is the cause of excess demand in the urban housing markets of Pakistan? Evaluate the economic impact of different forms of rationing. What determines the maximum price that black marketers can charge in a price controlled market? Why are governments sometimes reluctant to institute price controls for essential goods? Why are attempts by capitalist governments to stabilize commodity prices so rarely successful in Pakistan? What is the impact of price control on income distribution pattern? With the help of a diagram show the impact of (a) a price ceiling and (b) a price floor on market supply and demand. What are the costs that governments must bear when they impose price floors or price ceilings? Should the minimum wage be fixed by law? Why has such legislation been so infective in Pakistan?

What is the “signaling” function of freely determined prices in capitalist markets? What is the meaning of “price distortion”? Why are microeconomists apprehensive of non monetary competition–––which price controls and rationing entails? Why in capitalist societies must all activities be expressed as money values? “The economists’ preference for free markets demonstrates that economics is not a positive science but an ideology” Discuss. Why does the need for state regulation increase as capitalist markets mature? What is the purpose of market regulation by the state in capitalist order? Why do strong markets need strong states and why is state intervention usually unsuccessful. Chapter 5 ELASTICITY In chapter 3 our demand-supply analysis has been qualitative, i.e. in terms of the direction of changes in quantity demanded in response to changes in prices, income and other variables in capitalist markets. We will now extend the model to show how to derive quantitative results; i.e. the amount or magnitude of changes in demand and supply consequent upon changes in prices and incomes. But before moving on to this issue, let us develop the concept widely used by economists to desire these quantitative results. 5.1: Slope and Elasticity Elasticity is a measure of responsiveness. It states a quantitative relationship between independent and dependent variables, such as quantity demanded and price. It answers the question ‘by how much will the dependent variable (say quantity demanded) change due to one unit change in an independent variable (say price)’. In other words, it measures the responsiveness of the dependent variable to changes in the independent variable. Of course, as we saw in chapter 3 the slope of the demand curve also measures the same relationship. Consider the demand curve in figure 5.1. This shows quantity demanded of mangoes as a function of its own price in a capitalist market. The slope of this demand curve is written as the ratio of change in quantity demanded, ΔQm, to change in price, ΔPm. (5.1) Figure 5.1: Typical demand curveA0QmPmDm Figure 5.1: Typical demand curve A 0 Qm Pm Dm First note, that the expression (5.1) above is the inverse of the slope of the demand curve (see chapter 3). Usually, the slope is defined as change in the variable on the vertical axis divided by the change in the variable on the horizontal axis; here it is ΔPm/ΔQm. But in case of the demand curve, we invert this rule (the reason will be clear when we analyze the firm’s ‘cost behavior’ in chapter 11). We can see that this expression is a measure of responsiveness; it shows what happens to quantity demanded as price changes. When slope can also give a measure of responsiveness, why do economists use elasticity, instead of the concept of the slope, as a basis for their numeric analysis? What is the difference between slope and elasticity? Why not Slope? Actually, there are two conceptual problems in working with the slope. First, the value of the slope of a demand curve depends upon the units in which we measure quantity and price. The relationship between demand and price given by slope is not simply a number, but a number plus some dimensional units. To grasp this point, suppose that we measure mangoes in kilo grams and their price in rupees. Then the slope is measured in kgs per rupee. For example, if a one rupee per kg increase in the price of mango decreases its quantity demanded by 2 kgs, the slope is defined as two kgs per rupee:

However, measuring mangoes in quarters rather than kgs will make the slope four times larger (since a kg contains 4 quarters and the numerator will increase by 4 times) as: Similarly, measuring price in dollars instead of rupees will also change the value of the slope. The point to note here is that the value of the slope keeps on changing as we change the units of measurement. The second problem with the slope arises when we compare the slopes of two differently measured commodities and this problem is even more serious. Suppose we have two commodities; milk and mangoes and have estimated their slopes. The results are summarized in table 5.1: Table 5.1: Slopes of demand curves for two commodities If price increases by Then quantity decreases by Slope Mango 1 rupee 4 kgs Milk 1 rupee 2 gallons This says that a one rupee increase in the price of mangoes decreases its demand by four kgs while a similar increase in the price of milk decreases its demand by two gallons. Now ask yourself the question: what can we infer from this data about the responsiveness of the two commodities to changes in their prices? Does price have more effect on the demand for mangoes or on the demand for milk? Nothing can be said about this question since both the goods are measured in different units and kgs cannot be compared with gallons. For a meaningful comparison of responsiveness using the slope, we need to convert the unit of either of the two commodities into that of the other to make them comparable; i.e. either convert kgs into gallons or gallons into kgs. But all this conversion is not only messy but also makes remembering the estimates extensively difficult. Meaning of Elasticity If you look carefully into the nature of these two problems, you can observe that it is the dimension or unit of measure which is the source of difficulties here. So, to avoid these problems, it is necessary to drop the unit of measurement from the calculation of slope; i.e. we need a unit-free measure of responsiveness. Recall that the slope measures the rate of change in a dependent variable due to change in an independent variable. We can remove this unit of measurement using simple algebra by converting the rate of change into proportional or percentage rate of change. To achieve this objective, recall from your elementary mathematics course that division of a change in a variable divided by the initial level of that variable turns its change into percentage or proportionate change. For example, if the price of a commodity changes from Rs 10 to Rs 15, then change in price, ΔP, equals Rs 5 (= 15 - 10) while percentage and proportionate change is calculated as: where FP = final price while IP = initial price. So, in order to convert the rate of change (slope) into a percentage or proportionate rate of change (elasticity), just divide the numerator of (5.1) by initial quantity, Q, and the denominator by initial price, P and multiply both by 100. Thus, we get an expression of elasticity, (5.2) since 100s cancel out both in numerator and denominator. This is the expression for what economists call elasticity. Note that this gives us percentage change in the dependent variable, here quantity demanded, due to percentage change in the independent variable, here price. How does this conversion solve the two problems associated with slope due to unit of measurement? To see this, consider again the mango example. If mango is measured in kgs and its price in rupees, then elasticity is defined as:

Note that the units of measurement cancel out both in the numerator and in the denominator. Suppose that when the price of mangoes increases from Rs 10 (IP) to Rs 15 (FP), its quantity demanded decreases from 10 kgs (IQ) to 6 kgs (FQ). Elasticity can be measured as: or What does this number tell us? It says that a one percent increase in the price of mangoes decreases its demand by 0.8 percent (the negative sign indicates negative relation between price and demand). Further, it is a unit-free measure of responsiveness because percentage change in a variable is a unit free measure of responsiveness, a 10 percentage increase in price is the same percentage increase whether price is measured in rupees or dollars. Thus elasticity differs from slope in that the former is a percentage and proportionate rate of change while the later is simply the rate of change. Before we move ahead, let us see how useful the concept of elasticity is in comparing the effects of price on different commodities. Consider the milk-mango example again and note down data given in table 5.2. Table 5.2: Comparing Elasticity of demand of two commodities If price increases by Then quantity decreases by Elasticity Mango 1 percent 4 percent Milk 1 percent 2 percent These numbers say that one percent increase in the price of mangoes decreases its demand by four percent while a similar increase in the price of milk decreases its demand by two percents. Now we can answer the question: which commodity is more responsive to changes in its price. Obviously, demand for mangoes is more responsive to changes in its own price than is demand for milk. Changes in the price of mangoes create more effect on the demand for mangoes than do changes in the price of milk on its demand. Here is another example. Suppose a teacher asks you this question: ‘last year, my height increased by 2 inches while my weight increased by 5 kgs, which one increased by more: height or weight?’ Obviously, the two numbers are not comparable as they are measured in two different units. However, if he poses his question as: ‘last year, my height increased by 2 percents while my weight increased by 5 percents, which one increased by more: height or weight?’ then the correct answer is obviously weight. Let us generalize what we have so far stated. Elasticity, like slope, can be defined between any two variables, and not just between price and demand. In general, elasticity measures percentage change in a dependent variable (say y) due to percentage change in an independent variable (say x). (5.3) whereas slope is: (5.4) Keep this fundamental difference in mind. With this generalization, let’s apply the concept of elasticity to demand. The Elasticity of Demand We learnt above that elasticity can be defined between any pair of variables. We can also study the effect of changes in income on demand, as income is also one of the determinants of demand. Similarly, nothing prevents us from studying the effect of changes in the price of other goods on demand for a commodity. Generally speaking, elasticity of demand shows what happens to quantity demanded when the variables which affect demand undergo some change, that are the price of the good in question, price of related goods and income. Therefore, we can have elasticity of demand with respect to changes in these three independent variables. Let’s take them one by one.

5.2: Price Elasticity of Demand The price (sometimes called ‘own price’) elasticity of demand shows percentage change in quantity demanded of a commodity, say x, due to percentage change in its own price: (5.5) where the symbol η means ‘demand elasticity’ and subscript xp reveals that the relation is expressed between quantity and price. This is the elasticity of demand with respect to price. To further explore this relationship, expend it using the definitions of percentage changes as: Hence, elasticity can be expressed as the slope of the demand curve multiplied by something else [ratio of price to quantity (P/Q)]. It is important to note that the sign of price elasticity of demand is usually expected to be negative. To see this, recall that the slope of the demand curve is expected to be negative, so the first term in this expression is negative. What about the second term (P/Q)? Since price of a commodity cannot take negative values and, similarly, demand for a commodity can also not be negative (otherwise it would not be demand), therefore the ratio (P/Q) must be non-negative. Hence the multiplication of a negative number by a non-negative number gives a non-positive result. To take an example, review the calculations of elasticity that we performed above in our mango example. Our answer was -0.80 (with negative sign). However, instead of computing elasticities in negative numbers, like -2 or -3, it is more convenient to refer elasticities in absolute values; that is; we will express price elasticity of demand as a positive number, like 2 or 3 ignoring the negative sign. We do this because it is not easy for students to work with negative values (is elasticity -2 greater or lesser than –3?). Throughout our discussion in this chapter, we will make comparison in terms of absolute values. Thus, a price elasticity of demand -3 is grater than -2 because the number 3 is greater than 2 in absolute value. Point Elasticity Price elasticity of demand can be measured in two basic forms depending upon the available data. One, at a specific point on the demand curve, (called point elasticity of demand). Suppose that we have enough observations about the purchase of a commodity to estimate its demand function and, thus, its slope, ΔQ/ΔP. To estimate point elasticity, we multiply the slope term by the ratio P/Q. Point elasticity gives us the rate at which the quantity demanded changes as price changes, both in percentage terms. Consider figure 9.1. The elasticity at point A is given by the expression (5.5). For example, suppose that the initial price of mangoes is Rs 10 per kg and initial quantity sold is 100 kgs. The slope of the demand curve for mangoes is estimated to be, say, -5 kg/Rs. Then the elasticity is which says that a one percent increase in the price of mangoes causes its demand to fall by half, 0.5, percent (the negative sign indicates merely the negative relationship between price and quantity demanded). It is clear from this discussion that in order to calculate point elasticity of demand, the slope of the demand curve must be known, say, from some published sources or that we have available past data to estimate the slope.

Arc Elasticity Often we have data only at two, or slightly more, different prices rather than having complete data that allows us to estimate a complete demand function for a commodity. In this case, the point elasticity would not work, as we have discrete changes in price. To handle this situation, we use the concept of arc elasticity. It is the elasticity measured between two distinct points on a demand curve. Suppose that the price of mangoes has increased from Rs 10 to 12 per kg and the quantity consumed decreased from 100 to 90 kgs. But measuring elasticity between two points creates little confusion because changes in the direction of measurement will change the value of price elasticity of demand. For example, measuring elasticity from A to B and from B to A gives different values of price elasticity. This is so because percentage change in a variable keeps changing with changes in the direction of measurement. If a number increases from 1 to 2, we can note a 100-percentage increase in its value, but a decrease from 2 to 1 entails only a 50-percent fall in it. Similarly, moving from point A to B in figure 5.2 means a 10-percent decrease in quantity demand [(90- 100)/100] but the movement from B to A implies a rise of about 11.1-percent [(100- 90)/90]. This suggests that the value of price elasticity of demand will differ between A to B and B to A. Let’s work out the calculation using the given numbers in figure 5.2. From points A to B: and from B to A we have: Figure 5.2: Arc elasticity of demand1) An 18% increase in price…2) leads to an 11% fall in quantity demandedQm100900BA1012PmD Figure 5.2: Arc elasticity of demand 1) An 18% increase in price… 2) leads to an 11% fall in quantity demanded Qm 100 90 0 B A 10 12 Pm D We can see that the two estimates of elasticity differ even in the first digit. How could this discrepancy be corrected? If you closely observe at above calculations, you would see that the slope term remains the same in both the cases (i.e. -5) but the problem arises due to second factor (i.e. P/Q ratio). Which of the values of price and quantity to use here, Pa-Pb or final Qa or Qb? Since both, initial as well as final, values of price and quantity affect elasticity, we use the average of initial and final prices for better estimation. Denoting final price and quantity by FP and FQ while initial price and quantity by IP and IQ respectively, we have or after canceling out 2, we can write it as (5.6) which is simply the slope of the demand curve multiplied by the average ratio of price to quantity. Consider the above example again. Using (5.6), the elasticity is Note that the answer lies between our two early estimates of elasticities. Alternatively, we can calculate percentage change in each variable separately, and then elasticity is just the ratio of these changes. Continuing with our previous example, we calculate the percentage change in each variable separately as Which is exactly the same. The numbers indicated in figure 5.2 are calculated using the average percentage formula as discussed in Application Box 5.1.

A P P L I C A T I O N B O X 5.1 Using Elasticities Calculating Final Quantity One of the advantages of using elasticity is that given the elasticity of some commodity, we can estimate how much the relevant variable would change after a price change. Rearrange (5.5) to obtain which simply states that if we know the price elasticity and percentage change in price and, the estimated change in quantity demanded will be their product. Suppose we know that the elasticity of, say, beef is -0.58. The price regulatory authorities announce that the price of beef will be set 10 percent higher next month. With this information at hand, ηxp = -0.58 and %ΔP = 10, we can estimate that the consumption of beef will fall by -0.58 × 10 = -5.8%. Suppose that the consumption of beef is 100 kgs this month. What will be the new quantity demanded next month? One way to calculate this new quantity is to subtract 5.8 (which is 5.8 percent of 100) from 100, this gives 94.42 kgs. However, a better estimate can be obtained using the percentage change in quantity as (5.1.1) Note that (5.1.1) includes the average of quantity in the denominator, rather than just the initial value of quantity. Solve this for final quantity, FQ, using simple algebra as: or or or (5.1.2) The equation (5.1.2) shows final quantity as a function of percentage change in the variable and initial quantity. Now plugging the given values in example, we get The numerator contains negative sign because percentage change in quantity demanded was negative in our example and similar goes for denominator. Note the difference in the results derived by both methods. The average definition of percentage change gives the more precise calculation. This will become more obvious shortly. Calculating Final Price Equation (5.5) can also be used to calculate price changes due to a given change in quantity as: Suppose, as an example, that due to heavy rains in country, the wheat harvest is badly affected. Some of the wheat suppliers looking at this situation withhold the supply of wheat by 10 percent. If the price elasticity of wheat is -0.2, how much the equilibrium price is affected? Plugging these values in the preceding formula The price will increase by 50 percent. If the initial price of wheat is 10 Rs/kg, then the final price can be calculated using average percentage formula: (5.1.3) or which is again greater than the final price given by the simple percentage rule: 1.5 × 10 = 15 Rs/kg. It is always recommended to use the exact formula (5.1.2) when changes are greater than 10 percent. 5.2.1: Classifying Price Elasticity of Demand Quantity demanded of different commodities can respond to changes in their own prices by different proportions. You can think of change in price as a force while change in quantity demanded as the resultant effect due to that force. With this idea and the formula of price elasticity in mind, We can think of five possible outcomes about the value of price elasticity around ‘1’ (the convenience of setting one as bench mark will be clear shortly).

Looking at the above expression, it is clear to see that price elasticity will be less than one (in absolute value) if percentage change in quantity demanded is less than percentage change in price (numerator is smaller than denominator). Commodities which have price-elasticity less than one are said to have price-inelastic demand. An inelastic demand curve is one for which the quantity demanded is not very responsive to changes in price. Increasing price by one percent will decrease quantity demanded by less than one percent in this case. In capitalist societies necessities such as food and health care services have low elasticities. In Britain for example the demand for beer is very price inelastic. Increasing prices to higher levels has not reduced the consumption of beer in England. Even if the prices of these commodities increase by 50%, their demand will not decrease by 50%. Thus, demand for beer in capitalist societies will be called price-inelastic and it will be treated as necessary good. The above expression shows that price elasticity will be greater than one (in absolute value) if percentage change in quantity demanded is greater than percentage change in price, called price-elastic demand. For price-elastic demand, quantity demanded responds very much to changes in prices. Goods in this category are said to be luxury goods. When percentage change in quantity demanded is equal to percentage change in price, it is called unitary price elastic demand. This has elasticity of exactly one. It could be the case when quantity demanded does not change at all in response to changes in price, called perfectly inelastic demand. This will have a value of elasticity equal to zero since numerator is zero. Graphically, the demand curves will look like vertical lines at given quantity, as shown the figure 5.3 below. Demand for pork is perfectly inelastic in the city of Qum (lran) as it is not demanded at all, no matter what its price. Finally, price elasticity can take a value of infinity when quantity demanded changes infinitely even for very small changes in price, called perfectly elastic demand. Of course, elasticity will be equal to infinity, ∞, in this case and demand curves will be flat horizontal lines at given price, as shown in figure 5.3 below. Figure 5.3: Perfectly inelastic and perfectly elastic demandηxp = 0ηxp = ∞Qm0Pm Figure 5.3: Perfectly inelastic and perfectly elastic demand ηxp = 0 ηxp = ∞ Qm 0 Pm Note an important graphical property here that when price elasticity is zero, the demand curve is vertical while it is horizontal when elasticity is infinity. This means that as elasticity increases in absolute value from zero to infinity, the demand curve becomes flatter and flatter. However, it is false to conclude from this that flatter demand curve has greater elasticity than steeper one because steepness or flatness of a curve shows its slope and not elasticity. We will explain this issue in section 5.2.4. 5.2.2: Determinants of Own Price Elasticity

A question must be teasing your mind: what makes some of the goods to be more responsive to price changes than others. In general, the price elasticity of demand for a good depends on the following factors. Availability of Substitutes It is easy to see that goods that have readily available substitutes tend to have more elastic demand than those that have no close substitutes. Consider the case of beef and chicken. Since both are similar, any increase in the price of, say, beef will cause its demand to fall by a great deal in favor of chicken. However, the increase in price of flour will hardly change its demand because it has few close substitutes in the market. Degree of Necessity Another factor that affects price elasticity of demand for a good is the common use to which we put that commodity. The more intensive the demand for a good, such as beer in mature capitalist societies, the less elastic demand it has. Time Factor The amount of time available to a consumer to adjust his behavior to changes in price plays a key role in determining the price elasticity of demand. Suppose that the price of gas goes up. After one or two gas bills, most consumers will recognize that the price has increased and will start to cut back in their usage of gas. But in the short run, they can’t do much. Figure 5.4: More and Less Elastic Demand CurvesDSDLPmQm0 Figure 5.4: More and Less Elastic Demand Curves DS DL Pm Qm 0 However, if the price increase is expected to be permanent, a further response may occur. People may start using coal. But changing cooking equipment will, of course, take some time. This suggests that long run elasticities are much larger than short run elasticities which imply that, normally, long run demand curves are flatter than the short run ones as depicted in figure 5.4. But remember that it is not always the flatness or steepness of demand curves that reveals price elasticity. Something else also matters, as we discus below. Thus, price elasticity of demand becomes large in absolute value as more time is available to make changes in one’s consumption patterns. This occurs partly because some consumers are slow to notice price changes, partly because of habits and social customs regarding consumption patterns, and partly because of the nature of the commodity whose price has changed. Budget Share of a Commodity Finally, the amount of income spent on a particular commodity also affects its price elasticity. To understand this first note that by definition, the budget share of a commodity, of say X, denoted by Kx, is the proportion of total income spent on that good. Algebraically, (5.7) Where M = income. For example, suppose that the price of, say flour, is 15 Rs/kg while the income of a person is Rs 1,000/month. If the consumer is purchasing 20 kg of flour per month, then his budget share of flour is: Multiplying this figure by 100 will give share in percent terms. The budget share of flour for this consumer is 30%, i.e. he spends 30% of his income on the purchase of flour. The larger the budget share of a commodity; the larger will be its price elasticity of demand, and vice versa. This is so because when budget share of a commodity is large, an increase in its price means a large increase in its budget share if the consumer does not reduce its quantity demanded. For example, if the price of flour increases to Rs 20/kg while quantity demanded remains the same, then its budget share will be:

The budget share of flour thus rises to 40% which means that if the consumer does not adjust his consumption he will have to reduce consumption of some other commodities very significantly in order to keep his expenditures within his budget (Rs 1,000). However, consider the example of match which dictates a trivial budget share, if its price is Rs 1 and the consumer uses 2 matches per month, then: Now if the price of match increases to Rs 2, it will not have a significant impact on amount spent on matches and hence on consumer expenditures (Km will increase to 0.4% which is a trivial increase). This small increase in match budget share will not force the consumer to adjust quantities demanded of other commodities significantly, therefore he will ignore such an increase in price and keep consuming the same amount of match as he did previously. 5.2.3: Price Elasticity and Revenue (Expenditure) Changes The concept of elasticity has great practical application in capitalist markets due to its close relationship with price and revenue (or equivalently expenditure). Revenue from (or expenditure on) a good is defined as price of that good times quantity sold (purchased), that is Expenditures = Revenue = P × Q (5.8) A capitalist seller will be interested primarily in increasing his revenue (rather than in increasing price) since he wants more and more money for its own sake. For example, suppose Badmash is a charas (drugs) seller who offers a price of Rs 2,000/kg for charas, a price much higher than its market price of, say, Rs 1,000/kg. After a whole day of hard work, he is able to convince only charcee that he has some special type of charas to sell and sells him one kg. When Badmash calculates his sales of the day, it turns out to be Rs 2,000 (= 2000 Rs/kg × 1 kg). Suppose that there is another charas merchant sitting next to him who is offering a price Rs 1,000/kg and is able to sell 20 kg on that day. His revenue or sales will be Rs 20,000 (= 1000 Rs/kg × 20 kg), much higher than Basdmash’s (neglect the element of cost for the sake of argument). So, it is not price that matters, rather it is sales or revenue (P × Q) that is important for a seller. But how does elasticity come into play here? To grasp this point, think of the ideal case in which quantity sold increases with increase in price. Suppose that if price of charas increases from 1000 Rs/kg to 1500 Rs/kg, quantity sold goes up from 20 to 30 kgs, then revenue will increase from Rs 20,000 (= 1000 Rs/kg × 20 kg) to Rs 45,000 (= 1500 Rs/kg × 30 kg). Will the seller have to think what price to charge in this case? No, because if quantity sold keeps increasing with increase in price, he will keep on increasing price until it reaches infinity, and so does his revenue. Even if quantity sold remains the same after increasing price, the seller will charge a higher and higher price. But things are not so simple. Quantity sold does not increase with increase in price. In fact, when price of a commodity increases, then in capitalist markets its quantity demanded is expected to decrease, so revenue can either increase or decrease. For example, consider table 5.3 which shows the effect of increase in price from Rs 20/kg to Rs 30/kg on revenue. Note that if quantity sold decreases to 25 kgs, revenue increases (see case 2); if it falls to 20 kgs, revenue is the same (case 3); and if it falls to 15 kgs, revenue actually falls (case 4). What is going on here? Facing this situation as a seller, the capitalist producer will ask the question: ‘what will happen to the revenue after I change the price of my commodity? The answer to this question depends on how responsive demand is to changes in price; that is on price elasticity of demand. Let us explore this link.

Table 5.3: Revenue Responsiveness to Price (1) (2) (3) = (1) × (2) Case If price is and Quantity sold is Then sales is 1 20 Rs/kg 30 kg Rs 600 2 30 Rs/kg 25 kg Rs 750 3 30 Rs/kg 20 kg Rs 600 4 30 Rs/kg 15 kg Rs 450 For this purpose, it will be easier to work with expression (5.8) giving total revenue in percentage terms. We convert change in revenue into percentage terms writing it as: %R = %P + %Q (5.9) This simply says that percentage change in revenue is equal to the sum of the percentage changes in price and the percentage change in quantity. First note that the derivation of this expression from (5.8) makes use of the mathematical fact that the percentage change of the product of two variables is approximately equal to the sum of their percentage changes, that is: %∆ (a × b) ≈ %∆a + %∆b The advantage of expression (5.9) is that movement of revenue due to changes in price and quantity sold can be studied by looking at percentage changes in price and quantities directly. To understand this, we take three cases here. But first recall the formula of price-elasticity of demand: Case A: ηxp = 1: Price elasticity equal to one means %ΔQ = %ΔP according to the definition of price elasticity. Consider a one percent increase in price first. If there is no change in quantity demanded, then revenue will increase by one percent according to expression (5.9). However, if price elasticity equals one, it means that quantity demanded will also fall by one percent. Since percentage increase in price is exactly equal to the percentage decline in quantity, the net effect on revenue of their sum is zero %R = %P + %Q %R = 1% increase + 1% decrease = 0 The positive effect on revenue via one percent price increase is exactly off-set by the negative effect on revenue due to fall in quantity demanded by one percent, and revenue will remain unchanged. Thus it is easy to see now that for unitary-elastic goods, price leaves revenue unchanged because percentage increase in price is equal to the percentage decline in quantity demanded, and the two effects offset each other completely. Hence, goods for which elasticity is equal to 1, price and revenue are unrelated. Case B: ηxp > 1: According to the definition of price elasticity, price elasticity greater than one means %ΔQ > %ΔP. This means that the demand drops a lot when price increases. Consider a one percent increase in price first. If quantity sold does not change, revenue will increase by one percent. However, for price elastic goods, the quantity demanded falls by more than one percent, say by two percent. Since percentage increase in price (one percent) is less than percentage decline in quantity (two percent), the net effect of their sum is decrease in revenue [as is apparent from expression (5.9); that the positive effect on revenue via price increase is less than the negative effect due to fall in quantity demanded, the net effect of their sum is negative]. The reverse will hold if price is decreased by one percent. In this case, quantity demanded will increase by more than one percent and hence revenue will increase [because the negative effect on revenue via price fall is less than the positive effect due to rise in quantity demanded, the net effect of their sum is positive]. The important thing to note is that when price elasticity is greater than one, increasing price reduces total revenue and vice versa. So, we get a useful relationship: Goods for which elasticity is greater than 1, price and revenue are negatively related.

Case C: ηxp < 1: Now it is easy to work on this case. When a good has price-inelastic demand, quantity demanded drops only a little when the price increases which implies that the revenue will increase. This is exactly opposite of the price elastic goods demand case. A one percent increase in price causes, say, a half percent drop in quantity, and thus a half percent increase in revenue. This can directly be verified by expression (5.9). Therefore, we conclude that: Goods for which elasticity is less than 1, price and revenue are positively related. Table 5.4 summarizes all these relationships. Application Box 5.2 shows a useful way to apply these relationships. Table 5.4: Relationship between Price Changes, Price Elasticities and Revenue Type of good Price elasticity* ηxp Price change Total Revenue / Expenditures Unitary ηxp = 1 + - 0 0 Price elastic ηxp > 1 + - - + Price inelastic 0 < ηxp < 1 + - + - * Price elasticity is expressed in absolute values A P P L I C A T I O N B O X 5.2 Using Elasticities Bus Fare Increase Often we have data only of changes in prices and revenue from which we have to calculate elasticity. This application shows a useful method to analyze such data. Bus owners raise the fare of buses to increase their revenue. But is there any guarantee that increasing the fare will always increase revenue? Suppose that the fare is increased from 4 to 5 Rs / ride. Two months later, the revenue increases by 20 percent. What can we infer about the original price elasticity of demand for bus services from this information? First note that the percentage change in revenue can be written as (5.2.1) Note that the final quantity FQ by definition also equals initial quantity plus some change (FQ = IQ + ΔQ), so we can write the above as: Substituting the given values of final price (Rs 5), initial price (Rs 4) and the fact that revenue increased by 20 percent, we obtain: (5.2.2) Note that ΔQ < 0 is the fall in ridership. A little algebra shows that (5.2.2) reduces to Solving for the percentage quantity term as (5.2.3) We already know that (5.2.4) Equations (5.2.3) and (5.2.4) tell us that The demand for Bus rides turns out to be highly inelastic in response to changes in fare. The fact that revenue increased after price increase is consistent with this result. Thus, it is always profitable for bus owners to increase the fare because that will raise their revenue. Elasticity of a Straight Line and Total Revenue Curve We now discuss price elasticity of an important type of demand curve that is normally encountered in most of the economic text books. This is called a linear demand curve. Usually, in most economic examples, we work with linear or straight line demand curves as an approximation of real world data. We know that an important property of the straight line demand curve is that its slope remains constant along all points. What about its elasticity at different points? The elasticity of the demand curve is different at each and every point on a straight line demand curve. To understand the reason why this is the case, note that elasticity consists of two terms, (a) the slope and (b) the P/Q ratio (what we termed as ‘something else’ above). Even if the slope term remains constant, the P/Q ratio keeps changing as we move along the demand curve. To see this, recall the definition of price elasticity given by (5.5)

(5.5) Consider figure 5.5. Suppose that the slope of this demand curve is -1, a constant number. We see that at point A, the value of quantity demanded, Q, is zero, and hence P/Q is equal to infinity which implies that the elasticity [given by equation (5.5)] also equals infinity: At point A Similarly at point B, the value of P is zero which means that P/Q, and hence elasticity, is equal to zero. Now consider the mid point B. At this point, value of P and Q must be equal since it is a mid point. With slope equal to one and P = Q, the ratio P/Q will also be equal to one and, hence, the elasticity must be one. At point B Figure 5.5: Elasticity of linear demand schedulesη = ∞η = 1η = 0η > 1η < 1APbDQCqbqd0PdP Figure 5.5: Elasticity of linear demand schedules η = ∞ η = 1 η = 0 η > 1 η < 1 A Pb D Q C qb qd 0 Pd P B B Next consider movement from point A to B. As we do so, the value of P is falling while that of Q is increasing. Clearly, the ratio P/Q is decreasing all the times (since the numerator is decreasing while the denominator is increasing). With constant value of the slope, ever decreasing P/Q ratio implies a decreasing value for the elasticity of demand (in absolute terms). To find the exact range of elasticity between points A and B, take any point on the linear demand curve between these points, such as D. At such a point, the value of P must be greater than the value of Q (because point D is to the left of B which is the mid point). The P/Q ratio must be greater than one at this point. Hence elasticity will be: B/w points A and B So we can conclude that the elasticity will be greater than one not only at point D but also at all points above point B (since P/Q ratio will be greater than 1 in this region). Finally, obviously price elasticity will be less than one between points B and C (since P/Q ratio will be less than 1 in this region). The important thing to note about this result is that the slope is constant along all points on this demand curve (since it is a straight line), however elasticity is not constant. As a general principle, the elasticity of a negatively sloped straight line demand curve varies from infinity at vertical intercept to zero at horizontal intercept. This is an important result to remember because most of the times, students confuse the slope of demand curve with its elasticity. Elasticity is not merely slope, it is slope multiplied by average price. (5.10) Remember that flatness or steepness shows only the slope of the demand curve and does not imply anything about its elasticity; the P/Q ratio also makes its contribution in determining the value of price elasticity. Next we have to derive the total revenue curve from this demand curve. For this purpose, first note that the rectangular area below any point on the demand curve gives total revenue at that point. For example, consider point A in figure 5.6 with coordinates [(Q,P) = (10,20). Figure 5.6: Relation between total revenue and demand curveDO20 = CAB10 = DEFRa = 20 × 10= 200Rb = 20 × 10 = 300QP30010

Figure 5.6: Relation between total revenue and demand curve DO 20 = C A B 10 = D E F Ra = 20 × 10 = 200 Rb = 20 × 10 = 300 Q P 30 0 10 The area of the rectangle below this point AC0E measures total revenue, as total revenue equals price times quantity. To see this, note that the area of any rectangle is given by its height multiplied by its base. The height of the rectangle AC0E is given by the distance 0C while its base equals 0E. Multiplying both give the area of the rectangle AC0E. Area of rectangle AC0E = Height × Base = 0C × 0E The height 0C measures the price of this commodity at point A while the base 0E measure quantity demanded. Thus, the area of the rectangle also equals: Area of rectangle AC0E = Height × Base = 0C × 0E = P × Q = Revenue Since the product of price and quantity equals revenue, therefore the area of the rectangle below any point on the demand curve gives revenue at that point. Revenue at point A equals Ra = Rs 20/kg × 10 kg = Rs 200. Similarly, revenue at point B is given by the area BD0F = Rb = Rs 10/kg × 30 kg = Rs 300. Thus, each point on a demand curve measures total revenue. We are now in a position to derive total revenue curve by combining these two results. Consider figure 5.7 below. The top panel plots a straight line demand curve while the bottom panel shows total revenue against quantity demanded. We have summarized our results in table 5.5. Take point A first. Since we know that total revenue by definition is R = P × Q, and Q = 0 at point A, therefore revenue must be zero at this point. The same goes at point C because P = 0 at that point. So we obtain points a and c (in the bottom penel) on the total revenue curve. Next think of the range of the demand curve from A to B. In this range, price elasticity of demand is greater than one (see figure 5.5). Figure 5.7: Deriving total revenue from the demand sSchedules.baQqc0TRABPoQQC0P Figure 5.7: Deriving total revenue from the demand sSchedules. b a Q q c 0 TR A B Po Q Q C 0 P Recall that when price elasticity is greater than one, price and revenue are negatively related (see the discussion in previous section). Therefore, decreasing price in this range from A to Pb will increase total revenue and hence the total revenue curve must be rising in this range. This can be seen from the fact that the total revenue curve is rising in this range of output 0-to-qb (in the bottom penel). Similarly, in the price range Pb-to-0 (or equivalently quantity range qb-to-C) on the demand curve, price elasticity is less than one and hence price and revenue must be positively related in this range. Therefore, if price is reduced from Pb-to-0, revenue will decrease, as shown by the decreasing phase of the total revenue curve in output range qb-to-C. Finally, note that if the total revenue curve is increasing in the output range 0-to-qb and decreasing in range qb-to-C, then it must be at its maximum at qb (or point B on the demand curve). At this point, price elasticity is one which means that changes in price at this point will leave total revenue unchanged. Thus, we obtain an inverse U-shaped total revenue curve. Keep this shape in mind as it will be used in our discussion on monopoly (chapter 13). Here, Application Box 5.3 provides a useful application of this important concept.

Table 5.5: Demand and Total Revenue: A Summary At (or b/w) Point(s) on demand curve Price elasticity is Which implies that If price TR = P × Q Revenue-curve A Infinite - - Zero (because Q = 0) is at zero on output axis C Zero - - Zero (because P = 0) is at zero on output axis A-B Greater than one Price and revenue are negatively related Decreases in this range Revenue increases Rises b/w output range 0-to-qb B-C Less than one Price and revenue are positively related Decreases in this range Revenue decreases Falls b/w output range qb-to-C B One Price and revenue are unrelated Decreases or increases Revenue unchanged is at its maximum A P P L I C A T I O N B O X 5.3 Using Elasticities to Understand the 2006 Sugar Crises Let us now explore the 2006 sugar crises discussed in previous chapter in terms of elasticities. To analyze this situation, we develop a basic demand-supply model. The demand for sugar is expected to be price-inelastic because it has no close substitutes and it falls in the category of necessities. That is why the demand curve in the diagram below is drawn rather steep. On other hand, we have drawn a “normal” positively sloped supply curve of sugar. Their intersection determines a price of sugar at Rs 25/kg at which, say, 1 million kg of sugar is sold per month. This means that the revenue of the sugar seths amounts to Rs 25 million per month (= 25 Rs/kg × 1 million kg). Now suppose that the supply of sugar decreases because of hoarding made possible by the corruption of the Musharraf government. The supply-curve shifts backward, as shown by the dotted line. Such a situation will have an adverse effect on consumers as the “equilibrium” price of sugar rises to Rs 40/kg while quantity sold is 0.8 million per month. Consumers are purchasing less sugar at a higher price. But how would this situation affect the sugar seths in Musharraf government? To see this, note that at the new price, the revenue of the seths is Rs 3.2 millions (= Rs 40/kg × 0.8 million kg). They have enjoyed a 28% per month increase in their revenue. They put more and more pressure on Musharraf to let them continue hoarding. To confirm this result, we find that price elasticity of demand (using arc elasticity expression) turns out to be -0.48 (less than one in absolute value). It is for this reason that the sugar seths originated this artificial shortage by hoarding sugar in their godowns. Since many sugar mills are owned by ministers and government supporters no serious effort was made by price regulatory authorities to uncover the causes of the sugar shortage (Also see analytical problem 5 at the end of this chapter). 4025DSBASsoSs11) A 46% increase in price…2) leads to a 22% fall in quantity demanded Psugar 40 25 DS B A Sso Ss1 1) A 46% increase in price… 2) leads to a 22% fall in quantity demanded 0 0.8 1 Qsugar 5.2.4: Geometric Interpretation of Price Elasticity While classifying elasticity of demand, we said that a flat curve has a lower price elasticity of demand as compared to steeper one. But this assertion does not describe the general relationship between the curvature of a demand curve and its price elasticity. In fact, it is true for a specific case—true only when the two demand curves cross each other at some point in P-Q space. There exists a general geometric way to illustrate price elasticity of straight line demand curves. Here we discuss the procedure in brief. Consider figure 5.8 where the demand schedule has a vertical (or price) intercept A. The elasticity at point B, (or any other point) can be obtained by comparing the height of the intercept and the price level from the origin. To understand this, note the triangle AP0B formed by the price-axis, the quantity axis and the demand curve D. Recall the definition of price elasticity from (5.5):

(5.5) We need two factors, the P/Q ratio and the slope to estimate elasticity. Note that the price P is the vertical line segment 0P0 and, quantity Q is the distance 0Q0. Geometrically, the distance 0Q0 is exactly the same as the distance P0B. Therefore, we can state that the P/Q ratio is the ratio of the distances 0Po and Po B or: Now consider the slope term. The slope of the inverse demand curve D is given by change in quantity ΔQ = P0B divided by change in price ΔP = AP0 or the ratio P0B/AP0. Plugging these values in the elasticity formula (5.5) we have: or (5.11) Figure 5.8: Geometric estimation of price elasticityHDHNDPoABQoQm0Pm Figure 5.8: Geometric estimation of price elasticity HD HN D Po A B Qo Qm 0 Pm This ratio gives the price elasticity of demand at point B. The distance P0B appears both in the numerator and in the denominator, hence it cancels out. This is a strong result: Pick up any point along a demand curve, and the elasticity is given by the distance from the origin to price at that point divided by the distance of the vertical intercept to the price at the desired point; i.e. the ratio of the heights HN to HD (N and D denote heights to be placed in the numerator and the denominator respectively). Let us apply this geometric interpretation to see how useful it is. Elasticity of Two Straight Line Demand Curves Consider the left panel of figure 5.9 which has two demand curves, D and D1 with the same slope but different intercepts A and A1 respectively. Apparently, one might think that their elasticity should be the same. Let us compare their elasticity at price level Po. The corresponding quantities demanded on both the curves are Q and Q1 or points B and C (because the distance 0Q is the same as PoB). According to our above equation (5.11), the elasticity of demand curve D at price Po is equal to the ratio (5.12) While that of D1 at the same price is (5.13) Since A1 > A, the denominator of (5.13) is greater than that of (5.12) and, thus, the elasticity of the demand curve D1 is less than that of D at price Po. In general, for two straight line demand curves of the same slope, the one farther from the origin is less elastic than the one closer from the origin for any given price level. The reason in terms of equation (5.5) is that, with constant slopes of both the curves (ΔQ/ΔP), for any given value of P the corresponding Q value is greater for the demand curve that lies farther from the origin, hence, P/Q as well as elasticity is smaller. Elasticity of Two Pivoting Lines Now consider the right hand panel of figure 5.9. We see that both the curves have similar vertical intercepts while their slopes are different (this is exactly the opposite of the previous case). What about their elasticity? Apparently a surprising result, their elasticity is the same for any given price. To understand the reason for this, consider their elasticity at price P1. Note that by (5.11), the elasticity of the demand curve D at point B1 is: Figure 5.9: Slopes and Elasticities of Straight Line Demand SchedulesDP1AB1D1C10QoQ1QPDPoA1BD1CA0QoQ1QP

Figure 5.9: Slopes and Elasticities of Straight Line Demand Schedules D P1 A B1 D1 C1 0 Qo Q1 Q P D Po A1 B D1 C A 0 Qo Q1 Q P By the same token, the elasticity of D1 at point C1 is: The two are the same. What is going on here? The geometric reason for this result is that the difference corresponding to the quantity demanded at P1 (P1B1 and P1C1) appears in both the numerator and the denominator and thus cancels out. Alternatively speaking, if the slope of a straight line D is twice as steep as D1, this means that the quantity demanded Q is half at this demand curve at P1. Therefore, the steeper slope (a smaller ΔQ for the same ΔP) is exactly offset by the smaller quantity demanded (a smaller Q for the same P). Carefully note here that though the demand curve D1 has greater slope than D (as it is steeper), however the elasticity of both is the same at each price level. This confirms the fact that steepness or flatness of a demand curve shows its slope which is of course not the sole determinant of its elasticity. Elasticity of Two Intersecting Lines As a general rule, price elasticity of two intersecting lines can be compared at the point where they intersect just by comparing their slopes. The steeper line has less elasticity. Note that at the intersection point, P/Q ratio will be the same for both the curves. Therefore, it is only the slope term, ΔQ/ΔP, which determines the elasticity at that point. We know that the slope of the steeper demand curve is lower (because ΔQ/ΔP is the reciprocal of the slope of the demand curve ΔP/ΔQ which is higher for the steeper demand curve) than that of a flatter one, hence, it has lower elasticity. Flatter demand curve means higher elastic demand only if the P/Q ratio is the same in both cases. 5.3: Income Elasticity of Demand So far, we have considered only own price changes. Recall that while deriving the consumer demand curve, we held income constant and then verified the effects of changes in price on quantity demanded. However, income can also change. Similar to the price elasticity of demand, income elasticity of demand is used to describe how demand (not the quantity demanded) responds to changes in income. It is given by (5.14) where the subscript ‘xm’ indicates ‘elasticity of demand for x with respect to income’. Income elasticities are classified into two broader groups. In capitalist economies an inferior good is one for which there is a negative relationship between income and demand For this sort of good, income elasticity in capitalist society on the other hand is negative. “A normal” good in capitalist society is one for which an increase in income leads to an increase in demand; for this sort of good, income elasticity is positive. Economists further classify “normal” goods into necessities, if income elasticity is less than one, and luxuries or superior, if income elasticity is greater than one. In non capitalist societies consumption does not normally rise with income because income is basically not considered a source of increasing worldly comforts. What rises in these societies is expenditure on charity and on jihad. Thus in response to the inflow of wealth from South America there was an explosive growth in the building of churches and cathedrals in Spain in the sixteenth century. At the time of the Prophet (S.A.W) the conquest of Khyber led to a major increase in the wealth of the Muslim community but this did not lead to an increase in consumption—it is this which explains the total absence of inflation in that Nabawi period and the period of the Khilafat-e-Rashida. It was normal for men possessing great wealth to lead lives of extreme poverty. Sayidna Usman (RA), despite being a successful merchant and wealthy person, at the time of his appointment as caliph moved into a small Hujrah in the Prophet’s mosque and lived there for the next 12 years and historians accept that the shirt in which he aliened Shahadat was the only shirt he possessed at that time. In non-capitalist society production and trade is not undertaken for maximization of utility and profit. Production and trade are religious not economic produce and men participate in them to earn God’s favor. In non capitalist societies men are not “rational”—i.e. they are not self-interested utility and profit maximizers. Economic concepts such as income elasticity of demand do not provide any adequate basis for understanding production, consumption and trade in non capitalist societies.

Now consider how the variations in income elasticities across different commodities in capitalist societies can be explained. In general, the distinction between “necessities” and “luxuries” help explain differences in income elasticities. The more “basic” a commodity is in the consumption of a consumer, the lower is its income elasticity in capitalist society. However, it should also be noted that income elasticity for any commodity varies with the level of the consumer’s income in capitalist society. When income is low, consumer will end up consuming only food stuff and a little of other goods, such as cosmetics. However, as income increases, the consumer in capitalist society starts spending more of his budget on goods other than “necessities”, so the income elasticity of necessities falls for higher income levels. The demand for “necessities” will not increase by much for increments in income at higher income levels than it does at lower levels of income because necessities are consumed in more or less fixed amounts. That is why it is said that ‘there is a difference between necessities and wants’: the former refers to basket of goods that makes life possible on this earth whereas the letter amounts to those goods that add nothing to the achievement of our objective of salvation in life-here-after. “Necessities” keep on increasing in capitalist society, more and more luxuries—refrigerators, video cameras, mobile phones, microwave ovens—have become “necessities” even for the “poorest” people in America. It is only in non capitalist societies that necessities can be defined in physical terms (called intakes). In capitalist society, characterized by ever increasing scarcity, all luxuries—including even shares and bonds—are potential necessities. Calculation of income elasticity of demand is exactly the same as that for price elasticity of demand. For example, suppose that the income elasticity of demand for fast-food business in Clifton, Karachi city is 1.5; i.e. one percent increase in income of individuals in Clifton leads to 1.5 percent increase in fast-food sales. If incomes of people living in Clifton increase by 5% (on average) per year, then at what rate will demand for fast-food business increase? From expression (5.14) we note that Plugging in the given values we obtain: The explanation for such a large increase in fast-food demand in areas like Clifton is the effects of westernization on people’s living styles. Three factors contribute in this trend: firstly growing participation of women in the job markets. Families where women play a dignified role of ‘house-wife’ have less frequency to visit fast-food restaurants than families where females are working in offices. Secondly, increasing demand to ‘make most of this worldly life in terms of utility maximization’ leads individuals to adopt pleasure intermingling eating habits. People living in Pirbaba who are not exposed to enlightened moderation and the capitalist way of life have no preference for fast-food. Finally, advertisement by fast food restaurants, such as KFC and McDonald, distorts public preferences by portraying appearance at these restaurants as a symbol of status and a ‘higher standard of living’.

5.4: Cross Price Elasticity of Demand The concept of the cross price elasticity of demand addresses the question: what happens to the demand (and not the quantity demanded) for good x, Qx, when the price of good y, Py, changes, given by: (5.15) where the subscript ‘xy’ now indicates elasticity of demand for x with respect to price of y. Calculation of cross price elasticity is the same as that of own price and income elasticities (see analytical problem 3 at the end of this chapter). Its value can vary from minus infinity to plus infinity. Two goods are classified as substitutes if cross price elasticity is positive, that is an increase in price of one good increases the demand for another. Consider for example beef and chicken. A small increase in price of beef causes people to purchase more chicken (and hence a positive effect). As another example, a large rise in the price of cars would lead to a rise in demand for public transport because some people will shift from cars to public transportation. Goods are complements if cross price elasticity is negative; that is an increase in price of one good decreases the demand for another. For example, the increase in oil price causes the demand for cars to fall (and hence a negative effect). Higher values of cross price elasticity suggest stronger relationship between two goods, whether that of substitutability or complementarity. For example, if cross price elasticity between x and y is two, ηxy = 2, while for x and z it is three, ηxz = 3, then x and z are closer substitutes for each other than are x and y. 5.5: Supply Elasticities The concept of elasticity is not limited to demand. Economists refer to supply elasticity as the response of quantity supplied to changes in any of its determinants, such as its own price. More precisely, price elasticity of supply is the percentage change in quantity supplied due to percentage change in price, that is: (5.16) Since “normal” supply curves in neoclassical analysis have positive slopes, the price elasticity of supply, εxp, is a positive number. Price elasticity of supply can also be classified into five categories around its value ‘1’, just like demand elasticity. When supply of a commodity is fixed, such as the amount of wheat in a given year, supply elasticity is zero (a vertical supply curve). At other extreme, a horizontal supply curve displays an infinitely large response of quantity to price changes. In between these two extremes, the supply is called elastic or inelastic depending upon whether the percentage change in quantity supplied is larger or smaller than the percentage change in price. The supply elasticity ranges from zero to plus infinity. One of the major determinants of supply elasticity in capitalist societies is the ease with which production can be changed in an industry after a price change. If the price of some product increases, how much more can a firm produce of that good depends upon how easy it is for producers to shift from the production of other commodities to the one whose price has changed. If the prices of land rise suddenly, nobody can sell more land than what is available in fixed amount by nature. Another factor that affects supply elasticity is the duration of time. A given price change tends to have larger effects on quantity supplied as the time available to respond for suppliers increases. Suppose that the price of wheat increases this year. Capitalist farmers may increase the supply of wheat from their go downs, but they can’t produce more wheat immediately. However, if price increase persists in the next year, capitalist farmers can respond by cultivating more wheat and perhaps less cotton. The behavior of cost as output increases also affects the supply elasticity. This issue will be dealt in detail when we study cost curves and the theory of production. Suppose that the cost of producing any amount of output is fixed, then an increase in output price will stimulate capitalist producers, to increase their production by a great deal. However, if the cost of producing a unit of output also rises with the rise in output, then the increase in production will be dampened by the increase in the cost of production because profits will not rise for capitalist producers. In this latter case, supply will tend to be inelastic

5.6: Elasticity and Capitalist Policy Table 5.6 comprehensively summarizes all that is explained in this chapter. Here we discuss how we can use information on many types of elasticities to determine the outcome of any given change in market. Application Box 5.4 consolidates this understanding by discussing an example. Calculating Combing Effects We can combine several pieces of analysis to illustrate the application of elasticity concepts in capitalist societies. Consider railway ticket sale on Eid season at, say, Karachi Cant station. The seats available in trains for passengers are fixed in number, irrespective of its demand which means that the supply curve is perfectly inelastic in figure 5.10. The demand for tickets is drawn negatively sloped. The intersection of demand and supply gives the equilibrium price of tickets, say Rs PR. Suppose the demand for tickets increases, say, due to 20% extra income given by the government as an Eid-bonus (paid before Eid). Table 5.6: Summarizing Elasticity Concepts Terminology Symbol Numerical Value Definition Price Elasticity of Demand Negative %ΔQ due to %ΔP Unitary price elastic Equal to 1 (in absolute term) %ΔQ = %ΔP Elastic Greater than 1 (in absolute term) %ΔQ > %ΔP Inelastic Less than 1 (in absolute term) %ΔQ < %ΔP Perfectly inelastic Zero %ΔQ = 0 due to any %ΔP Perfectly elastic Infinity %ΔQ = ∞ due to small %ΔP Income Elasticity of Demand %ΔQ due to %ΔM Inferior Negative %ΔQ < 0 when %ΔM > 0 Normal Positive %ΔQ > 0 when %ΔM > 0 Income elastic Greater than 1 %ΔQ > %ΔM Income inelastic Less than 1 %ΔQ < %ΔM Cross Price Elasticity of demand %ΔQx due to %ΔPy Substitutes Positive %ΔQx > 0 when %ΔPy > 0 Complements Negative %ΔQx < 0 when %ΔPy > 0 Supply Elasticity Positive %ΔQs due to %ΔP Adapted from Lipsey If the income elasticity of demand for tickets is 1.5 and price elasticity of demand for tickets is -1.2, by what percent Pakistan Railway (let it be recently privatized) can increase prices and yet sell all the tickets? To answer this question, first think about the question: ‘what happens to demand when income increases’ in capitalist societies. We know that increase in demand due to increased income will shift the demand curve outward in typical capitalist societies. But by how much? To determine this, use the definition of income elasticity of demand (5.14): Solving it for quantity demanded Plugging in the given values we get, So, demand increases by 30%, and hence the curve shifts rightwards by 30%. This means that there will be 30% excess demand for tickets at the old price PR. Next ask the question: ‘by how much the newly privatized Pakistan Railway may increase prices in order to eliminate this 30% extra demand’. For this purpose, use the expression of price-elasticity of demand to determine price change: or Plugging in the given values, we get: The negative sign before ‘30’ indicates that demand has to fall by this much amount in order to clear the market. Thus, new price will be 25% greater than initial price, PR + 25%. Figure 5.10: Considering combing effects of elasticitiesDPRe1eD1CPR + 25%So30% shift in demand curvePRQRQRQR +30%0

Figure 5.10: Considering combing effects of elasticities D PR e1 e D1 C PR + 25% So 30% shift in demand curve PR QR QR QR +30% 0 Suppose Pakistan Railway is not a capitalist firm—not committed to profit maximization. It will then not raise price of tickets when demand rises. It will ration tickets on the basis of some criteria—e.g. give tickets to people going to destination not served by road transport preferentially. It is only the commitment to profit maximization which leads Pakistan Railway to increase price and there is nothing natural or inescapable about this capitalist response to demand. Nationalized companies do not normally raise price in response to demand. The normal response of non-capitalist societies is to ration goods in short supply on the basis of a criterion of justice—not to raise price. The identification of criteria of justice when rationing becomes necessary is one of the functions of the Khalifah in an Islamic bazzar according to Hanafi Fiqh. Application Box 5.4 applies the combining effects of elasticities on minimum wage law controversy example. A P P L I C A T I O N B O X 5.4 Using Elasticities Combining Effects & The Minimum Wage Law Controversy Revisited You learnt about ‘minimum wage law’ controversy in chapter 4 (see Application Box 4.5). Let us analyze this issue again in the light of tools developed in this chapter. Opponents of minimum-wage-law contend that minimum wage laws in capitalist societies will lower wages as demand for unskilled workers is price-elastic. To understand this logic, consider the left panel below. Here, demand curve for unskilled labor is drawn as being relatively elastic while supply curve is drawn positively sloped. The initial wage rate is, say, wa = Rs 100/day and La = 20,000 workers get jobs at this wage rate in Faisalabad. The total earnings of workers is given by wa × La = Rs 100/day × 20,000 = Rs 2,000,000/day (or Rs 2 millions). Now suppose that government imposes minimum wage law and sets wage at wm = Rs 125/day. This lead profit-maximizing capitalist firms to reduce its demand for labor and only Lm = 14,000 workers are employed (as explained in chapter 3). The incomes received by workers after minimum wage legislation is given by wa × La = Rs 125/day × 14,000 = Rs 1,750,000/day (or Rs 1.75 millions). Income received by workers has decreased from Rs 2 millions/day to Rs 1.75 millions/day. This result can be confirmed by the fact that elasticity of demand for workers with respect to wage rate is: Thus, price elasticity of demand for labor is greater than one (in absolute value) and this confirms the fact that increasing wage rates will decrease the total wage bill received by the workers provided firms are profit maximisers. However, if price elasticity of demand for labor is assumed to be less than one (inelastic demand), then minimum wage law will lead to an increase in workers’ total wage bill, as shown in the right hand panel. For this case, the total wage bill received by workers increases to Rs 2.125 millions/day while elasticity of demand for labor turns out to be:

SoDODoabwm=125Sowa =100m wage wage So DO Do a b wm=125 So wa =100 m U = 61.6% cmwm = 125 c m wm = 125 ewe = 100 e we = 100 0 Lm La Lb L 0 Lm Le Lc L 14000 20000 ? 17000 20000 ? Whether wages received by the workers increase or decrease crucially depend upon the wage elasticity of demand for labor in capitalist society where the firms employing labour are profit maximizers. We can further extend this analysis to study the effects of minimum-wage-law on unemployment in a capitalist economy. Consider the left hand panel again where demand elasticity is -1.59. Suppose that elasticity of labor supply with respect to wage is 1.3 (an elastic supply curve). How much unemployment will be generated due to increase in wage from wa to wm in capitalist society? To see this, recall from chapter 4 that unemployment in this case will be equal to the distance mb (the difference between supply of and demand for labor at wage wm). Part of this unemployment is generated by the fact that demand for labor has decreased, from La to Lm, while part of it arises because supply of labor increases from La to Lb as wage rate increases. Unemployment will be equal to the sum of these two changes (in absolute value) as: Unemployment = mb = Fall in demand for labor due to wage increase + Increase in supply of labor due to wage increase We need to find these two changes. For this, first note that wage has increased by 22% as: The fall in demand for labor can be calculated using definition of elasticity of labor demand: Solving it for quantity demanded gives Plugging in the given values we get, So, demand decreases by 35.2% (movement from a to m). Similarly, increase the labor supply can also be calculated using wage elasticity of labor supply as: Plugging in the given values we obtain, This means that increase in wage rate brings forward 26.4% additional workers into the market (movement from a to b). Total unemployment can now be obtained by adding these two numbers together (in absolute terms): Thus, unemployment of unskilled workers increases by 61.6%, a number quite large due to the fact that we assumed very large values of wage elasticities and changes in wage rate. As a matter of exercise, now apply the same procedure on the right hand penel numbers assuming. Also determine the final values of labor supply (with ‘?’ mark in the diagram) at wage wm for both cases. Note carefully that all of the above analysis depends crucially on two presumptions: Firms are capitalist firms—maximizing profits Workers are capitalist work force—responding with more effort to higher wages In non capitalist societies—medieval Europe or the Usmania Khilafat for example—wages are determined on the basis of an anticipation of a first wage. Since neither firms nor workers are capitalist—they are concerned neither with profit nor with utility maximization—a rise in the just wage (determined essentially by the rate of growth of population and changes in the total costs of production through out the economy) does not lead to unemployment. Non-capitalist producers do not reduce the demand for labour nor do non-capitalist workers increase the supply of labour when the just wage rises. Phyllis Deane has shown that both unemployment and wage inflation were unknown in Christian Europe and it was the emergence of capitalist economics which made inflation and unemployment a permanent threat to the economic life of modern Europe. The concept of elasticity is therefore useless for analyzing production, consumption and employment in non-capitalist societies. It is only when men are “rationally”—when they seek profit and utility maximization as ends in themselves—that inflation and unemployment become permanent threats to society.

The discussion in this section (including in the application box) shows some of the uses to which the concept of elasticity can be put both for justifying capitalist behavior and for developing policies for strengthening capitalist rule. Broadly speaking capitalist rule requires perfect demand elasticity—that is why the demand curve is shown as infinitely elastic in the perfectly competitive model (see chapter 13). Capitalism’s only conception of value (chapter 2) is price alone which must at least “in the last instance” determine choice. Capitalism also seeks to increase the price responsiveness of production (supply but since capitalism can survive only in conditions for perpetual, never ending scarcity, an infinity power elastic supply curve cannot be assumed so economic theory presumes the existence of a “normal” upward slipping supply curve (that such a curve cannot exist at the aggregate level, as shown by Sraffa is another matter and we will discuss this in chapter 13). Estimations of elasticity thus enable capitalist policy makers to identify constraints on rational utility and profit maximizing behavior as well as for deriving policies which can reduce these constraints. If the price elasticity of beef is low this may be because this is the only meat available. There is therefore scope for taxing the consumption of beef and using the money raised to subsidize pork production (which as research in Belgium has shown is a much more cost effective industry in the long run). The price and income and cross price elasticity of demand for pork in Pakistan is almost zero today. But so it was in Israel in 1949 which according to FAO statistics now consumes about 370,000 tons of pork annually. Cannot a modern ruler, like Musharraf, persuade an enlightened moderate scholar to issue a fatwa to the effect that it is only unhygienically produced pork that is haram? After all “non alcoholic” beer has been “hallalised” (made permissible) in many Gulf states. Such policies will increase the price elasticity of beef in the long run and enhance both utility and profit maximization. Of course utility calculations are useless if people refuse to act rationally. If instead of listening to the enlightened moderate scholar “halalising” pork people make a fun of his views, choices will not be widened and utility and profit maximization will not be facilitated in the long run. What is the point of estimating elasticities in these circumstances? Elasticity concepts are useful for legitimizing and facilitating capitalist rule. They are useless for every other purpose. Key Concepts Arc price elasticity reflects the change between two points along a demand curve Budget share is the proportion of income that is spent on a particular commodity Complements are the goods which share negative cross price elasticity Cross price elasticity shows relation between quantity demanded of one commodity and price of another. It measures the proportional rate of change in quantity demanded of one good due to proportional change in price of another good

Elasticity is a pure algebraically signed and unit-free measure of responsiveness between two variables. It measures percentage rate of change in the dependent variable due to change in the independent variable Elasticity of demand shows what happens to demand for a commodity when the variables which affect demand undergo some change, that are the price of the good in question, price of related goods and income Income elastic demand is greater than 1. The demand changes by more than the change in income in percentage terms Income elasticity of demand shows percentage change in demand due to percentage change in income Income inelastic demand is less than 1. The demand changes by less than the change in income in percentage terms Inferior good has a negative relationship between income and its demand. It displays negative income elasticity Linear demand curve is one for which the slope is constant at all points while elasticity varies from zero to infinity Luxuries are the goods which have income elasticity greater than 1 Necessities are the goods which have income elasticity less than 1 Normal good is one for which an increase in income leads to an increase in demand. It has positive income elasticity Point elasticity measures elasticity at a specific point on a demand curve Price elastic demand is greater than 1 in absolute value. The quantity demanded changes more than the change in price in percentage terms Price elasticity of demand shows the percentage change in quantity demanded due to percentage change in price Price elasticity of supply is the percentage change in quantity supplied due to percentage change in price Price inelastic demand is less than 1 in absolute value. The quantity demanded changes less than the change in price in percentage terms Slope measures the rate of change in the dependent variable due to change in the independent variable Substitutes are the goods which posses positive cross price elasticity Unitary price elastic demand is equal to 1 in absolute value. Change in quantity demanded and price are equal in percentage terms Chapter Summary The inverse of the demand curve slope is measured as Q / P < 0 Slope should not usually be used to measure responsiveness of quantity demanded to changes in price or income because Slope has to be measured in specific units and not as a pure number It makes the comparison of responsiveness of commodities measured in different units difficult Price elasticity of demand is measured as %Q/%P Elasticity may be measured at a point on the demand curve. To calculate point elasticity we must have sufficient data to estimate the slope of the demand curve. In principle this requires information on quantity demanded at every (possible or actual) price in the market. This is usually not available and we have information about quantity demanded at only a few prices. Arc elasticity of the demand curve is measured as Where IP and IQ are initial price and quantity demanded and FP and FQ are final price and quantity. When quantity demanded changes less than proportionality to change in price (ηxp < 1) the demand is said to be inelastic (in mature capitalist societies demand for alcohol is price inelastic). When ηxp > 1 demand is price elastic. If ηxp = 0 price is perfectly inelastic. When ηxp = 1 demand is said to have unit price elasticity. When ηxp = elasticity of demand is said to be infinite

Price elasticity is affected by the price of substitutes. Necessities are less elastic than luxurious—a prayer rug is a luxury in mature capitalist societies, a necessity in non-capitalist ones. Elasticity increases over time. Other factors which influence prices elasticity are availability of substitutes and the share of the expenditure on a commodity in the budget of the consumer. Sellers are primarily interested in change in net revenue. When ηxp = 1 change in price exactly cancels out change in quantity demanded. With elasticity > 1, price and quantity are negatively related and with ηxp < 1, there exists a positive relationship between price and revenue. While the slope of the linear demand schedule remains constant its elasticity changes at every point since P/Q ratio keeps changing. Figure 4.5 shows that with slope of the linear demand schedule equal to 1, ηxp > 1 for all points above the mid point of the schedule and ηxp < 1 for all points below the mid point of the demand schedule The elasticity of a demand schedule with constant slope varies between infinity and zero. This shows that the flatness or steepness of a demand curve is only one determinant of its elasticity. The other determinant is the P/Q ratio The rectangular area below any point on the demand curve gives the total revenue at that point At every point on a straight line demand curve elasticity is given by the distance from the origin to price at that point divided by the distance of the vertical intercept to the price at the desired point. For the straight line demand curves with the same slope the one further from the origin has lower elasticity than one nearer the origin at any given price The elasticity of straight line demand curves with different slopes but the same vertical intercept is equal at every price level Flatter straight line demand curves have higher elasticities than steeping ones at their intersection point—i.e. at the point where P/Q is the same in both cases Income elasticity of demand is estimated by ηxm = Qx/M × M/Q where ηxm is income elasticity of demand The concept of income elasticity of demand is applicable to consumer behavior only in capitalist societies. In non-capitalist societies demand does not normally rise with income. That is why inflation is a very rare phenomena in non-capitalist societies In capitalist society goods are classified as (a) inferior if ηxm < 0, (b) necessities if ηxm < 1 (c) luxuries if ηxm > 1. “Necessities” are defined by an individual’s orientation of the society in which he lives. All luxuries are potential necessities in capitalist society (because of the condition of perpetual scarcity). In non-capitalist society only necessities are defined on the basis of physical needs Cross price elasticity of demand is measured by ηxy = Qx/Py × Py/Qx Where ηxy indicates the elasticity of demand for commodity x with respect to change in the price of good y. The value of this ratio can vary form minus infinity to plus infinity. Goods are (a) substitutes where ηxy > 0 = (b) complements when ηxy < 0.

Price elasticity of supply is measured as The neoclassical assumption is that the “normal” supply curve is upward sloping i.e. the quantitative estimate of εxp is expected to be positive. This “normal” supply schedule is unlikely to exist in non-capitalist societies and this shape of (especially the aggregate) supply curve has been disputed even by analysts of capitalist production Supply elasticity ranges from zero to plus infinity. Speed at which production can be increased or decreased in response to price signals is likely to vary over time. Cost is another determinant of supply elasticity. If costs of production rises as much as price, capitalist producers will have no incentive to expand production and εxp = 0 The elasticity concepts cannot be used to analyze production, consumption and unemployment in non-capitalist societies—i.e. societies in which men do not seek profit and utility maximization. The typical response of producing to changes in supply in such societies is rationing, not price increases. Unemployment and inflation are the products of capitalist rationality. They are virtually unknown in non capitalist societies Review Questions Why is the slope not used by economists to measure the responsiveness of quantity demanded to changes in price and income? How is elasticity measured? What is the difference between slope and elasticity? How is price elasticity of demand measured? Why is price elasticity of demand usually expected to be a negative number? What is point elasticity and how is it measured? Why is demand for beer inelastic in mature capitalist societies? Why are flatter demand curves not always more elastic than steeper ones? What factors determine the price elasticity of demand for a particular commodity? Show why price and revenue are unrelated in the case of goods where the price elasticity of demand is unity. Show why price and revenue are negatively related where price elasticity of demand is greater than one and that price and revenue are positively related when demand elasticity is lower than unity. A company produces a model of car of which 16000 cars/year are sold out. Suppose that cross price elasticity of demand for cars with respect to petrol is -0.5. If price of car remains same, but the price of petrol increases from Rs 40 to 50 per liter, calculate change (not percentage change) in the demand for this car. Assume that 100 plates of Biryani are demanded at the moment in your institute’s cafeteria at a price Rs 20 per plat. If the price of Biryani increases to Rs 25 and its demand decreases to 90 plates, then: Calculate the value of price elasticity of demand for Biryani from the given data on price and quantity Calculate the total expenditures on Biryani at new price, both before and after price change? How can you conclude your answer in (a) about price elasticity of Biryani by comparing the information on total expenditures data in (b)? What general relationship between price, demand elasticity and expenditures can you confirm from this example?

Suppose that you are called by Pakistan’s ‘drugs usage controlling authority’ in a meeting. The agenda of the meeting is to devise an effective policy to reduce crimes committed by drugs addicted people. One of the members suggests putting a ban on the sale of drugs. However, another member, who is economist, argues that this will not reduce drugs related crimes, rather increase them. He gives his explanation in the following quote: ‘As the demand curve for drugs is expected to be price inelastic, ban on the sale of drugs will shift supply curve to the left which means that expenditures of addicted people will increase. This will force them to commit more crimes in order to fulfill their demand’ Using an appropriate diagram, explain the logic of this argument to other members as they could not understand it. Why does the elasticity of straight line demand curves keep changing at every point? Show why the elasticity of a linear demand curve with constant slope varies between infinity and zero. Illustrate your answer with a diagram How did Musharraf’s sugar seths benefit from the inelasticity of demand in the sugar market in 2006? What can you say about Syedna Usman Ghani’s income elasticity of demand? What are “necessities” in (a) non-capitalist and (b) capitalist societies? Why is the income elasticity of junk food high in Clifton but almost zero in Pirbaba? Should income elasticity of demand be raised in Pirbaba? How can it be raised and who will gain from this increase? What is cross price elasticity of demand and how is it measured? What is the price elasticity of supply and what is its range? What according to neoclassical theory are the determinants of the elasticity of supply? Suppose there is a prolonged draughts and production of wheat falls drastically. What would happen to its price in (a) a capitalist market and in (b) an Islamic bazzar? Suppose that the demand for a commodity is perfectly inelastic. Currently 100 units are sold at a price Rs 5/unit. If the price is raised to Rs 6, how many units will be sold? ‘A good harvest of wheat will generally lower the income of farmers because its demand is price inelastic’. Explain this statement using a demand-supply diagram. Can the concept of elasticity be used for an analysis of production and employment in non-capitalist societies? P A R T T H R E E Behind Markets Consumer and Firm Behaviours Chapter 6: Preferences and UtilityChapter 7: Budget Set, Choice and DemandChapter 8: Changes in Demand: A Comparative Static AnalysisChapter 9: Firm and Production in Capitalist SocietyChapter 10: Neoclassical Theory of ProductionChapter 11: Neoclassical Theory of Cost Chapter 6: Preferences and Utility Chapter 7: Budget Set, Choice and Demand Chapter 8: Changes in Demand: A Comparative Static Analysis Chapter 9: Firm and Production in Capitalist Society Chapter 10: Neoclassical Theory of Production Chapter 11: Neoclassical Theory of Cost Chapter 6 PREFERENCES AND UTILITY The previous three chapters show how prices of goods and services are determined within the neoclassical demand supply model. But one must raise an important question at this stage. Where do demand and supply come from? And is the demand and supply analytical model applicable to all societies? If yes, what is the justification for this claim? If not, what are the characteristic features of the society to which demand and supply analysis is applicable? Answering these questions requires us to understand the source of demand and supply, the motives of demanders and suppliers, and the scope, the range of applicability, of these theories.

Let’s begin by looking at the motives of the ‘demanders’—the consumers. Neoclassical economists analyze consumer behavior in order to justify the negatively sloped individual and aggregate (market) demand curve. Before we begin with the formal neoclassical analysis it is necessary to explain what lies behind this formal theory—philosophers would call this the metaphysics of the neoclassical theory of consumer behavior. 6.1: Who is Consumer? The economic theory of consumer behavior is founded on the Enlightenment doctrine known as possessive individualism. This doctrine holds that: Every person is committed to the promotion of his own interest This (self) interest is the maximization of the freedom of the individual; i.e. the ability of the individual to himself determine what is good for him. He is not obliged to accept or reject something as good on the basis of some other authority. Man is “autonomous”, as Kant puts it, and he does not accept any authority’s right to tell him ‘what he ought to do’. This is the essence of the conception of ‘home economicus’—economic man—which underlies all economic theory. Abdullah Zhaghazai will be a “homo economicus” only if: he is self interested. His own well being—and not that of Munira his daughter, Aleemullah, his employee, the Zhaghazai tribe, Pakistan or the Muslim Ummah—is his primary concern and its promotion his main motivation he defines his interest himself and does not accept any one else’s authority—that of his tribal chief, his Peer, his community customs, the Quran and Hadith—to define his self-interest he regards this capacity to choose—to himself determine what is good—as primary; i.e. more important than any particular choice that he makes. What is really important for him is that he has the money so that Abdullah can either (a) buy a car or (b) finance the construction of a mosque or (c) choose the choice to do either (a) or (b) or both (a) and (b) or to buy a car in 2010 and finance the mosque in 2011. For Abdullah to be a consumer, it is primarily important for him that he has the right to do whatever he likes and nobody (neither his family, nor his tribe nor God) has the right to tell him what he should like or dislike in his life The above is not entirely possible for Abdullah and there are important constraints on Abdullah’s right to choose (not a particular thing but choice itself). First if Abdullah is a homo economicus he must accept Munira and Aleemullah as homo economicuses too. This is because Abdullah cannot flourish in a non-capitalist society—in a society of Muslims or Christians or Red Indians or other non-homo economicuses. But recognizing Munira as a homo economicus is problematic. If Aleemullah has the right to choose just like Abdullah has, then Abdullah cannot choose anything which restricts Aleemullah’s right to go his way. Abdullah cannot choose for example to ban the production of whisky for Aleemullah may want to drink it. Thus Abdullah can choose not to drink whisky but he cannot choose to ban its production, no matter how much utility he derives from such banning. Thus recognizing Aleemullah as a homo economicus requires that only those types of utility maximizing activities should be recognized as legitimate which do not impede aggregate utility maximization (i.e. the sum of the utility of all consumers).

This means that “utility” has to be defined in a particular and specific way. Aggregate utility is necessarily utilities derived from the expansion of everyone’s choices. Since aggregate utility is the sum of all individuals’ utility, the component of individual utility derived from acts which reduce or constraint aggregate utility must be factored out before the aggregation of personal utility takes place. To understand this idea, suppose Abdullah derives utility from the following three: eating coconuts—this yields 1 util (util is a measure of utility) playing football—this yields 2 utils preventing Aleemullah’s drinking of whisky—this yields 3 utils Here while (a) and (b) do not restrict aggregate utility (i.e. do not restrict the expansion of Aleemullah’s choices), however (c) does impede aggregate utility. Thus while (a) and (b) may be “added up”, (c) must be “netted out” while calculating aggregate utility. In aggregate utility calculation Abdullah’s net utility is zero according to our example (1 util ‘from coconuts, 2 from football and minus 3 from banning whisky). He contributes nothing to aggregate utility and is therefore not a homo economicus. Thus, the ‘right to choose anything’ rules out the right to choose banning whisky, for this specific choice impedes choice in general. This ‘choice in general’ can only be measured in Rupees and Dollars and Euros. For it is Rupees and Dollars and Euros alone which confer the right to choose in general on Abdullah. That is why the utility (or welfare) function aggregates are expressed in Rupees or Dollars in economics. Anything which cannot be so expressed—mother’s love for example—cannot be incorporated in individual utility functions (the concept of the utility function will be explained in detail later). This is another proof of the essentially normative character of economic analysis. There is no such thing as positive economics because economic analysis illuminates the process of “the production of dollars by means of dollars” assuming that dollars can measure everything worth measuring and we want everything—i.e. more and more dollars. If Abdullah is willing to do something that cannot be measured in rupees (e.g. to love his mother, to honor his tribal customs, to serve God), economics cannot tell him how to use resources efficiently for such purposes. This is because in such a case Abdullah’s net contribution to aggregate utility is zero or negative. He must be “netted out”—sent to Guantanamo Bay or shot, declared insane or fundamentalist—until he agrees to become “homo economicus” and internalizes capitalist rationality. Economic theory pretends that as “homo economicus” Abdullah leads a dual life. In his private life Abdullah is supposedly free to choose anything depending upon his desires—praying five times a day or playing football. In his public life he must submit to the market (and to the capitalist state which guarantees its existence). The market will reward or punish Abdullah on the basis of the exchange value of his activities. For example, praying five times a day commands no exchange value and there can be no market rewards for this activity as there can be for playing football depending on the value of football player. The market and the capitalist state basically lie when they claim that they are neutral in terms of the type of private life Abdullah chooses. By valuing all of Abdullah’s activities in terms of their exchange value they are forcing Abdullah to prefer the life of a footballer. That is why capitalist norms—lust, greed and jealousy—flourish in the private lives of most people in capitalist society.

Economic theory holds that it is rational to be lustfull, greed and jealous. It calls jealousy ‘competition’ and greed ‘accumulation’. The rational individual is necessarily accumulative and competitive. He is necessarily committed to the maximization of his well being and this “well being” is necessarily measured in terms of the (appropriately discounted) exchange value of the goods and services he consumes during his life. If Abdullah does not seek maximization of his “well being” he is an irrational, insane, unenlightened savage. If Pakistani society values Abdullah’s activities on basis other than their exchange value, Pakistan is an uncivil society and a failed state. Abdullah’s conception of himself as a consumer, his commitment to maximization of his consumption during his life, is based upon the Enlightenment conception of self interest. A self-interested person is one who seeks to maximize his consumption during this life. If Abdullah regards his self-interest in obeying God’s commands so that he reaches heaven, the market can provide no valuation calculus for evaluating the progress he is making for the achievement of this objective and the realization of this type of self-interest. The only conception of self interest that economics recognizes as rational and that the market can value is the one which is expressed in the unconditional commitment to the maximization of consumption in this life. 6.2: Consumer Behavior and the Theory of Choice Economics studies consumer behavior within the context of the theory of choice. Choice is necessary due to the existence of scarcity. If there are many more coconuts growing in Maldives than people want to eat, Abul Bashr can have as many as he likes. If American Fruit Enterprises buys all the coconut trees in Maldives, Abul Bashar will have to purchase coconuts from the wages American Slave Holdings pay him as their workers. Moreover, since American Seafood Inc. has bought up all of Maldive’s fishing, so Abul Bashar has to decide how much to spend on fish and how much on coconuts—he is free to decide how much he will spend on fish and how much on coconuts given his income. He is not free to spend nothing on them, for in that case he will starve. He is free to work for American Slave Inc, or American Sea Foods or American Fruit, given his skills. He is not free to work for none of these corporations for there is no other employment. He is also not free to prevent the development of capitalist property in the Maldives, for if he does so, he will be shot as were the 80 million Red Indians who opposed the development of capitalism in America. The two determinants of Abul Bashar’s “free choice” are: his tastes—he may like fish more than coconuts his income—fish may be so expensive that he cannot buy any of it Due to the miserable wages paid by American Slave Holdings, Economic theory assumes that Abul Bashar’s tastes are independent of his income and are not determined by his place in time and space. He is assumed to have ‘this taste’ because he has it; i.e. his tastes are predetermined and fixed. So are Rahiman’s (his wife) tastes—she may like coconuts more than fish for no other reason but that she likes coconuts more than fish.

Figure 6.1: The economic conception of societyFixed taste of Abul BasharFixed taste of RaheemanFixed taste of MubashirPrices of goods, income and opportunities of consumersAbul Bashar’s ChoicesBasharians ChoicesMubashir’s ChoicesMaldive = Choices of Abdul Bashar + Choices of Raheeman + Choices of Mubashir Figure 6.1: The economic conception of society Fixed taste of Abul Bashar Fixed taste of Raheeman Fixed taste of Mubashir Prices of goods, income and opportunities of consumers Abul Bashar’s Choices Basharians Choices Mubashir’s Choices Maldive = Choices of Abdul Bashar + Choices of Raheeman + Choices of Mubashir It is this assumed independence of individual tastes which allows economists to add them all up to obtain ‘aggregate or social utility’ (to be discussed in chapter 8 in details). Maldivian society is seen merely the sum of the tastes of all Moldavians. This economic conception of society is shown in Figure 6.1. In the economists vision of society, Abul Bashar as consumer is sovereign (so too are Raheeman and Mubashir, their son) precisely because it is his own choices—given his income—that will determine the production and distribution of value in Maldivian society. This consumer sovereignty would vanish if we recognize that Abul Bashar’s choices are determined by the family he comes from, the people he works with, the sufi order be belongs to and the income he has. In this case he would not be sovereign as a consumer as his tastes would be determined by his relationships. The economic theory of consumer behavior as outlined below claims that it is universally applicable—in Maldives and Congo and Sweden and Cuba and the Taliban’s Afghanistan, in BC 5000, AD 1, AD 2007 and AD 100,000. All consumers are and ought to be sovereign. They have and ought to have predetermined ‘given’ tastes entirely un-influential by their social relationships. They all pursue and ought to procure the over-riding objective of maximizing consumption in this life. It is not difficult to see the underlying misconception behind this presumption of ‘given innate taste’ even within capitalist society. In a capitalist society, wants of consumers do not exist independently of the products created by firms for maximizing their profits. Not only do firms determine the range of market goods from which consumers must choose, they keep on persuading consumers, through advertisement and promotion drives, to choose that which is being produced today and reject that which was being produced yesterday. Therefore, capitalist society (civil society) is fundamentally a want-creating, and not a want-satisfying, mechanism. An unchanging pattern of wants is the hall mark of non-capitalist societies, such as religious ones. Tastes haven’t changed much in Pirbaba since the times of Abdullah’s great grandfather. Contentment (Qana’at) and unchanging taste pattern are not compatible with the capitalist project of utility and profit maximization because a society exhibiting such traits would not absorb the rapid growth in the flow of goods coming on to the markets. Hence, the part of national income devoted to create new wants always keeps increasing in capitalist societies. Manufacturers strive to create an atmosphere which simultaneously glorifies the ‘pace-setters’ and ridicules the fashion laggards. Women’s fashions are merely a familiar case in point. The art and fashion industries are the perfect examples of activities dedicated to using up resources not to produce satisfaction, but to create dissatisfaction with what people posses—to create a sense of ‘out datedness’ in otherwise perfectly satisfactory goods. Infinite wants have somehow to be created to sustain this rising industrial capacity.

6.3: Modeling Consumer Preferences This section presents the formal economic model of consumer preferences. Remember that this model is based on assumptions about individual motivation and behavior and the relationship between the individual and society outlined in sections 6.1 and 6.2. Satisfying consumer preferences is said to be the ultimate goal of a capitalist society, (this is not true as explained in sec 6.2). To analyze consumer preferences, we need to analyze consumer behavior, the way a consumer reacts under different economic settings. Before we start, it will be useful to learn how economic goods are perceived by “homo-economicus”. There are innumerable commodities that Bush wants to use. We need some way to reduce the complexity to handle consumer choice. Let’s pick fish and coconut. The reason to start with two goods is that we can use a two dimensional graph. Consider a point showing the quantity (4, 3) as point A in figure 6.2. Figure 6.2: Consumption bundlesAB112345Fish02345Coconut Figure 6.2: Consumption bundles A B 1 1 2 3 4 5 Fish 0 2 3 4 5 Coconut The first number represents the quantity on the horizontal axis, 4 units of fish, and the second entry shows the quantity on the vertical axis, 3 units of coconut. Such a pair of non-negative numbers shows a consumption bundle or basket of commodities. Point B also represents a consumption basket. The smallest consumption bundle can be, of course, (0, 0) which is the origin of the graph. Negative quantities do not appear for nobody can consume -1 unit of anything. We can think of a number of such pairs between two commodities and compare them in two general relationships which are as follows. The Strict Preference Relation Consider the following choice situation: A B 3 fish 7 fish 4 coconut 5 coconut Suppose Farooq is offered a choice between bundles A and B each Friday. If he chooses bundle A, we say that Farooq prefers A to B, denoted by, A P B spoken as “A is strictly preferred to B” If A P B to Farooq on a certain Friday, then B P A is not true at the same time because that is inconsistent behavior. Note that we stay nothing about why he prefers A to B because, as noted above, economists deal with given consumer preferences. All that is important is the fact that he makes a consistent choice between a pair of commodities. The Indifference Relation But suppose that sometimes Farooq chooses A sometimes he chooses B. Farooq may then be said to be indifferent between the two bundles. Hence, A I B “A is indifferent to B” By indifference, we mean that Farooq doesn’t care whether he consumes A or B; i.e. he will be equally happy with both of them. We can say that Farooq will be ready to receive any bundle if a coin is tossed to decide which bundle he receives. Note that if A is considered indifferent to B then this must mean that B is also considered indifferent to A. Also both A P B and A I B cannot be true at the same time. This is because if A P B, then B cannot be equal to A at the same time—Farooq prefers bundle A to bundle B, he cannot at the same time be indifferent between them.

Based on this information, we can conclude that if we consider a pair of different consumption bundles A and B, a consumer can have three possible reactions to these pairs: A P B: A is preferred to B or B P A : B is preferred to A or A I B : A is regarded as indifferent to B Equipped with this information, we can model consumer preferences as understood by economic theory. 6.3.1: Assumptions about Consumer Preferences: Rationality Conditions Economics analyzes the behavior of only “rational” consumers and in its view, as we have seen above Abdullah Zaghazai is irrational. The question is: ‘who is a rational consumer?’ The following four assumptions define the minimum conditions underlying the economic conception of consumer rationality. The rational individual must posses these characteristics. Completeness or Comparability This assumption says that the consumer is fully aware of his tastes and can always compare and rank all commodity bundles. Technically speaking, given any two bundles A and B, the consumer must be able to decide whether he prefers A to B or is indifferent between them, that is, one of the following statements must be true: A P B or B P A or A I B Economists cannot say anything about the consumption behavior of an individual if he is unaware of his taste. If Farooq cannot compare commodity bundles in terms of preference or indifference, then economists can’t say what Farooq will choose to do. Completeness of preferences is a strong assumption, as it requires complete information of all the relevant outcomes of an action. In the real world, Farooq usually faces uncertainties and has to take risks. Economists simply rule out the possibility of uncertainty in their formal analyses of consumer behavior. This implies the existence of an all-wise and all-knowing consumer (see Box 6.2 at the end after reading this chapter)—the consumer is not only sovereign, he is also God. Transitivity By transitivity, economists mean that given any three commodity bundles, A, B and C if A P B and B P C then A P C. This idea is very similar to the mathematical notation: if A > B and B > C, then A > C. Transitivity is not a pure statement of logic, however it is a hypothesis which presumes that individual’s choices are consistent. Consider a person who prefers ice cream (I) to burgers (B) and burgers to fish (F), but then also says that he prefers fish to ice cream. Is his choice pattern rational? Not according to the economists. Look at table 6.1 which ranks Farooq’s preferences. His first statement places ice-cream above burger and his second statement places burgers above fish. Therefore, ice-cream must precede fish in ordering. But his third statement, in contrast, puts fish ahead of ice-cream, and his preference ranking becomes in-determinant. Table 6.1: Ranking Preferences. Statements Ranking 1. I P B implies i. I Imply i. I ii. B I P F ii. B 2. B P F implies i. B iii. F ii. F 3. F P I implies i. F Implies F P B Not possible due to contradiction with statement 2

ii. I Therefore, we say that consistent choices can take place only if preferences satisfy the transitivity axiom. Otherwise economic theory will not be able to identify choice patterns. Greed It is not possible to rank preferences of an individual for different commodities without answering the question, ‘what is consumption for?’ This purpose of consumption is given a technical name by economists non-satiation. Economics presumes that the consumer always prefers more of all goods; he prefers more of any bundle to less of that bundle, called ‘more is better’ because it is more. If bundle A contains one unit more of at least one commodity than bundle B, then bundle A must be preferred to bundle B by the rational consumer. Thus, a consumer prefers bundle (3x, 2y) to bundle (2x, 2y) because the first bundle contains at least one unit more of commodity x. Unlike the first two assumptions, this assumption is not a technical one. Rather, it expresses the psychological and spiritual state of the consumer. According to this assumption, a rational consumer is “naturally” greedy and it is exactly this bizarre impulse that constitutes the rationality of the consumer. The rational individual is one who is greedy. Greed is the essence and the most important constituent of his rationality. This choice of greed as a standard of rationality is not an arbitrary one. Recall that economics begins with an unjustified presumption that wants are (and should be) infinite and, hence, it is always impossible to satisfy all of them. Therefore, a rational individual is one who always wants more; that is he must be greedy. Moreover the attainment of economic efficiency is guaranteed when society is dominated by greed. People committed with the desire to keep on increasing their consumption or standard of living will exert them for enhancing efficiency. Contented people, like Abdullah’s sufi sheikh, will not worry about efficiency for very much because the ideal of religious rationality is Zuhd, Faqr and Qana’at. The absence of contentment (qana’at) is a necessary condition for consumer rationality to hold. Independence Almost all microeconomics textbooks leave an important condition for rationality; i.e. of independence. The axiom is concerned with the relation between ‘the one’ and ‘many’. As we saw in chapter 3 that economists study individual demand behavior in order to obtain market demand curves. The market demand is obtained by summing up the demand curves of various individuals. But this summation of individual demand curves is possible only if the demand functions of all individuals are independent of each other. This means that one of the rationality conditions is to assume the absence of interdependence between the preferences of individual agents. Alternatively stated, the independence assumption says that a rational consumer is one who seeks to promote only and only his own self-interest irrespective of the concerns for others. His choice pattern should be independent of what others think or do in the society. While considering what to do in his life, Farooq should pay no attention to what his parents expects him to do. Neither should Farooq try to imitate what his peer has been doing throughout his life. Instead Farooq should consider himself an autonomous and self-determined being. He should recognize others but only in the capacity of another isolated self-interested selves incapable of evaluating the quality of desires and feelings held by the others in society.

6.3.2: From Assumptions to Indifference Curves These four assumptions form the basis of consumer behavior analyses. Thus a rational consumer is one (a) who is happy to be greedy and (b) makes logically consistent choices based on his greed. There is one more technical assumption that we will add later. Now consider figure 6.3 where we have shown two axes representing a consumer’s consumption of the two commodities x and y. Figure 6.3: Representation of preference relationsABDUIIIIIIIV112345x02345y Figure 6.3: Representation of preference relations A B D U I II III IV 1 1 2 3 4 5 x 0 2 3 4 5 y C C Given our assumptions, we know that the consumer can indicate either preference or indifference between all commodity baskets. This information can be used to rank all of the consumer’s choices. Let’s pick a certain consumption bundle, say U (3x, 3y) and find the bundles that are preferred to and are considered indifferent to it by the consumer. We have divided the diagram into four quadrants around point U. Any point in the first quadrant will be preferred to bundle U as it contains more of both goods (recall ‘more is better because it is more’). Similarly, any point in the third quadrant will be less preferred than U because it consists of less of both the goods; e.g. C (1x, 1y) in this region. So we can say that any curve that is passing through point U and representing those bundles which are considered indifferent to each other cannot enter the first or the third quadrant of this diagram because all bundles in quadrant I are preferred to U while all bundles in region III are considered to be worse than U. Now we are left with quadrants II and IV. It is possible that all points that fall in these quadrants might be considered to be indifferent to U. Why? Consider point B which consists of more y but less x than bundle U. The reduction in x decreases utility; however the increase in y raises it. It is reasonable to assume that both of these effects, negative and positive, might offset each other and the consumer obtains the same utility as at point U. The same reasoning applies for point D in the quadrant. Through this procedure we have located some points which contain all those bundles which may be considered to be indifferent to U; these points yield the same utility as it. If we join such bundles that are considered by the consumer to be indifferent to each other by a curve, then this curve must pass through quadrants II and IV. Such a curve is drawn in figure 6.4 (forget about its exact shape for the moment, which we discuss shortly). This curve is called the indifference curve, (labeled I0). It shows all combinations of two goods that are considered indifferent to each other; because they yield equal utility to a consumer. The utility level is constant at all points of the curve passing through points B, U and D. Figure 6.4: An indifference curveABDUIoI1112345x02345y Figure 6.4: An indifference curve A B D U Io I1 1 1 2 3 4 5 x 0 2 3 4 5 y The Indifference Map Note that there was nothing special about point U to begin with. We could start with point A instead and could derive all the points that could be considered indifferent with it and the resulting curve would be I1 as shown in figure 6.4. Because of the assumption of greed economists assert that bundles on the indifferent curves farther from the origin must be preferred to the bundles on curves closer to the origin as the former contain more of at least one good.

Figure 6.5: The indifference mapI1IoI2I3112345x02345y Figure 6.5: The indifference map I1 Io I2 I3 1 1 2 3 4 5 x 0 2 3 4 5 y The bundle A on I1 is preferred to all bundles on I0 due to the implications of the transitivity assumption: (if A P U, and U I B and D, then A P B and D). Look at figure 6.5 which shows a number of indifference curves. As we move up and to the right in this figure, we are reaching indifference curves containing more preferred consumption bundles. Such a graph is known as an indifference map. It shows a set of indifference curves representing the utility a consumer can obtain from all possible consumption options. It is possible to construct an infinite number of such indifference curves given the taste of a consumer. Let us discuss some of the vital properties of indifference curves. Property 1: Indifference curves are negatively sloped The assumption of greed implies that indifference curves must be negatively sloped. Upward sloping indifference curves will violate this assumption. To see this, consider figure 6.6 where bundles A and B lie on a positively sloped indifference curve. Can these two bundles be considered as indifferent by the consumer? Figure 6.6: Slope of the indifference curveAB123401234yx Figure 6.6: Slope of the indifference curve A B 1 2 3 4 0 1 2 3 4 y x Obviously not, because bundle B contains more amounts of both commodities than bundle A. Bundle A could be considered indifferent to B only if we rule out the assumption of universal greed (non-satiation). This of course is never allowed by economics. Therefore, the relation between A and B is of preference, and not of indifference. Bundles that could be considered to be indifferent to each other must fall on a negatively sloped curve (recall quadrants II and IV of figure 6.3). The negative slope of the indifference curve conveys the idea of commodity substitution—the smaller quantity of one good is compensated by a larger quantity of another to keep utility constant. Property 2: Indifference curves can’t intersect To see why this is so look at figure 6.7 where this situation is depicted. This case is unfeasible according to the assumptions underlying consumer preference theory. Bundle A is on both the curves. By definition, the consumer considers bundle A to be indifferent to B as they fall on the same indifference curve I0. So, we get the information: From indifference curve I0 A I B Figure 6.7: why can’t indifference curve intersectCBAI1Ioy0x Figure 6.7: why can’t indifference curve intersect C B A I1 Io y 0 x But, bundle A and C can also be considered indifferent to each other because they fall on the same indifference curve I1. So, From indifference curve I1 A I C These two statements imply that B I C by the assumption of transitivity. But we can see that this is a violation of the assumption of greed because bundle C contains more commodities than bundle B, so it must be preferred to B. If the two indifference curves were distinct from each other, then B cannot be equal to C, but we have shown that they are the same. Nothing distinguishes the two curves if point A lies on both of them. The underlying assumption of universal greed and transitivity necessitate that indifferent curves cannot intersect. There can be one and only one indifference curve passing through any point.

Property 3: Higher Indifference curve shows preferred bundles This property is a straight forward implication of the assumption of greed, as explained in figure 6.4 above. Due to this assumption, all bundles that fall on an indifference curve farther from the origin are preferred to those bundles that fall on an indifference curves closer to the origin. So far we have been able to locate the position of indifference curves. However, its exact shape not has been determined. Even if we know that bundles that are considered to be indifferent to each other, such as A and B, must be joined by a negatively sloped curve, nothing rules out any of the shapes of indifference curves shown in the left and right panels of figure 6.8. Economists impose another assumption on the taste of the consumer to give a precise shape to the indifference curve. This assumption implies convexity. The importance of this assumption will be revealed in chapter 6 when we discuss the idea of consumer equilibrium. Let us understand its meaning and implication for the shape of the indifference curve at this stage. Figure 6.8: Shape of indifference curve?ABABxy0ABxy0 Figure 6.8: Shape of indifference curve? A B A B x y 0 A B x y 0 A A B B Convexity Convexity is a mathematical property of a function. In consumer behavior theory, it means that a weighted average sum of any two bundles of commodities, say bundles A and B, is preferred to those bundles themselves. To understand this idea, let us first understand the concept of ‘weighted-average’. Suppose you teach two classes, class a and b, each comprising of 20 students. Further assume that each class contains 10 boy (B) and 10 girl (G) students. Suppose you want to develop a new class of 20 students containing 50% students from class a and 50% students from class b. This means that you will pick up 10 students from class a (5 boys and 5 girls) and 10 from class B (5 boys and 5 girls). The new class, say class c, thus created will be a weighted-average representative of classes a and b. The representation of each class in the new class in this case is 50%. Similarly, we can construct any new class out of the two classes with different proportions of representation. Table 6.1 shows some examples: Table 6.1: Proportionate Representation Actual Class a = (10 Ba, 10 Ga) Actual Class b = (10 Bb, 10 Gb) New class with 50% representation of each class c = (5 Ba, 5 Ga, 5 Bb, 5 Gb) = (5 Ba, 5 Bb, 5 Ga, 5 Gb) New class with 80% representation of class a and 20% of b d = (8 Ba, 8 Ga, 2 Bb, 2 Gb) = (8 Ba, 2 Bb, 8 Ga, 2 Gb) New class with 20% representation of class a and 80% of b e = (2 Ba, 2 Ga, 8 Bb, 8 Gb) = (2 Ba, 8 Bb, 2 Ga, 8 Gb) Thus, each class, c, d and e, is a weighted-average sum of the classes a and b with different proportions. With this understanding of weighted-average, consider bundles A (2x, 4y) and B (4x, 2y) in the left panel of figure 5.9. We can construct a new bundle, say C, by taking some amount of x and y from bundle A and some amount from bundle B. That bundle will be a weighted-average of bundle A and B. Suppose we take 50% of x and y from bundle A and 50% from B. Such a bundle will contain 3x and 3y as:

Bundle C = [(0.50 × 2xa + 0.50 × 4xb), (0.50 × 4ya + 0.50 × 2yb)] Bundle C = [(1xa + 2xb), (2ya + 1yb)] = (3x, 3y) Figure 6.9: Representing proportionate bundlesBA2442C = (0.5×xa, 0.5×xb, 0.5×ya, 0.5×yb)3xy03BA2442D = (0.75×xa, 0.25×xb, 0.75×ya, 0.25×yb)2.5xy03.5 Figure 6.9: Representing proportionate bundles B A 2 4 4 2 C = (0.5×xa, 0.5×xb, 0.5×ya, 0.5×yb) 3 x y 0 3 B A 2 4 4 2 D = (0.75×xa, 0.25×xb, 0.75×ya, 0.25×yb) 2.5 x y 0 3.5 This bundle falls exactly in between the two bundles A and B. Similarly, we can construct another weighted average bundle; say D, with 75% weight of A and 25% of B as: Bundle D = [(0.75 × 2xa + 0.25 × 4xb), (0.75 × 4ya + 0.25 × 2yb)] Bundle D = [(1.5xa + 0.5xb), (3ya + 0.5yb)] = (2.5x, 3.5y) and this falls closer to bundle A (see the right hand panel) because the weight of bundle A was assumed to be greater (75%) than B (25%) in this bundle. But it is important to note that both bundles C and D fall on the straight line joining bundles A and B in both diagrams. This is a general result; the weighted average of any two bundles, say A and B, will fall exactly on the line segment joining those two bundles. The exact location of that weighted average bundle on the line segment AB depends upon the weights assigned to each bundle. If bundle A is given greater weight than B, the new bundle will fall closer to A on the line segment AB. You might be tempted to ask, why are we doing all these messy calculations for developing weighted average bundles? “Let us go back to the assumption of indifference curve convexity. It says that a weighted average sum of any two bundles, say bundles A and B, is preferred to those bundles themselves. Then according to this assumption, bundle C and D, will be preferred to both bundles A and B. And not only bundles C and D, but all bundles on the line segment AB must be preferred to both A and B because the line segment AB represents all weighted average bundles of A and B. This is exactly what the assumption of convexity means. Intuitively, what the assumption of convexity says is that people have a taste for variety in their consumption. That is, instead of having ‘4 units of coconut and 1 of fish’ or ‘1 of coconut and 4 of fish’, the individual will prefer to have a mixture of them, say (3, 3), and that mixture would be preferred to either extreme bundles, generally speaking, we assume that balanced bundles are preferred to the bundles that are heavily inclined towards one commodity, such as bundles A and B. Property 4: Indifference curves are convex to the origin The assumption of convexity helps economists derive the exact shape of the indifference curve. If A and B are considered to be indifferent to each other, the problem is to find another point that is indifferent to A and B so that a curve joining A and B could be obtained. To see what such a curve would look like, consider the left panel of figure 6.10. Draw a ray such as OR from the origin crossing the line segment AB at some point such as C. Figure 6.10: Convexity of IC y 0 xABDCR y 0 xABDECR

Figure 6.10: Convexity of IC y 0 x A B D C R y 0 x A B D E C R In order to find another bundle that is considered indifferent to A and B, ask the question: on ‘which side of the line segment AB will that point fall on ray OR”? First, think of a point like D on ray OR to the right of the line segment AB (see left hand panel). This bundle cannot be considered as indifferent to A and B. To prove this, note that bundle C on the line segment AB is a weighted average bundle of A and B. By the convexity assumption we know that C P A and B. Further we also know that D P C due to the greed assumption. Therefore, transitivity of preferences implies that D P A. An indifference curve joining A and B cannot pass from any point to the right of the line joining bundles A and B, as shown in the left hand panel of Fig 6.10. For a similar reason, a point considered to be indifferent to A and B cannot be on the line segment AB. This is so because the line segment AB shows the weighted average bundles of A and B, and by the convexity assumption all weighted average bundles of A and B are supposed to be preferred to A and B themselves. Now we are left with the region to the left of line segment AB as the only available area to find an indifferent bundle. This means that any point considered as indifferent to A and B must be to the left of the line segment AB as this does not violate any of the economist is assumption about consumer preferences. For example, consider a point like E to the left of the line segment AB in the right hand panel of this diagram. Such a point can be accepted as indifferent to A and B because you can clearly see that C P E (on the basis if the greed assumption) and also C P A (on the basis of the assumption that weighted averages of two bundles are proffered). Thus we conclude that an indifference curve joining points A and B must be convex to the origin. We will see in the next chapter that the assumption of convexity of indifference curves will ensure that there exists a unique solution to the consumer choice problem. Convexity and the Slope of the Indifference Curve Now we have derived the exact shape of the indifference curve. Let us understand the geometry of its shape. Algebraically, the average slope of an indifference curve between any two points is given by the change in the quantity of good y divided by change in the quantity of good x, and it is negative: (6.1) This is the standard way of writing the slope, the rise over the run, meaning change in the variable on the vertical axis divided by the change in the variable on the horizontal one. Note that the slope term is negative because indifference curves are negatively sloped. However, since the indifference curve is a ‘curve’ and not a ‘straight line’, its slope changes between any two given points. Therefore, the exact slope of the indifference curve at any point is given by the slope of the line tangent at that point. We have shown such tangents at Z and U (the dashed lines) in figure 6.11. Note that the slope (the tangent) of the indifference curve becomes flatter as we move down from left to right (compare the tangent at point Z and U). This means that the slope of the indifference curve gets shallower (less steep) as we move down from left to right.

Figure 6.11: Slope of the indifference curve y 0 xIoZU Figure 6.11: Slope of the indifference curve y 0 x Io Z U Indifference Curve as Representative of Taste What does the slope of the indifference curve mean? Consider two individuals Farooq and Nomi, with their distinct indifference curves. We try to compare the preferences of two individuals at point Z in figure 6.12. If we take some x away from Farooq, say ΔxF (= 1) unit, we need to give him ΔyF (1 unit) y to keep him on the same indifference curve IF. But taking the same amount of x from Nomi requires much more y (2 units) to compensate him, as his indifference curve has a steeper slope at point Z. We can say that Farooq will be willing to sacrifice 1 unit of x to get 1 additional unit of y, or alternatively, he will forgo 1 unit of y for one additional unit of x. Thus, we see that for Farooq, the value of ΔxF (1 unit of) x is ΔyF (1 unit of) y while for Nomi, it is ΔyN (2 unit of) y. So, the value of the slope of the indifference curve of Farooq is: And that of Nomi it is: Figure 6.12: Meaning of the slope of IC y 0 x y 0 x∆yN = 2∆xN = 1NomiZIN∆yF =1∆xF = 1FarooqZIFwhere the negative sign shows that increase in one commodity must be off-set by fall in another commodity in order to keep utility constant on both bundles. Figure 6.12: Meaning of the slope of IC y 0 x y 0 x ∆yN = 2 ∆xN = 1 Nomi Z IN ∆yF =1 ∆xF = 1 Farooq Z IF What do the numbers 1 and 2 measure? Remember that the slope of the indifference curve measures the utility yielded by one commodity in terms of another. It is a relative concept. It measures the utility yielded by x in terms of that of the utility lost by not consuming one unit of y. So, For Farooq at point Z → 1 x = 1 unit of y For Nomi at point Z → 1 x = 2 units of y Furthermore, it is the rate at which the consumer is willing to substitute the good on the vertical axis with the additional unit of the good on the horizontal axis so that his utility level remains constant. For example: For Farooq at point Z → Rate of exchange of y for one extra unit of x is 1 For Nomi at point Z → Rate of exchange of y for one extra unit of x is 2 This rate of substitution between x and y, or any commodities, at constant utility level is called the marginal rate of substitution (MRS). With this added information, we can define the slope of indifference curve algebraically as: (6.2) Note that MRS is defined as the negative of the slope of the indifference curve. Since the slope of the indifference curve is itself negative, therefore MRS is a positive number. Also note that this trade-off between two goods is supposed to be voluntary, the consumer is not forced to accept it. He himself makes utility evaluations of different commodity bundles and then decides at what rate he should exchange the two goods. In other words, the slope of the indifference curve is expected to show voluntary exchanges that an individual is willing to make. Recall that at the start of this chapter, we defined the taste of an individual as all hypothetical exchanges that he is willing to make. Thus the indifference curve is a representative of consumer taste. The steeper indifference curve implies a stronger taste for the good on the horizontal axis (because with a steep indifference curve, Nomi is willing to sacrifice many units of y for one additional unit of x), while a flatter indifference curve shows a stronger taste for the commodity on the vertical axis (e.g. 1y = 1x for Farooq with flatter indifference curve while 1y = ½ x for Nomi with the steeper one).

Diminishing Marginal Rate of Substitution (DMRS) Look at figure 6.13 below and move from point A to B. As we do so, we are adding more x to the consumption and reducing y. From A to B, the consumer is willing to substitute one unit of x at a sacrifice of two units of y. But at C, the consumer is willing to substitute one unit of x by giving up only ½ y. Note that the substitution ratio at C is smaller than at A. Thus, starting from point A and moving to B, we find that the consumer is willing to sacrifice many more units of y (2 units) for x than he is willing to do when he moves from point C to D. Thus, as more and more of x is added to his consumption, he is expected to be willing to give up lesser amount of y for an additional unit of x and hence the value of MRS decreases. Economic rationality requires that we expect the consumer to give up fewer amount of another good as more of one is consumed whatever the goods that are being consumed. Suppose Farooq is spending money on going to haj (x) and on buying footballs (y). Figure 6.13: Marginal Rate of SubstitutionIoCABD∆y=½∆x=1∆x=1xy∆y=2MRS = 2MRS = ½ Figure 6.13: Marginal Rate of Substitution Io C A B D ∆y=½ ∆x=1 ∆x=1 x y ∆y=2 MRS = 2 MRS = ½ The utility yielded by buying footballs will increase as the number of haj performed by Farooq increase—if he has gone for haj 20 times he will enjoy spending money by buying footballs (rather than Ahram) than if he had never been to haj. Economic rationality assumes that Farooq’s love for haj will necessarily decline as he performs it again and again. This tendency of decreasing rate of substitution between x and y is called diminishing marginal rate of substitution. This means that Farooq is greedy as such, not greedy for any particular commodity. He wants more of all things not of a particular thing. Competition is the capitalist way of life, not just a means for getting on a particular thing. Summarizing the above discussion, we can say that the slope of the indifference curve measures the consumer’s rate of substitution (MRS) between two goods. When indifference curves are expected to be convex the slope of the indifference curve diminishes which implies diminishing marginal rate of substitution between commodities that are being consumed. It is important to realize that indifference curves do not exist—they cannot be directly observed. All that we can observe in the market are specific prices and specific amounts of commodities purchased. How much utility is yielded by the consumption of any particular bundle of commodities is neither observable nor measurable. Economics assumes that rational consumers ought to behave in the way that indifference curves portray him to behave—this is another proof of the necessarily normative character of economic analyses. Abdullah is accepted as rational only if he seeks to maximize utility generally. The diminishing marginal rate of substitution assumption implies that Abdullah must derive utility from consumption as such—not from the consumption of a particular commodity. Abdullah is irrational if he derives “utility” only from spending on haj and never plays football at all. If he derives “utility” only from going to haj, utility collapses and going to haj becomes an end in itself. Economic theory insists that a person is rational only if he regards utility maximization (maximization of his ability to consume everything; i.e. freedom) alone as an end itself. Everything else is a means for achieving this supreme, over arching, dominant end in itself. Utility thus has a specific meaning. Utility is maximized only when we seek to be free—to consume more and more of everything. If Abdullah goes for haj to express his freedom, it shows that he can consume anything he wants to consume. We can legitimately say that he derives utility from performing haj as he does from consuming other commodities. If he goes for haj because God commands him to, he is “harmoniously” rejecting freedom and it would be nonsensical to speak of his “utility” in circumstance where Abdullah seeks ma’arifat. We simply would not know what to put on the y-axis. It would be meaningless to speak of his “indifference curve”, its “convexity” and the marginal rate of substitution.

6.4: Taste for Special Commodities: Example of IC In this section, we use indifference curve maps to illustrate the taste for different kinds of commodities in order to consolidate the understanding about indifference curve. Let’s first define a general way of constructing an indifference curve for the capitalistically rational consumer. Make a point on a graph paper, say (xo, yo) along two axis showing different amounts of commodities x and y. Now think what would happen if you give a little more of x, say Δx to the consumer to take him to the point (xo + Δx, y). Now ask how the consumption of y should be changed to make the consumer indifferent between the old and new situation, that is (xo, yo) and (xo + Δx, yo + Δy). After you have determined this movement, you have drawn a point of an indifference curve. Now let us consider different types of consumer goods in capitalist society. An Economic Bad Economic theory does not regard that all goods are not “good”, some of them are bads. A good is bad for a consumer if it reduces his utility. Suppose that a consumer does not like cigarettes and there is a trade-off between cigarettes and fish. How can we represent his taste for such a commodity? Suppose we start at point (5, 0); 5 units of fish and 0 units of cigarettes, in figure 6.14 (point A). What if we increase the amount of cigarette by one unit holding the amount of fish at 5 units, bundle B? Since each additional unit of cigarette will decrease the consumer’s utility the bundle B will be worse than A because it contains more units of cigarette which is a bad commodity. What do we have to do to put our consumer on the same indifference curve; that is to keep his utility constant? Because additional cigarettes reduce his utility level, we have to give him some extra fish to compensate him for additional cigarettes, such as bundle C (6, 1) which contains one unit more of both the goods as compared to bundle A (5, 0). This suggests that the indifference curve will slope upward as depicted in this figure 6.14. Figure 6.14: IC for an economic badIoI1ABC1560FishCigarette Figure 6.14: IC for an economic bad Io I1 A B C 1 5 6 0 Fish Cigarette A Useless Good A good is classified as neutral or useless if it does not increase the utility if the consumer. Suppose that Farooq is neutral about the consumption of Pepsi. This means that adding Pepsi into his consumption basket does not increase his satisfaction. Only by consuming additional, fish can his utility increase. In this situation, his indifference curves will be vertical lines because Farooq only drives utility from fish and the number of Pepsi drinks he consumes make no difference to him. These curves are drawn in figure 6.15 (the arrows are indicating the direction of preferences). The more fish Farooq has the greater his utility but adding Pepsi makes no difference to. For example, the vertical line Io represents the utility level I0 as long as he has 5 units of fish no matter how many Pepsis he consumes. Extra utility derived from an additional unit of a neutral good is always zero.

Figure 6.15: IC for neutral goodIoI1I2PepsiFish0510 Figure 6.15: IC for neutral good Io I1 I2 Pepsi Fish 0 5 10 Perfect Substitutes Convex indifference curves were drawn on the assumption that consumers have taste for variety in consumption bundles. What if the two goods are perfect substitutes, goods that yield equal utility to a consumer and he does not care how much he has of one commodity or the other? Consider a choice between two types of pens, Picasso and Piano. Figure 6.16 shows this situation. Figure 6.16: IC for perfect substituteIoI105PicassoPiano Figure 6.16: IC for perfect substitute Io I1 0 5 Picasso Piano 5 5 Suppose we start with a particular bundle (5, 5). Then any other bundle that contains 10 pens in it is just as good as this bundle. Because the consumer does not care which pen he has, he is always willing to trade one Picasso pen with only one pen of Piano, Thus, MRS along this indifference curve is 1 at all points. The indifference curves are straight parallel lines for such goods. However, the one-to-one exchange rate is the simplest of the cases of perfect substitutes; it is not a general one. The important fact about perfect substitutes is that the indifference curves have constant slope, the slope can be more or less one, say 3. In that case, one commodity is substituted for three units of another good. Perfect Complements Figure 6.17: IC for perfect complementIoI1I245oLeft ShoeRight Shoe0223Goods are said to be perfect complements if they are always used together in some fixed proportion. The famous example is that of a right and left shoe. The consumer always uses a pair of shoes. Having only one out of a pair of shoes does not increase the utility level of the3 consumer. Again, start with some point, say (2, 2). Now add one more right shoe to the consumption bundle. This will not increase the utility of the consumer and will leave him indifferent with the original bundle. It is only the extra pair of shoes that will increase the utility of the consumer and put him on a higher indifference curve. Thus, the indifference curve is L-shaped in figure 6.17 centered at 45o line coming from the origin. Remember that the important thing about perfect complements is that they are used in a fixed proportion, but that proportion is necessarily is one-to-one. As an example, suppose that a consumer always uses two teaspoons of sugar in a cup of tea and does not use it for any other purpose. In this situation, the corner of the L shaped indifference curve will occur at (2 teaspoon sugar, 1 tea cup), (4 teaspoon sugar, 2 cups of tea) and so on. Figure 6.17: IC for perfect complement Io I1 I2 45o Left Shoe Right Shoe 0 2 2 3 Recall that indifference curve maps reflect consumer’s preferences about the goods they choose, in the market; such maps provide us with the first building block for analyzing consumer behavior through their choices. The next sector, opportunities, will be taken up in the next chapter. Note that goods are differentiated only in terms of the contribution they make to utility (negative, zero, prehorticuate) i.e. to the capacity of the consumer to consume anything and everything. All other qualities of goods are disregarded.

6.5: The Utility Function Economists use utility as a measure of consumer welfare or well-being. A person’s preferences are summarized by a utility function. Preferences are always represented in utility functions because the capitalist consumer seeks the fulfillment not of a particular preference but of preference in general—i.e. utility. The utility function shows information given by the preference relation. It represents an individual’s taste or preferences regarding the consumption of various bundles of goods. A utility function U(A) is a way of arbitrarily assigning a number such as 2.6 or 5 to every bundle of commodities. The number of more preferred bundles is larger, and higher A number means a more preferred bundle. That is, we say that if a bundle A(x1, y1) is preferred to bundle B(x2, y2), this means that the utility obtained from bundle U(A) is greater than that from U(B). Symbolically, we state it as: (x1, y1) > (x2, y2) if U(x1, y1) > U(x2, y2). Let’s see how indifference curves are generated from a utility function. 6.5.1: Indifference Curves and Utility Functions A question must be teasing you: what does it mean that a utility function assigns an arbitrary number to each indifference curve? Consider the utility function, (6.3) Where x and y are the quantities of consumerables x and y. This function says that the utility the consumer derives depends upon the consumption of these two goods. To simplify the nature of analysis, we have assumed that the consumer has only two goods to consume, this restriction allows a geometric presentation of the results. Nomi is always willing to give up some amount of one commodity to get an additional amount of the other. We know that the maximum amount he is willing to give up of one good, say y, to get one extra unit of x is that amount which leaves him indifferent between the old and new situation because his utility remains the same. That is how trade-offs were described, and this shows an indifference curve (recall the concept of MRS). If all combinations of two goods along an indifference curve are regarded as being indifferent to each other by the consumer it is assumed that this is so because they give equal utility. Therefore, to covert the utility function (6.3) into an indifference curve equation, we have to hold the utility level, U, constant in (6.3) as (6.4) and then find out all combinations of x and y which give that constant level of utility. See Application Box 6.1 to understand this idea. A P P L I C A T I O N B O X 6.1 Generating Indifference Curves Consider a simple utility function: U = x × y (6.1.1) This is a mathematical form of the utility function (6.3). It says that utility attained from any bundle of x and y is the product of the amounts of x and y consumed. For example, a bundle (2x, 3y) will give a utility equal to 2 × 3 = 6 utils. Note that the bundle containing more units of x and y will give higher “utility” level according to this function, e.g. the bundle (3x, 3y) produces U = 3 × 3 = 9 utils. Thus, this function attaches a number to each consumption bundle. Some of these numbers are shown in this table.

Bundle U = x × y (2x, 3y) 6 utils (3x, 3y) 9 utils (3x, 4y) 12 utils (4x, 2y) 8 utils However, there is nothing special about function (6.1.1) to begin with. This function can take some other mathematical form as well. One of its example is: (6.1.2) Note that this function will assign a different number to each consumption bundle as compared to function (6.1.1) as shown in below table. Bundle (2x, 3y) 2.45 utils (3x, 3y) 3 utils (3x, 4y) 3.46 utils (4x, 2y) 2.82 utils The point here to note is that the exact mathematical form of such a function does not matter and like the numbers assigned to x and y is chosen arbitrarily. Such transformations of utility functions are nothing but a redrawing of indifference curves. It makes no difference whether we label an indifference curve by 10 or by 100 utils because these numbers are arbitrarily used to reveal the (necessarily subjective) ranking of different bundles, not the intensity of their demand. What matters are the fact that the function must assign a specific number to each consumption bundle and a higher number is attached to preferred bundle containing at least one more unit of a commodity. To generate indifference curves from such utility functions, recall that the indifference curve shows all combinations of x and y where utility level is expected to be constant. Thus, in function (6.1.1), we fix utility level at some arbitrary level, say 100 “utils” to obtain: 100 = x × y (6.1.3) In this function, x and y take only those values for which utility remains at 100 “utils”. Note that the function shows one equation with two unknowns x and y. For solution, we solve the function for one independent variable in terms of another, that is: (6.1.4) In this solution, x always adjusts to any value of y so as to keep the function equal to 100. The following table gives some x-y values associated with 100 utility level. x Y 100 4 25 - 100 5 20 5 100 8 12.5 2.5 100 12.5 8 1 100 20 5 0.4 100 25 4 0.2 If you join all those values of x and y for which the utility is 100, you will get an indifference curve like the one in the figure below. U = 100Note that MRS is decreasing along this indifference curve illustrating that the consumer prefers more utility as such and not any particular commodity. So, for any mathematical function to be used as a utility function, it must posses the property that MRS decreases along the indifference curve generated from that function. Thus, (6.1.4) is a valid equation for indifference curve and labels it as U = 100. U = 100 Further note that increasing the level of utility from 100 to, say, 110 will generate a higher indifference curves because either x or y will take a larger value to make 110 “utils” than they took to make 100 “utils”. For example, the following table keeps the values of x at the same level as in the above table but the values of y are different: x Y 110 4 27.5 - 110 5 22 5.5 110 8 13.75 2.8 110 12.5 8.8 1.1 110 20 5.5 0.4 110 25 4.4 0.2 Joining these points will give an indifference curve of 110 “utils” and this curve will be higher than that of the 100 util level. Both curves will depict diminishing MRS since both curves assume that the consumer wants more utility not just more of a particular commodity.

The exact mathematical form of the utility function (6.3) depends on the function that is arbitrarily chosen to represent consumer preferences. Economic theory postulates that such a function must have certain well defined mathematical properties; three of them are explained in Application Box 6.1. Some of these are reflect in the concept marginal utility in which we now turn. Marginal Utility As Nomi consumes more of a commodity, say x economics assumes that his utility level keeps changing. This rate of change in total utility due to change in the consumption of one more unit of x is called marginal utility of x. It is the extra utility derived from the consumption of one extra unit of x. Algebraically, the marginal utility of x can be denoted as: (6.5) Consider figure 6.18. Suppose that x and y are the only two commodities available for consumption and that their utility can be represented by a utility function, U(x, y). Further assume that initially Nomi is at point P in this diagram which has xp amount of x and yp amount of y. This consumption bundle will provide a certain level of utility to Nomi, say U(P) = U(xp, yp) = Up. The exact value of Up depends upon the particular mathematical function chosen by the economist (see box 6.1 again if you are unable to understand this point). All bundles lying on the indifference curve IP provide equal utility to Nomi (i.e. Up). Now consider what happens when Nomi consumes one additional unit of x, call it Δx. Given the amount of y = yp, the new bundle will be R (xp + Δx, yp). The additional unit of x is expected to take Nomi to a higher indifference curve at point R. The utility level is also expected to increase while moving from point P to R because the bundle R contains more units of x and hence falls on a higher indifference curve than bundle P. How can we ensure that utility has increased, and not decreased, from point P to R? Recall the assumption of greed (more is better’). R (xp + Δx, yp)IR = U(xp + Δx, yp)IP = U(xp, yp)∆x∆Uyp0xpxp + ΔxxyFigure 6.18: Marginal Utility R (xp + Δx, yp) IR = U(xp + Δx, yp) IP = U(xp, yp) ∆x ∆U yp 0 xp xp + Δx x y Figure 6.18: Marginal Utility This assumption ensures that an additional unit of any commodity will increase the utility level of Nomi (who wants utility not any particular commodity). So, the bundle R gives a utility U(R) = U(xp + Δx, yp) = UR. Thus, the indifference curve IR is labeled with this utility level. Now the change in utility from P to R, denoted by ΔU, can be defined as the difference between utility levels of the two bundles R and P: or (6.6) To obtain the expression for change in utility due to change in x; that is the marginal utility of x, divide equation (6.6) by Δx: (6.7) If more of x is always preferred to less of x (more is better), then marginal utility from each unit of x will always be positive; that is each additional unit of x will give positive satisfaction to Nomi and will not harm him. As a numeric example, let bundle P(xp, yp) = (1x, 2y) and assume that it provides a utility of 20 “utils”. Suppose we add two additional units of x into Nomi’s consumption bundle. The new bundle will be R(xp + Δx, yp) = (2x + 2x, 2y) = (4x, 2y). Assume that now the utility from this bundle is 30 “utils”. The marginal utility from these two extra units of x can then be calculated using (6.7) as:

This says that each extra unit of x adds 5 “utils” to Nomi’s utility at point P. The definition of marginal utility in (6.7) implies that we can also calculate change in utility resulting from the change in the consumption of any commodity, say x, as: (6.8) For example, if we know that MUx = 5 “utils” and 2 units of x are added in the consumption bundle of Farooq, then change in his utility level will be 10 utils (= 5 × 2). The calculation of marginal utility depends upon the particular utility function that we assume will represent consumer preference ordering. The method for calculating marginal utility from any utility function uses calculus. We cannot calculate marginal utility from consumer preferences since preferences show only the way a consumer ranks different bundles of commodities. Finally, note that the amount of y is held fixed while calculating the marginal utility of x. The marginal utility of y can also be expressed in a similar way keeping x constant as: MRS as the Ratio of Marginal Utilities We have discussed the idea of MRS. Another explanation of MRS can also be obtained applying the idea of marginal utility. Figure 6.19 plots the indifference map of Farooq. Consider removing a very small amount of y, say Δy, at point S down to M. The reduction in y keeping the amount of x constant will put Farooq on a lower indifference curve and, hence, his utility level is expected to decrease which can be shown as: (6.9) The negative sign indicates the fact that the utility level has decreased while moving from S to M. To put Farooq on the original indifference curve, we need to give him some extra amount of x, say Δx, for the reduced y. This is shown in the move from point M to Z. This time the utility level will increase because more x is added to Farooq’s consumption. This increment to utility can be expressed in the same way as for change from S to M. (6.10) Since S and Z lie on the same indifference curve, both bundles represent the same level of utility. This means that the reduction in utility going from S to M is exactly equal to the increase in utility going from M to Z. There is no change in Farooq’s utility level from S to Z as the negative and positive effects sum to zero. If both changes are equal, then, or Solving this equation for the slope term Δy / Δx gives: (6.10) Figure 6.19: Difference b/w MRS and Marginal UtilityZSMI1Io-∆y∆xxy0 Figure 6.19: Difference b/w MRS and Marginal Utility Z S M I1 Io -∆y ∆x x y 0 The negative sign behind the slope term shows that indifference curves are expected to slope negatively. Remember that MRS is defined as minus the slope of the tangent (Δy / Δx) at any point on the indifference curve. Thus multiplying the slope term by minus we have, (6.11) Note carefully that marginal utility of x is in the numerator while marginal utility of y is in the denominator in this expression. The marginal rate of substitution is the ratio of the marginal utilities of the goods on the horizontal and vertical axes. We can say that MRS measures the marginal utility of the commodity on the horizontal axis in terms of the one on the vertical axis. If this ratio is 3 for Farooq, it means that he is ready to give up 3 units of y to obtain 1 unit of x. In other words, extra utility from one extra unit of x is three times the extra utility from one extra unit of y. Remember that it is a relative concept. The interesting thing about MRS is that it can be measured by observing a person’s actual behavior as revealed by his willingness to exchange two goods. What cannot be directly measured is the utility the consumer derives from this exchange.

Difference between Marginal Utility and MRS A common misperception is that marginal utilities and MRS are two names for the same concept. To see the difference between marginal utility and MRS graphically, consider figure 6.18 again. As we reduce the amount of y from Z to M, the utility level changes and this change in utility is called marginal utility. However, MRS is measured along movements from Z to S. What is the difference? Remember that marginal utility is measured by the shift from one indifference curve to another changing utility from one level to another; it is a change in utility. On the other hand, MRS is measured along the same indifference curve keeping the utility level constant as shown in figures 6.12 and 6.13. Also see appendix to this chapter to note some other technical differences. FYI: B O X 6.2 The All Knowing godly Consumer We made a comment that assumption 1 (of completeness) about consumer behavior implies an all-wise and all-knowing consumer. Now it is time to explain this statement. This assumption seems sensible in a two-commodity model but becomes ridicules when we consider a typical market situation. To see this, let us consider a real world example. Suppose you are standing in a super market which contains 1,000 different commodities. Further assume that you have to decide whether or not to buy but one unit of each commodity. How many bundles do you have to consider? In standard two-goods model, only 4 bundles are to be ranked: i- (0x, 0y); ii- (0x, 1y); iii- (1x, 0y); iv- (1x, 1y). In general, the number of combinations to be considered in a given choice situation equals: Number of units being considered + 1, raised to the power of how many goods are available In our example, the consumer has to consider 1 unit of each commodity. Hence the number of units to be considered is 1 + 1 = 2; i.e. 0 and 1. If there are only two goods, then total combinations will be 22 = 4 combinations If there are three goods, then total combinations will be 23 = 8 combinations If there are four goods, then total combinations will be 24 = 16 combinations So, how many combinations in a 1,000 good super market will you have to consider? It is: 21000, or roughly 10300 How big do you think this number might be? Spelling it out in full, it is: 10,720, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000 combinations! To have an idea of how big this number is, think about the question ‘how big a brain would you need to remember these combinations?’ Let us pretend that each neurone of your brain could remember the utility of 100,000,000,000 (100 billion) combinations. Your ‘grey matter’ weighs about one kilo: 100,000,000,000 (100 billion) neurones, each weighing 1/100,000,000 grams. Here is a quick quiz for you: what would be the weight of so big a brain?

(1) More than your brain? (2) More than your weight? (3) More than our elephant? (4) More than the earth? (5) More than the Sun? The correct answer is: 10224 times as much as the entire known universe! But this is not enough. Now think about the question: If you could recall utility of each combination in 1/10,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000, 000,000, 000,000,000,000,000,000,000,000,000,000,000,000,000,000th of a second, how long would it take you to remember the combination with maximum utility? The answer is 10200 seconds: 10180 times the speculated age of the known universe! What is going on here? The problem arises due to the ‘curse of dimensionality’ according to which the number of combinations grows exponentially as more options are considered. The point here to make is that it is practically impossible for a consumer to consider even a tiny fraction of options available and the utility they would yield in effectively finite time. Key Concepts Bads are the goods which give negative marginal utility to a consumer. Concavity is the property of a set which says that a set is concave if a line joining any two points in that set remains entirely below that set Consumption bundle is the quantities of each consumption commodities that a consumer has available for his consumption. It is shown by a point in a commodity space representing some commodities Convexity is the property of indifference curve which says a weighted average sum of any two bundles, say bundles A and B, is preferred to those bundles themselves. Mathematically, convexity is the property of a function which says that a function is convex if a line joining any two points of that function remains entirely above that function Diminishing marginal rate of substitution (DMRS) is the tendency of MRS to decline. The more x one has and less of y, the less is the relative value placed on the extra unit of x compared to that placed on y. DMRS comes from the assumption about people behavior that they have a taste for variety in their consumption Indifference curve represents all combinations between two goods that give equal satisfaction or utility to a consumer Indifference map shows a family of indifference curves representing the utility an individual can obtain from all possible consumption options Marginal rate of substitution (MRS) measures the rate at which the extra unit of x is substituted with y to keep utility constant Marginal utility is the rate of change in utility due to change in the consumption of a commodity. Marginal utility is usually assumed to decline as more of a commodity is consumed, other things held constant Neutral goods are those which have zero marginal utility to a consumer Non-satiation is a claim about consumer psyche which says that a consumer is always greedy; i.e. he prefers more goods to less Perfect complements are the goods that are used in specific combination with each other. Perfect substitutes are those commodities that have equal value to a consumer and he ranks them same in order in terms of taste

Rationality is a hypothesis about consumers by which they can make logical and consistent choices based on universal greed Tastes are all the hypothetical exchanges that an individual is willing to make at various terms of trade Transitivity is an assumption about consumer taste which says that given any triple of commodity bundles, A, B and C if A P B and B P C then A P C Utility function is a way of assigning a number to every possible consumption bundle such that more preferred bundles get larger numbers than the less preferred ones Chapter Summary Economic analysis of consumer behavior presupposes that every individual is self interested. This self-interest is the maximization of freedom. Such an individual is “homo-economicus” “Homo economicus” is committed to maximizing aggregate utility. Maximizing personal utility in a way which reduces aggregate utility—i.e. everyone’s right to choose anything they wish to choose—is considered illegitimate If personal utility is derived from an act which restricts aggregate utility—everyone’s right to choose—it is regarded as “disutility” and netted out from aggregate utility calculations. Utility is measurable only in Rupees because Rupees alone can be a measure of choice in general, though Rupees cannot measure many specific choices such as mothers’ love Since the market values all acts in terms of their contribution to aggregate utility, it creates a powerful incentive for individuals to choose private lives which increase their ability to promote capital accumulation. That is why capitalist norms—greed, lust and jealousy—flourish in capitalist society The only conception of self-interest that can be assigned value by the market is that expressed by the commitment to maximize a (discounted) flow of consumerables over a definite time period. The market cannot evaluate any other conception of self-interest and well being The consumer must choose, says economic theory, because resources are scarce. Choice is determined by (a) tastes and (b) income. Economic theory does not specify any determinant of tastes. This allows economists to aggregate individual tastes The concept of consumer sovereignty is also grounded on the assumption of the independence of individual choices. In capitalist society consumer sovereignty is undermined by the corporations’ quest for want creation Consumers must choose consistently. If they prefer A to B they are expected not to prefer B to A at the same time. Consistency also implies that if someone is indifferent between two commodity bundles (because they yield the same utility) he cannot prefer one bundle to another Economics analyses the behavior (only) of rational consumers. ‘Rational’ consumers fulfill the conditions of: Completeness; i.e. the consumer must have the full information to be able to rank his preferences transitivity; i.e. consistency greed; i.e. the consumer always prefers more to less, and independence, i.e. the consumer taste is unaffected by the behavior of others An indifference curve shows all combinations of two consumerables which yield the same utility for a consumer. An indifference curve farther away from the origin yields higher utility

Indifference curves slope downwards because the consumer is expected to prefer more to less. Upward sloping indifference curves could imply that the same utility is yielded by a bundle with more of both commodities. Indifference curves cannot intersect because utility yielded by points on different indifference curves is different. There can be only one indifference curve passing though one point Indifference curves are assumed to be convex to the origin. This implies that the weighted average of two commodity bundles is necessarily preferred to each of these bundles The assumption of convexity implies that people do not want particular commodity as such they consume a commodity to obtain utility since utility is assumed to decrease as more of a commodity is consumed people prefer to “balance” the consumption of different commodities so as to maximize utility MRS is the rate of substitution of the consumption of commodity x for commodity y at a constant utility level i.e. on the same indifference curve. MRS is the negative of the slope of the indifference curve. Since the slope of the indifference curve is negative. MRS is positive The slope of the indifference curve and its negative MRS is assumed to show the voluntary exchanges that consumers make. The indifference curve reflects the tastes of an individual Economics expects that MRS decreases as we move down and to the right on an indifference curve. The consumer is willing to give up less and less of y as his consumption of x increases; without reference to the nature of x and y. MRS is expected to diminish because the consumer wants more of all. He is essentially greedy, not greedy for any particular thing If more of something is always preferred, say going to haj, over more of something else, say playing football, then the former becomes an end in itself and utility collapses in the sense that utility maximization can no longer be regarded as an end in itself. Utility is maximized only when one seeks freedom Indifference curves have constant slopes for perfect substitutes and are L-shaped for perfect complements. Goods are differentiated only in terms of the contribution they make to utility—i.e. the ability of the consumer to consume everything (the preference for preference itself). Every other quality of the good is disregarded The utility function represents the taste of a consumer. It shows how consuming different bundles of commodities allows a consumer to express his preference for preference itself—i.e. utility Marginal utility is the rate of change in total utility consequent upon increasing the consumption of one commodity holding the other constant MRS can be defined as the ratio of the marginal utility of the two goods on the x and y axes. MRS measures the MU of the good on the horizontal axis in terms of the MU of the good on the vertical axis. MU is measured by the shift from one indifference curve to another while MRS is measured along the same indifference curve Empirical studies have shown that even in mature capitalist countries consumers do not maximize utility and consumer decisions are not based on utility calculations. Indifference curves, marginal utility and MRS are ideological concepts

Utilitarianism is the ideology underlying consumer behavior theory. Utilitarianism says that all acts and rules should be assessed in terms of the consequences they produce with respect to the maximization of total consumption over a given time period. Utilitarian moral agents seek the maximization of total consumption irrespective of the wishes of those whose consumption is maximized. The commitment to the maximization of aggregate consumption is an expression of the commitment to prefer preference in general (freedom) over all specific preferences. Hence the commitment to the maximization of aggregate consumption once again illustrates the normative framework within which the positive analysis of consumer behavior is necessarily situated Only a neutral world agent (the economist) can judge all acts and rules in terms of their impact on aggregate consumption. Therefore only the world agent has the right to evaluate acts and rules and make policies If a consumer does not accept maximization of aggregate welfare / profit as an end in itself and refuses to accept the authority of the World Agent who judges acts and rules and makes policies on this basis, such a consumer becomes a danger for capitalism Economics deals with this danger by: showing how the ideal / prefect capitalist economy and society should function developing policies for moving actually existing systems of consumption, production and exchange towards ideal capitalist systems of consumption, production and exchange thereby ensuring that people who refuse to accept capitalist rationality, norms and practices starve to death like the eighty million Red Indians of North America. Review Questions What is possessive individualism? And what are the characteristics of “homo economicus”? What are the necessary constraints within which “homo-economicus” maximizes his personal utility? Why can aggregate utility not be derived from supporting the Taliban? Why can utility and welfare be measured only in Rupees? How does the market affect the private life of individuals in capitalist society? Why can “well being” not be anything other than maximization of consumption? What is the relationship between choice and scarcity? What is Abul Bashr free to do and what is he not free to do in a capitalist economy? What is the meaning of consumer sovereignty? Why and how is consumer sovereignty undermined in a capitalist market? What is transitivity? Is it a requirement of logic? “Greed is the core constituent of rationality”. Comment. “Greed guarantees the prioritization of efficiency as a social objective. Why? What does the indifference curves show and what is an ‘indifference map’. Why must indifference curves be negatively sloped? Why can they not interact? Why are indifference curves assumed to be convex to the origin? Show why concave to the origin indifference curves violates the assumption of transitivity and greed? Give a numerical example. Why cannot indifference curves be drawn as a straight line with a constant slope joining two points (for normal goods)?

Why does the slope of indifference curve change at every point? Why does the indifference curve become flatter as we move to the right? What is MRS and how is it measured? What is the assumption underlying the expectation that MRS decreases as we move to the right of an indifference curve? What do you think will happen to MRS if the commodity on the x axis is expenditure on haj and the commodity on the y axis is whisky? Why and how does the assumption of universal greed lead to the expectation of diminishing MRS. “Indifference curves do not exist”. Comment. Why can utility not be derived from acts which reject freedom, such as obeying God? What are economic “bads”? What are economically “useless” goods? Draw indifference curves for “bads” and “useless” goods. Draw indifference curves for perfect substitutes and perfect compliments. What is a utility function? What is marginal utility? How is marginal utility calculated? What is the difference between MU and MRS? Why is it impossible for all consumers in a typical capitalist market to estimate MRS? Illustrate assuming that there are 30 items in the market. “Consumer behavior theory shows that economics is essentially an ideology”. Do you agree? What are the main features of utilitarianism? Is it “rational” to accept maximization of aggregate consumption as an end in itself for all consumers for all times? Who has the right to judge acts and rules and make policies according to utilitarianism? How according to utilitarian ideology should a rational consumer express his preferences? If economic theory does not describe how a consumer behaves in a typical capitalist market, where lies its usefulness? Chapter 7 BUDGET SET, CHOICE AND DEMAND Recall the ideal capitalist vision of individual choice as stated at the beginning of chapter 6: consumer choices should be determined by autonomous tastes with given resources and unlimited wants. We analyzed tastes in the previous chapter. In this chapter, we first look at resource constrain and then go on to see how actual choices are supposed to be made in the market. Section 1 discusses the idea of consumer opportunities. Section 2 explains choice decision of an ideal capitalist consumer. Section 3 assesses the concept of demand. 7.1: The Budget Set Two additional assumptions are required to explore consumer choice. First, apart from the assumption of ‘given innate taste’, economics also presumes ‘given initial resources for all individuals in society’. According to this assumption, all individuals living in a society enter the market with initial resources they happen to posses. In other words, capitalist society begins with a given distribution of resources among its citizens. The question ‘what determines this initial resource distribution or what should this initial resource distribution be is not addressed by economic theory. This is important presumption that we will explore in greater detail in chapters 15 and 16. Secondly, the consumer is supposed to know the prices of all goods in the market. He is supposed to behave as a price-taker—one who has no control over market prices and accepts them as given by the market before taking his decision to purchase commodities. This idea will become clear as we proceed further in this chapter.

Suppose again that there are only two goods, x and y. The consumer, as presumed, has some income, denoted by M, to spend on these goods. Further, he also knows the prices of each commodity, Px of x and Py of y. We will assume that buying these commodities is the only possible use of his income, so he will spend all his income on their purchase. We further assume that our consumer will spend all his income in the current time period; he will neither save nor borrow. This implies that total income must be equal to total expenditure. Total Income (M) = Total Expenditures (TE) (7.1) Since the available income must be spent either on x or on y, total expenditure is equal to the sum of expenditure on x and y: TE = Expenditures on x + Expenditures on y (7.2) By definition, expenditure on x are given by the price of x times the amount of x purchased, that is Px × x (this idea has already been discussed in chapter 4). Similarly, Py × y is the expenditures on y. We have: TE = Px × x + Py × y (7.3) Substituting TE from (7.3) into (7.1) we get: M = Px × x + Py × y (7.4) This is the algebraic statement of the consumer budget constraint. Let us see what this budget constraint looks like when we draw it in the (x, y) commodity-plan. It is drawn in figure 7.1. Let us understand how this line is drawn. Consider the following data. M = Rs 100 Px = Rs 1 Py = Rs 2 This says that the consumer has an income of Rs 100 (M = 100) to spend on commodities x and y. The price of one unit of x is Rs 1 while that of y is Rs 2. First assume that he does not purchase any amount of x. In this case, all his income will be spent on y and the maximum units of y he can purchase are given by his income divided by the price of y: units This is the vertical intercept of this line, Z. Similarly, if he does not purchase any amount of y and spends all his income on x then: Units Figure 7.1: The Budget Line y 0 xCABZ20404030DS Figure 7.1: The Budget Line y 0 x C A B Z 20 40 40 30 D S S S 0 0 This is the horizontal intercept of this line, (S). Thus we see that the vertical and the horizontal intercepts of this line measure how much the consumer can afford if he spends all his income only on one commodity. Joining these two points, Z and S, by a straight line gives us a line ZS called budget line. This budget line ZS shows all possible bundles that can be purchased at given prices and income. To see this point, consider point A. If the consumer purchases 20 units of x, this means that the maximum units of y he can purchase are 40. Why? This is so because since Px = Rs 1, purchasing 20 units of x means that expenditure on x is: Expx = 1 × 20 = Rs 20 This leaves the consumer with Rs 80 to spend on y out of his total income of Rs 100. Since Py = Rs 2, he can purchase 40 units with these Rs 80 . Thus, (20x, 40y) is another maximum affordable consumerable bundle given the income of the consumer (Rs 100) and prices of x (Rs 1) and y (Rs 2). The same logic applies at point B (40x, 30y). Thus, all points on this budget line represent maximum affordable bundles. To fully understand this point consider bundle C (20x, 30y) inside the budget line ZS. This bundle will leave some of the consumer’s income as his expenditure will be less than his income:

At point C → Rs 1 × 20 + Rs 2 × 30 < 100 This shows that though bundle C is affordable, but it is not the maximum affordable bundle. Finally, bundle D (40x, 40y) is not affordable as it costs more than the income that the consumer has. Thus we conclude that: All points on this budget line are maximum affordable bundles for the consumer and exhaust his income All points below this line are affordable but do not exhaust his income All points above this line are not affordable as they cost more than the income Note that the budget constraint requires that the expenditures on the two goods must not be greater than the amount of income the consumer has to spend. The affordable consumption bundles of x and y are those that don’t cost any more than his income, M. This set of all affordable consumption bundles (all bundles on and below the budget line) is called the budget set of the consumer. On the other hand, the budget line shows only those bundles that are both affordable and fully utilize the consumer’s resources. Slope of Budget Line The slope of the budget line is its key feature, as it will be revealed shortly. One way of looking at the slope is to study the changes in quantities of the two goods consumed while moving from one point to another on a budget line. For example, think of moving from point A to B on budget line ZS in figure 7.1. The slope of budget line is given by the ratio: and it must be negative, as indicated by the negative slope of budget line. Note that change in y from point A to B equals: while change in x is equal to: Dividing them we obtain: (7.5) The value of the slope of this budget line is ½, where minus sign indicates the negative slope of the budget line. The budget line has a negative slope because Δx and Δy must always move in opposite direction in order to keep expenditures constant: an additional unit of x could be purchased only when some amount of y is forgone. Thus the slope of the budget line shows a trade off between the two commodities x and y. One important aspect of this value of the slope of budget line is that it equals the ratio of the price of x to the price of y: Recall that the price of x was Rs 1 while the price of y was Rs 2. No matter what prices you assume, the slope of the budget line will always equal their ratio. This is a general result that holds for any budget line for any given prices of x and y. Let us derive this result graphically. Look at point A in figure 7.2 with xa amount of x and ya amount of y. Now consider a move from point A to B on this budget line. Since both these points are on the same budget line, each must satisfy the budget equation: Px × xa + Py × ya = M (a) Px × xb + Py × yb = M (b) That is, at both these points, (xa, ya) and (xb, yb), expenditures are the same (equal to the consumer’s income) because both bundles are on the same budget line. Subtracting equation (a) from (b) we get: collecting terms: The bracketed terms denote changes in the amount of x and y respectively while moving from point A to B. Denoting these changes by Δx and Δy respectively, we get:

Figure 7.2: Slope of the Budget Line and the Price Ratio. y xa xb xyaA (xa , ya)B (xb , yb)ZSyb Figure 7.2: Slope of the Budget Line and the Price Ratio. y xa xb x ya A (xa , ya) B (xb , yb) Z S yb 0 0 This equation says that the total value of change in expenditure must be zero (remember that the total expenditure on a budget line is constant since income is fixed, so total expenditures cannot change while moving from A to B and remains equal to M). We want to solve for the slope term of the budget line which is Δy/Δx. With slight rearrangement we get: (7.6) which is exactly what we wanted. Algebraically, the value of the slope of the budget line is equal to the price ratio. In terms of our numerical values with Px = 1 and Py = 2, the slope of budget line was ½. What is the meaning of this number, ½? Look at the following table. Table 7-1 Trade off between goods If Px = 1 Rs and 1 unit of x = ½ unit of y Py = 2 Rs, then 1 unit of y = 2 units of x With given prices of x and y, if the consumer wants to add one more unit of x to his consumption, he must sacrifice ½ a unit of y (because the price of y is Rs 2, reducing its consumption by ½ unit will release one rupee which can be used to purchase one unit of x as its price is assumed to be Rs 1). Similarly the market value of one unit of y is 2 units of x. Remember that the slope of the budget line shows the rate at which the consumer can substitute one unit of x with y, or rate at which the market allows substitution of one good for another. Thus we find that the consumer can substitute 1 unit of x for ½ of y at these prices. This is the relative price of x—relative price is the price of a commodity (say x) in terms of another commodity (y). Similarly, the consumer can substitute 1 unit of y with 2 of x. This is the relative price of y given by the inverse of the expression (7.6): Py / Px = 2, to consume one more unit of y; the consumer must sacrifice 2 units of x. But usually, the slope of the budget line is measured for the commodity on the horizontal axis. It is for this reason that economists say that the slope of the budget line measures the opportunity cost of consuming either of the two commodities. In order to consume more of x, you have to give up some amount of y. it is easy to see how this conception of the budget, constraint is based on the presumption of universal scarcity. Remember that there is a difference between the nominal price and relative price. The nominal price of a commodity is what a consumer pays to purchase it in monetary terms, say Rs 1 is the nominal price of x. But the relative price of a commodity is the number of units of other good(s) the consumer has to forgo to purchase one unit of that commodity, e.g. ½ y is the relative price of x. The slope of the budget line measures the relative, not the nominal price of the good on the horizontal axis, here x. 7.2: Consumer Choice We can now put together our representation of taste and opportunities. The economic problem of choice is that the consumer wants to choose the bundle yielding the highest level of utility he can afford.

What Does Consumer Want to Do? Consumer behavior theory is built on the assumption that capitalist consumers make the most of their opportunities to satisfy their unlimited wants in the light of their arbitrary preferences. The consumer can never achieve a point of ‘maximum utility’ because his wants are infinite. The consumer choice problem is not of maximizing utility / freedom in general, but of maximizing utility given specific resource reflected in his budge line. To understand this idea, recall that we have shown that higher indifference curves contain bundles that are preferred to those contained by lower indifference curves because they yield higher levels of utility. Preferences in economic theory are represented by a utility function written as U(x, y). This allows us to reformulate the consumer problem. Rather than saying that a consumer is trying to attain the highest indifference curve, we can say that he is trying to attain highest level of utility; i.e. to his maximize utility. If the consumer choice problem is to maximize utility, then the consumer is concerned to find the highest indifference curve since it yields the highest utility. Since consumer is greedy, therefore the highest indifference curve will never be attained because there will always be a bundle yielding even more utility (he can always wish for more). Thus, the desire to maximize utility / freedom itself is infinite and never satiable. However the consumer has limited resources given the assumption of scarcity, as he is not Abul Bashar who can pick as many coconuts as he wants—but picks only one per day because his peer has told him to fill only one third of his stomach. To see why the conventional consumer choice problem will not be applicable to a person like Abul Bashar, we can say, in terms of figure 7.1, that: Income is not a constraint on Abul Bashar’s consumption. He can pick as many coconuts as he wants His consumption is however limited by: his own inclinations. He does not want to raise his living standard. He wants to live a life of Zuhd and faqr his traditions and society. He lives in a Muslim community which values sabr and qana’at and abhors greed, lust, jealousy, accumulation and competition The Shariah which outlaws alcohol, the wearing of silk and jewelry, gambling, interest bearing transactions and widely distributes Abul Bashar’s wealth at the time of his death making accumulation somewhat pointless. Moreover Mubashir—Abul Bashar’s son—is a member of the Dawat-e-Islami and probably gives away most of what he inherits. Moreover Bashir, Abul Bashar’s other son, has already left the Maldives to enroll as a mujahid in the Chechnya jihad and Abul Bashar’s Youngest daughter is Abdullah Zhagliazai’s wife. In these circumstances who can convince Abul Bashar to be concerned about maximizing utility? Figure 7.3 summarizes the factors that affect upon a consumer’s choice. Contrast this with the mind set and social environment of Mr. Bill Gates. Mr. Gates is demonically greedy, lustful, jealous, competitive and accumulative. He lives in America founded on the dead bodies of eighty million Red Indian and practicing loot and plunder on a global scale for the last two hundred years. Promoting lust, geed, jealousy, competition and accumulation is America’s national mission. Moreover the vague recollection of Christian teachings which Mr. Gates has inherited has no Shariah contents at all. Saint Augustine subordinated cannon law and ecclesiastical law to Roman law in the fourth century and today even a lesbian can head the Evangelical congregation that Mr. Gates attends.

Most importantly Mr. Gates subscribes to the Enlightenment conception of truth—all other conceptions of truth are mythic in his eyes. The Enlightenment conception of truth is embodied in the natural sciences and the social sciences (see Table 7.2). The natural sciences tell Mr. Gates how to exploit nature for accumulation of capital and for the subordination of all natural forces to Mr. Gates arbitrarily determined desires. Social sciences teach him how to organize society so that domination of nature becomes a means for the efficient accumulation of capital/resources. Figure 7.3: Constraints on consumer’s consumption patternAbul BasharLegal limits, e.g. Shariah lawsSocial limits, e.g. traditionsPhysical limits, e.g. physical lawsInternal Constraints Figure 7.3: Constraints on consumer’s consumption pattern Abul Bashar Legal limits, e.g. Shariah laws Social limits, e.g. traditions Physical limits, e.g. physical laws Internal Constraints Thus, the knowledge systems, to which Mr Gates is exposed to from his childhood, are applicable to facilitating utility / profit maximization and maximization of the rate of accumulation. Their purpose is to eliminate all personal, social and legal constraints on utility / profit maximization and from the maximization of capital accumulation. It is therefore “natural” for subjects of capitalist order such as Mr. Gates to seek utility maximization. Table 7-2: Objectives of Enlightenment Knowledge Systems Discipline Objective Natural Sciences To discover regularities in the universe in order to allow man’s control over it so that he can use them for the accumulation of capital and fulfillment of his desires Social Sciences Give a framework of social arrangements which ensures maximization of freedom (utility / profit) for all individuals In mature capitalist societies, the constraint of finite income is the single most important constraint that an individual faces. Mr. Gates is a rational consumer who is universally greedy; he is always feeling ‘dissatisfied’ even if he becomes the richest man in the world. The moment Mr. Gates ceases to wish for more, he ceases to be ‘rational’ and disqualifies him as ‘human’ being. The limits of a citizen’s freedom are defined principally by the amount of income he has in capitalist society. Mr. Gates can exercise more freedom (i.e. satisfy more wants) than Hobo Rasters because he has more income. Income is the major constraints on consumption and the consumer has to maximize utility such that he does not violate this income constraints. In our two commodity model, this means that though the consumer desires to purchase the combination of x and y from which he derives the highest level of utility, his income is limited and he cannot purchase unlimited amounts of the two goods. His problem can, thus, be stated as of maximization of utility subject to this budget (income) constraint. Formally, his utility-maximization problem is written as: Maximize U (x, y) By choosing optimal amounts of x and y Subject to the constraint: Px x + Py y = M

Maximize U (x, y) By choosing optimal amounts of x and y Subject to the constraint: Px x + Py y = M This expression is a compact way of stating the consumer’s choice problem. It tells (a) what is the objective of the consumer—maximize utility; (b) what is the consumer choosing—a consumption bundle of commodities and (c) what are the constraints the consumer faces—the budget set. More precisely, the capitalist consumer wants to maximize his utility by choosing quantities of x and y such that those quantities are affordable with his limited income. For example, bundle D in figure 7.1 will give higher utility than bundles A and B; however this bundle is not affordable with given income and prices. The consumer can choose a bundle on or below his budget line not above it. Before going onto the graphical analysis of the solution of the consumer choice problem, we can infer one important result; i.e. where his selected bundle will fall. It must lie on the budget line, and not below it. Why? Consider for example the bundle C in figure 7.1 which falls inside the budget line. This cannot be the utility maximizing bundle because the assumption of greed implies that any bundle on the line segment AB of the budget line is preferred to the bundle C as it contains more of both the goods. Therefore, we can safely ignore all bundles below the boundary of budget line and say that the capitalist consumer always picks a bundle on the boundary, indicated by the budget line. 7.2.1: Consumer Equilibrium Now we are ready to describe the solution to the consumer choice problem. The consumer is free to move anywhere along the budget line ZS. Positions to the right and above ZS are not affordable because they require more than the current income of the consumer. We impose the indifference map of the consumer on this budget line in figure 7.4. We saw in the last chapter that choice is determined by two factors: taste and opportunities. The indifference map shows the taste of the capitalist consumer while the budget line shows his opportunities. What will be the choice? Start moving form the left-hand corner of the budget line to the right-hand corner. The consumer is moving to higher and higher indifference curves. Where should we the consumer? Surely, at the point where he reaches the highest possible indifference curve that just kisses the budget line. Here it is at point E in the right panel of figure 7.4. At this point, the budget line just touches, and does not cross, the indifference curve. This point of tangency is on the highest attainable indifference curve, I2, and provides the highest possible utility to the consumer. All bundles on I3 have higher utility than I2, but they are not affordable. Thus, the consumer attains equilibrium at the point where his budget line is tangent to the highest indifference curve. y y* 0 x* xI2I1I3PEIoZSFigure 7.4: Locating Consumer Equilibrium y 0 xPMRNIoI1ZS y y* 0 x* x I2 I1 I3 P E Io Z S Figure 7.4: Locating Consumer Equilibrium

y 0 x P M R N Io I1 Z S Why Tangency? At the point of consumer equilibrium, the indifference curve must be tangent to the budget line. But what about bundle P lying on the indifference curve I1 (look at the left panel of figure 7.4)? This bundle is also affordable as it lies on his budget line. Why does the consumer reject it in favor of bundle E? The reason is that this bundle does not maximize the utility of the consumer. To see why, note that all bundles on the budget line between points P and R are affordable. Further, recall the fact that the weighted average bundles of any two bundles which fall on the line joining those two bundles are necessarily preferred to those two bundles (assumption of convexity). This means that any bundle on the line segment PR of budget line will be preferred to P and R because that bundle will be a weighted average of P and R (the line joining P and R will be this budget line). Since these bundles are preferred to P and are also affordable, the consumer will select that bundle which is a weighted average of P and R. But note that any bundle on the line segment PR will be on a higher indifference curve, such as bundle N. Since a higher indifference curve shows higher level of utility, so consumers’ utility is not maximum at bundle P because it is possible for him to increase his utility by moving to a bundle like N. If utility were maximum at P, it could not be increased at all. If you look at bundle N, you will see that this also does not maximize the utility of the consumer because any bundle on the line segment NM will be on a higher indifference curve (due to convexity assumption as explained above). As long as there is a line segment above the indifference curve, the consumer can increase his utility by choosing a bundle on that line segment. Now look at point E in the right hand panel. At this point, there is no preferred bundle available to our consumer. So, this is the bundle that maximizes his utility. Note that such a utility maximizing bundle falls on the point of tangency between indifference curve and budget line. The convexity assumption thus ensures that the consumption of a good is a means for the maximization of utility. It is not an end in itself nor a means for any other purpose. The preference for preference itself (utility maximization) is the sole purpose of consumption. Recall from chapter 5 that the slope of the indifference curve at any point is given by the tangent at that point. One such tangent is drawn at point P on indifference curve I1 in the right hand panel. Since this tangent is steeper than the budget line, it means that the slope of the indifference curve is greater than the slope of the budget line at point P: At P The tangent of the indifference curve is steeper than Budget line Therefore, The slope of the indifference curve > this slope of the budget line However, if you draw a tangent on indifference curve I2 at point E; that tangent will fall exactly on budget line. This means that at the point of tangency, point E, we have the condition:

The slope of the indifference curve = the slope of the budget line Tangency implies that slopes of the indifference curve and the budget line are exactly equal. Meaning of Tangency What is the economic meaning of equating slopes? To understand this important idea, recall the definitions of MRS and the commodity price ratio: Slope of Indifference curve → MRS measures the rate at which a consumer is willing to substitute two goods Slope of budget line → measures the rate at which a consumer can substitute two goods Consider a simple numerical example to understand the idea. Continuing with our previous data, suppose that Px = Rs 1 and Py = Rs 2 while consumer’s income is M = Rs 100. This gives us a budget line with a slope of - ½ [as shown above, see equation (7.5)]. This means that the consumer can buy one unit of x in place of ½ a unit of y. Alternatively, he can substitute ½ a unit of y for one unit of x as the price of y is double than that of x. Now consider point P in figure 7.5 where the indifference curve is crossing the budget line. The tangent of the indifference curve at point P is steeper than the budget line which implies a greater MRS than the price ratio (recall that the slope of the indifference curve shows MRS). Say, MRS is 1 (or any number greater than ½, the slope of the budget line) at P. This means that the consumer is willing to substitute one unit of x with one unit of y, or in other words the utility of one unit of x is equal to the utility one unit of y in his eyes. Point P is not his optimum since MRS is greater than price ratio: The consumer can do better by reallocating his expenditure on x and y. Because he is expecting utility derived from consumption of x to be higher than the market does (the price of one unit of x is equal to ½ units of y in the market while 1x = one y to consumer), it is in his interest to consume more x and less y. Why? Suppose that he reduces his consumption of y by one unit. This will save Rs 2 (as Py = Rs 2). He can purchase two units of x from these Rs 2 (as Px = Rs 1). But how many x were needed to compensate the reduction in the consumption of y by one unit? Clearly, he needed only one x to compensate for one unit of y (as MRS = 1). Since the consumer can purchase two units of x in place of one y, the one extra unit of x will put him on a higher indifference curve. This reallocation of expenditure from y to x will be of benefit for the consumer as long as his MRS is greater than the commodity price ratio and he will stop only where both are equal, (at point E). Figure 7.5: MRS and the Commodity Price Rates. y 50 y* 0 x* 100 xPESlope of IC = MRS = 1Slope of budget line = - ½ Figure 7.5: MRS and the Commodity Price Rates. y 50 y* 0 x* 100 x P E Slope of IC = MRS = 1 Slope of budget line = - ½ The equating of the slopes implies that the consumer should consume a commodity up to the point where his personal evaluation of a commodity is equal to that of the market. It reflects the idea that the consumer’s rate of exchange between x and y is equal to the market rate of exchange between the two goods. Recall that the slope of the indifference curve shows consumer’s rate of evaluation between two goods, while the slope of the budget line shows the market rate of exchange between the two goods. Equilibrium occurs when the two rates are equal. Tangency means that the consumer will be in equilibrium when:

(7.7-a) or (7.7-b) Thus, the equilibrium condition can be stated as: (7.8) Since MRS is also equal to the ratio of marginal utilities, the equilibrium condition becomes: (7.9) Finally, look at the equilibrium quantities of x and y, x* and y* at point E. This bundle provides the maximum utility to the consumer as it lies on the highest attainable indifference curve. With given income and prices, point E is the demand point of the consumer where he opts to purchase x* and y* quantities of the two goods x and y. These are the solution values of x and y in his maximization problem. The bundle (x*, y*) is therefore called the optimum bundle (the bundle that maximizes utility). From Two-Goods to Infinity If the model of choice between two goods is extended to choice among three or more goods, then the two dimensional graph will no longer be useful. Mathematical techniques allow economists to extend their model of two-goods to any number of goods (see appendix to this chapter). However, the basic idea underlying equilibrium analysis of consumer behavior remains unchanged, no matter how many goods are considered. For example, suppose there are three goods, x, y and z with prices Px, Py and Pz respectively. The equilibrium quantities of three goods will be given at the point where the following three conditions are satisfied: (7.10-a) (7.10-b) (7.10-c) The same conditions must hold even if there were an infinite number of commodities. Consumer Sovereignty Equilibrium is a centrally important concept in economic theory. Our discussion of consumer behavior provides one illustration of its importance. It shows that in equilibrium the personal valuation of the consumer are subjected to the discipline of the market. He can only maximize his utility by accepting the market valuation of x and y. If he refuses to accept the market valuation—if he refuse to move from point P in Figure 7.5—he will never maximize utility. If he is a capitalist consumer and committed to utility maximization as an end in itself (remember Abdullah Zhaghazai and Abul Bashar are not so committed, they are not capitalist consumers) he must accept the relative prices of x and y set (independent of his preferences) by the market. Market-evaluation rules capitalist society. All personal preferences are subject to the evaluation of the market. It is this necessary social dominance of the market which ensures that in equilibrium both profits and welfare (aggregate consumption) are maximized. But we will be able to show why this is so only after we have looked at the theory of costs and production. Economists begin their model of consumer behavior with the presumption of ‘given innate taste’ of individuals. The objective behind this assumption is to pretend that since it is the capitalist individual himself who ‘makes free decisions’ in the light of his own taste, therefore he is himself master, and hence responsible, for his own life. But the solution to the utility maximization problem through reconciling preferences with market determined price ratios does not allow us to reach this conclusion. It was stated above that an individual is in equilibrium—a position where he will not be willing to change his decision—when his personal evaluation of all goods or activities is inline with the market [conditions (7.7a) and (7.7b)]. In other words, he must place as much value on all goods and services as the market demands that he should. If this does not hold; i.e. if his taste and preferences are not inline with market valuations, he is in disequilibrium—a position he is supposed to leave sooner or later if he is a rational individual (i.e. one committed to utility maximization as an end in itself). This logic of utility maximization has two noteworthy implications:

Any choice or objective that is not valued by the market is an irrational one and, therefore, must be ruled out be a rational individual. Thus, if Aleemullah chooses to be a Muhaddis, [a person who holds mastery over the interpretation of the Sayings of Prophet (SAAW)], a Mujahid or a Da’i (preacher of Islam), he is making an irrational choice. These choices are not valued and allowed by the market because they do not contribute to the objective of maximization of utility / profit / freedom / capital. Thus, an individual is not free to choose whatever he wants to choose; rather he is disciplined and expected to choose from whatever the market offers him to choose. Equilibrium means that an individual must adjust his taste in any given choice situation as market requires him to do. His choices should be consistent with those allowed by the market. In other words, it is the market which determines the objectives set by the individuals for themselves. Choices made by rational (utility maximizing) individuals are not independent pursuit of their own self-defined objectives; rather they are expressions of submission to the discipline of market. Since the rational consumer cannot affect prices of goods (opportunities offered by the market) and is merely a price-taker, therefore, all utility maximizing individuals are equal in their powerlessness before the anonymous and impersonal market: Sovereignty belongs to the market not to the consumer. Freedom = Income The link between maximization of freedom and accumulation of capital has been explained at several places in this book. But this link becomes clear in the context of consumer equilibrium. Note that the solution to the utility maximization problem (tangency point) says that ‘the level of utility a consumer can attain depends upon the position of his budget line’: the higher the budget line, the higher the indifference curve and hence utility level the consumer can attain. How far away the budget line will be located from the origin depends upon the level of the consumer income. To see this clearly, note that the vertical and horizontal intercepts of the budget line are given by: and With given prices of x and y, the larger the income of the consumer, the farther away will be the intercepts of the budget line from the origin. This situation is shown in figure 7.6 where the equilibrium points of Farooq are shown at two different levels of income, Mo and M1 where M1 (say Rs 200) > Mo (say Rs 100). Note that in order to attain a higher level of utility or to satisfy more wants (i.e. to increase his freedom); he must enjoy higher levels of income. That is the only way freedom (maximization of utility) can be realized. The theory of consumer behavior shows that if an individual wants to maximize his utility there is one and only one rational preference that he must pursue: and that is the preference for higher income through participation is the accumulation of capital. Figure 7.6: Freedom is a function of income y 0 x

Figure 7.6: Freedom is a function of income y 0 x ABIoI1 A B Io I1 Thus we have the fundamental relation: Maximization of Freedom = Maximization of Utility = Maximization of Income It is for this fundamental reason that we see individuals living in a capitalist society committed to ‘higher levels of income’, ‘higher standards of living’ and ‘better quality of life’ phobias. 7.2.2: Assumption of Convexity and Uniqueness of Equilibrium We have derived the result that the tangency between the indifference curve and the budget line is the necessary condition for identifying the optimum bundle which maximizes utility. But the important question to ask is: whether a tangency condition is always sufficient for a commodity bundle to be optimal in this sense? Look at figure 7.7 where three bundles satisfy the tangency condition. Bundle A is not optimal because there are other bundles which lie on a higher indifference curve such as bundles B and C (remember that the optimal bundle is one which is on the highest indifference curve). Both bundles B and C are optimal bundles as they fall on the highest possible indifference curve and they satisfy the tangency condition as well. What caused this type of situation to occur? Obviously, it is the non-convex shape of the indifference curve. Recall that in chapter 5 while discussing convexity of indifference curves, we said that this assumption plays a crucial role in determining a unique solution to the consumer choice problem. In the case of convex preferences, any point that satisfies tangency condition must be an optimal point. And since convex indifference curves do not have any flat spots in them, there is one and only one optimal bundle which maximizes consumer utility. Convex indifference curves are bowed towards the origin and must curve away from the budget line on that bow; they can’t bend back to touch the budget line again. Thus, we learn an important principle: when indifference curves are strictly convex, the tangency condition shows the only one point at which utility is maximized (that is what we mean by a unique solution to the consumer choice problem). Such a solution is called an interior solution, the one in which quantities of both goods are consumed in positive amounts. The importance of the unique solution of the consumer choice problem will become evident when we consider the demand function later in the next chapter. Thus far, just keep in mind the condition for his unique solution. Figure 7.7: Non Convex Indifference Curves and Multiple Equilibriums y 0 x Figure 7.7: Non Convex Indifference Curves and Multiple Equilibriums y 0 x ABCIoI1 A B C Io I1 Consumer Optimum with Concave Preferences The above argument is made clearer by considering what happens when preferences are non-convex. With non-convex preferences, the tangency condition does not show the optimum, instead it shows the minimum. To understand this, look at figure 7.8 where we have presented concave preferences. We can see that MRS increases along these indifference curves as x is substituted for y (tangent becomes steeper as we move along the indifference curve). Consider point A first where the indifference curve is tangent to the budget line. This point is the worst bundle because it lies on the lowest indifference curve, Io and the consumer can do better by choosing point S lying on a higher indifference curve I1. But even bundle S is not the best the consumer can choose. To see this, look at the place where indifference curve I1 hits the vertical axis, at point K below point Z on the budget line. Since Z has more of y than does K, so Z P K. Since K I S (from I1), then, by transitivity, Z P S. So, point Z is the equilibrium point of the consumer with zero amount of x.

In general, with non-convex (increasing MRS along an indifference curve) but non-satiated preferences (more is better), consumer equilibrium must be where the budget line intersects one of the axis. Such a solution is called corner solution showing the fact that the consumer always specializes in the consumption of one commodity and does not consume both the goods. This result states an important principle: the maximum-utility point occurs at the convex region of the indifference curve, tangency in the concave region implies minimum point rather than maximum. The importance of convexity assumption will become further clear when we discuss the idea of demand curve in chapter 8. Figure 7.8: Concave Indifference Curves and Consumer Choicey 0 xKIoAZSI1I2 Figure 7.8: Concave Indifference Curves and Consumer Choice y 0 x K Io A Z S I1 I2 7.2.3: Equi-Marginal Principle: Restating Consumer Equilibrium Consumer equilibrium or optimum consumer choice described above can be restated in a more interpretable way. As slight rearrangement of the equilibrium condition (7.9) gives: (7.11) This condition simply states that to maximize utility, the consumer must spend his income in such a way that the marginal utility of the last rupee spent on each good is the same. What does this mean? First, note that this statement of the equilibrium condition makes sense only when we assume that utility is measurable in terms of cardinal numbers (one, two, three rupees). Understanding equation (7.11) requires us to introduce another concept known in economics as the law of diminishing marginal utility which says that the marginal utility derived from any commodity tends to decrease as more of that commodity is consumed, other things held constant. This is to say that as the consumption of a certain commodity increases, the extra unit of that commodityyeilds lower utility. As we have seen this idea is also behind the assumption that normal indifference curves are convex. Consider table 7.3. Note that as units of Pepsi consumed increase from 1 to 2, the total utility that the consumer obtains increases from 10 to 18 utils. The marginal utility of this unit—extra utility derived from this extra unit of Pepsi—is obtained by subtracting utility of the previous unit from the last one; e.g. 18 – 10 = 8. We can see that as consumption of Pepsi increases, total utility is increasing. However, marginal utility of each extra unit is decreasing in this table. This is exactly what is meant by the tendency of diminishing marginal utility. This behavior is supposed to hold for all commodities. Now we pose the important question: How can a consumer maximize his utility with decreasing marginal utility? There are two things that a consumer must do to achieve this objective. First, he can do this by spending his income on different commodities rather than purchasing only one commodity. Table 7.3: Total and Marginal Utility Units of Pepsi Total Utility Marginal Utility 1 10 - 2 18 8 3 24 6 4 28 4 5 30 2 To see the look at table 7.4 where decreasing marginal utilities of two goods, Pepsi and burger, are recorded. Suppose that the consumer has only Rs. 50 to spend; i.e. M = Rs 50 while each unit of burger costs Rs.10 (Pb = 10) and each can of Pepsi costs Rs. 5 (Pp = 5). You can afford to buy 5 burgers if you spend all your income on it (50/10) and similarly 10 cans of Pepsi (50/5) if all income is devoted to Pepsi. If you spend all your income on burger and purchase five units, you will obtain 100 utils utility (= 28 + 24 + 20 + 16 + 12; i.e. sum of the marginal utilities of all units of burger). Similarly, if you purchase only Pepsi, your total utility will be 85 utils. Obviously, you are better off by spending all your income on burgers than Pepsi if given a choice between either of them.

Table 7.4: Deriving equi-marginal principle Units Marginal Utility from burger Marginal Utility from Pepsi 1 28 16 2 24 14 3 20 12 4 16 10 5 12 8 6 7 7 6 8 5 9 4 10 3 100 utils 85 utils However, your total utility will be greater if you buy 3 burgers and 4 cans of Pepsi as the sum of their marginal utilities is 124 (= 28 + 24 + 20 + 16 + 14 + 12 + 10). But a question arises: How did we find this bundle? The key to find the optimal bundle of a utility maximizing consumer is to assume that he compares the marginal utilities from the purchase of the additional units of two commodities, and purchases that combination which gives him the higher marginal utility. To see how this is done, first note that for a valid comparison between Pepsi and burger, we must compare two units of Pepsi with one unit of burger because the price of the burger (Rs. 10) is twice the cost of Pepsi (Rs. 5). The utility gained from one burger should be compared with the utility from two cans of Pepsi because you have paid exactly twice as much for the burger as you did for Pepsi. Now think about spending Rs. 10 out of your total Rs. 50. Which commodity should you purchase first? If you purchase 1st unit of the burger, your utility will be 28 utils, but you can purchase two units of Pepsi with Rs. 10 (its price is Rs. 5) and you will gain 30 utils (16 + 14). Surely, you should purchase two units of Pepsi and not the burger. After purchasing two units of Pepsi, you should spend the next ten rupees on purchasing the first burger because that will add 28 utils to your utility which is greater than the sum of marginal utilities of the 3rd and 4th cans of Pepsi, (22 utils = 12 + 10). Which one to purchase next? Again, one burger because 24 utils is still greater than 22 utils. 20 rupees are still left with you. Now you should spend the next ten rupees on Pepsi because the joint marginal utilities of the 3rd and 4th cans of Pepsi (22) are greater than that of the 3rd burger (20). Finally, the last ten rupees should be devoted to burger for the same reason. You have spent all your Rs. 50 in an optimal way. Note that no other way of spending your income will give you higher utility than this bundle (try to work this out). What is the lesson to be drawn from this numerical example? Diminishing marginal utility forces capitalist consumers to use their resources for purchasing a variety of goods. But what is its rule? Would you expect that the last pencil you are buying brings you the same marginal utility, as does the last pair of shoes? Not at all, simply because shoes cost you much more per unit than the pencil. The rule would be: if good A costs twice as much as good B, then buy good A only when its marginal utility is at least as great as good B’s marginal utility. This is exactly what you did when you bought burgers and pepsi. Since the price of the burger was double that of Pepsi, the last unit of burger is bringing you twice as much marginal utility (20) as the last unit of Pepsi (10). This is the consumer equilibrium condition which can be written in the following way:

Since the last unit of burger was purchased with Rs. 10, and it brings you a utility of 20 utils, this means that the last rupee spent on burger adds 2 utils to your utility. Similarly, i.e. the last unit of Pepsi was purchased with Rs. 5, and it brings you a utility of 10 utils, this means that the last rupee spent on Pepsi also adds 2 util. Note that the marginal utility of the last rupee spent on each good is the same, 2 utils. So our general equilibrium formula will be: (7.12) This is what is meant by the law of equi-marginal utility as stated above: “A consumer having a fixed income and facing given market prices of goods will capitalist maximize utility when the marginal utility of the last rupee spent on each good is exactly the same”. Alternatively, when the ratio of marginal utility of a good to its price is equal to the ratio of marginal utility of another good to that goods price, capitalist consumer attains equilibrium—a position he will not change because he can’t maximize utility by any other pattern of consumption. Why Must this Condition Hold? Understanding the mechanism how that equilibrium is attained when we start from a disequilibrium condition tells us a great deal about economics. Suppose that Pepsi gives Nomi more marginal utility per rupee than burger; i.e: What would Nomi do? He can increase his utility by taking money away from burger and spending more on Pepsi. As he starts spending more on Pepsi, its marginal utility will fall, while that of burger will increase (because its consumption is decreasing). How long should he continue substituting Pepsi for burgers? Simply, until the law of diminishing marginal utility drives the marginal utility of Pepsi per rupee down to the equality level with that of burger. In the next chapter, we will see how this principle is used to derive the demand curve for a commodity. See application box 7.1 to gain further insight of this rather difficult principle. A P P L I C A T I O N B O X 7.1 Deciding Study Hours We can apply the concept of equi-marginal utility to a wide range of optimization problems in capitalist societies. Every student faces a problem when studying for final exams deciding how much time to allocate capitalist to each subject, especially when all the studies have to come during last few weeks before the exams. Obviously, the amount of time spent on each subject will depend on how well the student understands the subject he is already doing in that cource. Let us suppose that he has to appear in two exams, economics and mathematics. He has a number of hours available for studying and he wants to maximize his total score in the exams. Assume that the student has a rough idea about the technology that transforms the time allocated to a subject into marks; that is he knows the expected effects of different amounts of study time on the marks. For example, he is doing well in economics and knows that 3 hours spent studying this subject will surely bring 80 out of 100 marks. The following Table shows the relevant information on studying and marks. Column (3) shows the effect of each hour of studying mathematics on the final exams, that is the marginal marks. For example, devoting one extra hour to the study of mathematics after the first hour will add 10 marks to the total score in mathematics, and so on. As he devotes more and more hours studying mathematics, expected increase in marks becomes less and less likely (because it becomes difficult to obtain extra marks as he approach as the maximum 100).this also applies to marks in economics.

Suppose that the student has only five hours a day for studying both these subjects. How should he allocate these hours studying these two subjects? If he wants to maximize the sum of total score in both these subjects, then he should spend three hours on studying economics and two on mathematics because the marginal contribution of the last hour spent on each subject is 10 marks with this distribution. This becomes clearer if, for example, you assume that one additional hour is available for study. Then where should the student devote this extra hour? Clearly to mathematics because that will add 8 marks to his total score while giving the same hour to economics will add only 4 marks. (1) (2) (3) (4) (5) Study Hours Marks in Mathematics Changes in Marks Marks in Economics Changes in Marks 1 50 - 55 - 2 60 10 70 15 3 68 8 80 10 4 73 5 84 4 5 74 1 85 1 You might be tempted to think that we cannot tell the exact relationship between time devoted to study and the results of the exams. Although it is true, still the equi-marginal principle suggests the optimal allocation of time in the simple way as: if an additional hour devoted to the study of economics is more productive than studying mathematics, then reallocation of time away from mathematics and towards economics is suggested. This is the central idea behind equi-marginal principle. The equi marginal principle applies only when we are concerned about the consequences of actions—that is why it is so useful for utilitarian analysis as they are essentially consequentiality (see Chap 5). In this example the consequences of taking the two exams is the production of marks. The student is primarily interested in getting marks which in capitalist society are a means for acquiring utility / profits. Marks can substitute for utils because studying economics and mathematics are not ends in themselves—they are means for acquiring marks if a student is really interested in understanding economics and mathematics marks will become completely irrelevant to this decision about how to allocate time / between mathematics and economics. Suppose he wants to understand both—then he will allocate more time to the subject he finds difficult to understand. The marks he obtains will become quite irrelevant to his allocation of time between the subject. Here we learn one of the most fundamental principles of economics theory: prices are not arbitrary numbers, but they are supposed to reflect how people value things at the margin. It is assumed that at this equilibrium point, MRS is equal to the price ratio. The price ratio measures marginal rate of substitution. This means that we have a way to value possible changes in consumption. If we observe one choice at one set of prices, we get the MRS at that consumption point. If prices change and we observe another choice, we get another MRS at that point. That is what economists mean by the statement that ‘prices are a measure of valuing goods’. The important thing to understand is that MRS is a conceptual phenomenon. It does not exist in the real world in the same sense as prices exist. We can observe prices and calculate what happens to quantity demanded when prices fall. We can never observe MRS and therefore can never verify or refute the existence of the equi marginal principle as a determinant of consumer behavior. Economics is simply saying that what people ought to do is the maximization of utility (the preference for preference itself). Economics cannot answer the question ‘why should people seek utility maximization as an end in itself’. Because it cannot answer this question, economics is essentially normative and ideological. Its positive analysis requires that its normative presumptions be accepted as valid. That is why while the equi marginal principle can be used to understand how a student allocates time when studying for exams, it cannot be used to understand student behavior not looking for marks (See Application Box 7.1).

Why Alternative Approaches? Historically speaking, the equi-marginal utility approach (also known as the cardinal utility function) of analyzing consumer behavior predates the indifference approach, which was discussed earlier in this chapter. However, the critical assumption underlying the marginal utility approach was that utility could be measured in terms of cardinal numbers. The cardinal utility function asserts that the order of preferences is determined by the relative size of the utility numbers assigned to each bundle of consumption. The cardinal utility function says that utility can be measured in cardinal numbers (one, two, three ), it requires information about utility differences as well as the preference ordering their difference represent. Thus if U(x), = 10, U(y) = 11 and U (z) = 13 we can say that z is preferred to y by more than y is preferred to x because the utility difference between z and y is greater (2 = 13 - 11) than that between y and x (1 = 11 - 10). But the problem with this approach was the way how to measure utility. How can in principle we calculate the “amount” of utility associated with the consumption of a commodity? How can we measure the utility derived by the consumption of, say, bread? Is Farooq’s utility the same as that of Nomi? These difficulties because utility does not exist therefore it cannot be observed? Due to these conceptual difficulties, economists stopped thinking that utility is a cardinal measure of well being. Gradually, it was realized that all that matters about utility is the fact that one bundle has a higher utility than another, but how much higher does not matter at all. This lead to the idea of the ordinal utility function which says that the numbers attached to consumption bundles give only the ranking of preferences; it has little to do with the numerical utility differences in those bundles (the idea is also known as the indifference approach). Thus if A P B, we conclude that the utility of A [U(A)] is greater than that of B, but we don’t calculate by how much it is more, that is why it is called ordinal, meaning it gives only the order of the preferences (first, second, third…). This move from the cardinal to the ordinal conception of utility does not eliminate the problems which course from the fact that utility cannot be directly observed. Do not confuse the two ideas, as they are different. The cardinal utility function makes sense only if the increments to marginal utility are measurable. This additional information is no more required to study consumer behavior with an ordinal utility function. Remember that the numbers attached to indifference curves (first, second …) serve only to order the curves and not to attach weights to them. They don’t mean that the first indifference curve is two times preferred to the second one. Secondly, with the cardinal utility approach, preferences are defined in terms of utility. When we say that bundle A is preferred to B, it means that bundle A has higher utility than bundle B:

Cardinal Utility Approach: A P B But with ordinal approach, we go the other way around. The preferences of a person are taken as fundamental and primitive (as given) while utility is only a way to describe preferences. Ordinal Utility Approach: A P B The only property of utility function that is important is that it orders or ranks the bundles of goods, its magnitude serves only to rank different bundles, and the size of the utility differences makes no difference. The most important similarity of the two approaches is that the ordinal utility approach gives the same results regarding consumer choice problem as does the cardinal utility approach without using the assumption of the measurability of utility. This can be seen by comparing the consumer equilibrium condition of the two approaches for two goods case: Consumer Equilibrium in Cardinal Utility Approach as per (7.11) Consumer Equilibrium in Ordinal Utility Approach as per (7.9) Note that both are the same. Since the ordinal utility approach requires less information to derive this result than the cardinal utility approach, therefore the former method replaced the later over time. In the next chapter, we will see how the downward sloping demand curve can also be derived using both approaches. Both approaches give the same results because both are grounded on utilitarian ideology. The ordinal approach puts the emphases on preference and pretends that utility is a means for ranking them, but this is a dangerous half-truth. Utility is the only means for evaluating preferences according to the ordinal approach. Hence utility is the essence of preference—the one and only thing which all preferences generate and the one and only measure on the basis of which they can be ranked. Utility as we have seen is the preference for preference itself, it is nothing else. If Abdullah’s preferences reject the preference for preference itself, his preference can neither be measured (cardinally) nor ranked (ordinally) on the basis of utility. 7.3: Explaining Choice For Special Tastes In chapter 5, we used the concept of preferences to illustrate the taste of an individual for certain types of commodities. In this section, we add the notion of the budget set to determine the choice for them given his taste. A Useless Good We noted in the last chapter that the taste for a neutral commodity is illustrated by vertical indifference curves as reproduced here in figure 7.9. We have also depicted the standard budget line ZS. We can easily determine the choice under this situation for capitalist consumer. First note that since indifference curves are vertical lines, there is no point at which the slope of the indifference curve and the budget line will be equal, so the tangency solution is not possible. Because indifference curves originate from the horizontal axis, the equilibrium will be where the highest indifference curve hits the budget line at point S at the horizontal axis. Thus, in case of neutral goods, the consumer does not consume any amount of the useless commodity, here (Pepsi for Farooq) consumer, and devotes all his resources to the consumption of bread. It is quite easy to understand the reason for this outcome: if something is useless, don’t spend anything on it.

Figure 7.9: The Budget Line and Useless Good. Pepsi 0 5 10 BreadIoI1I2ZSI3 Figure 7.9: The Budget Line and Useless Good. Pepsi 0 5 10 Bread Io I1 I2 Z S I3 An Economic Bad Recall that an economic bad was defined as the commodity for which “more is bad, not good” and its taste is represented by positively sloped indifference curves, (see figure 7.10). Again, it can easily be shown that point S is the equilibrium point because Farooq does not want to have any amount of cigarettes. Figure 7.10: Budget Line and “Bads” Cigarette 0 BreadI1I2IoZS Figure 7.10: Budget Line and “Bads” Cigarette 0 Bread I1 I2 Io Z S Perfect Substitutes The taste for perfect substitutes is shown in figure 7.11 (the thicker lines are the indifference curves with MRS = 1). We can have three possible situations with regard to the budget constraint: Price of Piano > Price of Picasso pens Price of Piano < Price of Picasso pens Price of Piano = Price of Picasso pens Recall that the slope of the budget line equals the price ratio, here it is:. Now if we consider the first case, Ppiano > Ppicasso, the ratio will be greater than one and the budget line will be steeper than the indifference curve because the slope of the indifference curve was assumed to be one. This situation is depicted in figure 7.11 where the dashed line ZS is the budget line. At this price ratio, Nomi can afford fewer pianos and more Picassos (b/c Picassos > Picassos). The equilibrium is at Z. As a rational consumer, he should buy only Picassos because one piano pen costs more than one Picassos (relative price of piano is greater than 1) but he gives equal value to both of the pens. Therefore, he will specialize in his consumption and buy only the cheaper pen Picasso. Figure 7.11: The Budget Line and Perfect Substitutes. Picasso 0 PianoIoI1ZS Figure 7.11: The Budget Line and Perfect Substitutes. Picasso 0 Piano Io I1 Z S Now, following this reasoning, we can easily see that if we had the second case, Ppiano < Ppicasso, then Nomi will choose only Piano. What about the third situation when both the commodities have equal prices? The slope of the budget line will be one which means that indifference curves and the budget line will be parallel to each other. It simply means that there is no unique choice point in this situation, rather Nomi can choose any point on the budget line as MRS will be equal to the slope of the budget line at all points (draw a diagram to clear your understanding. In this diagram, indifference curve and the budget line will coincide). This means that Nomi will not care about which pen he purchases because they cost him the same amount. Any amount of both the commodities will satisfy him equally and he can choose any point on the budget line to attain his equilibrium. So, we can conclude that: Choose only Picasso if Ppiano > Ppicasso Choose only Piano if Ppiano < Ppicasso Choose any combination of the two if Ppiano = Ppicasso Perfect Complements

Perfect compliments were defined as goods that are always used together in some fixed proportion. Suppose that Farooq has money to buy only two pairs of shoes. This point occurs at U on the budget line ZS in figure 7.12. The best possibility for him is to choose point U with equal amounts of both the shoes, no matter what their individual prices are. Note that the consumer equilibrium point must lie on the diagonal, here on the 45o line joining all kink points because this line represents an equal amount of both the shoes at all points along it. More insight on this situation will be gained when we consider how budget line changes its position in the next chapter. Figure 7.12: The Budget Line and Perfect Complements Left Shoe 2 0 2 Right shoeIoI1I245oU Figure 7.12: The Budget Line and Perfect Complements Left Shoe 2 0 2 Right shoe Io I1 I2 45o U 7.3: Demand In the preceding sections, we saw how the consumer choice problem is solved. The point where this problem is solved, the point of tangency between the indifference curve and the budget line, is a point on the demand curve. Given market prices for the two goods and his money income, the tangency point shows what amount of the two goods the consumer is going to purchase in the market. For example, given an income of Rs 100 and prices of x and y equal to Rs 2 and 1 respectively, Farooq will demand x* amount of commodity x and y* of commodity y as indicated in figure 7.4. These are the equilibrium values of x and y and are thus called the solution values for his maximization problem. Observing these values, we can define the demand function for this consumer. We can observe that Farooq purchases these amounts of x and y and economists assume that while doing this he equalizes marginal utilities and price ratios to the equality revenue condition. 7.3.1: Demand Functions Having established the demand point of the consumer; think about the factors that can change this demand point. One can, obviously, say that the factors that can change the equilibrium or demand point should be those which were responsible for its occurrence. Refresh how we determined the consumer’s demand point. There were two objects, the indifference curve (taste) and the budget line (opportunities). So changes in these two factors can alter the demand point of the consumer. Consider taste first. Taste Differentials and Demand Changes in taste over time or differences in taste across individuals can alter the consumer demand point, as indicated by figure 7.13 which depicts the choice situation under two different types of taste. Suppose that these are indifference curves of two different individuals Farooq and Nomi. Farooq is assumed to be more inclined towards commodity x than y, so his indifference curves are steeper such as IF. Similarly, Nomi is fond of commodity y, therefore his indifference curves are relatively flat such as IQ (see chapter 5 to recall the concept that steeper indifference curves show greater taste for the commodity on the X-axis). Let us assume that both have the same level of income and are facing the same set of prices for the two commodities in the market. This means that their budget lines look similar, ZS, with identical slope and intercepts. The rule for calculating the optimum bundle is the same for both; it will be where the indifference curve is tangent to the budget line.

Figure 7.13: The Impact of Taste on Demand y yq yf 0 xq xf xZSQIFFIQ Figure 7.13: The Impact of Taste on Demand y yq yf 0 xq xf x Z S Q IF F IQ IE IE For Farooq, equilibrium is at point F where he purchases xf and yf amounts of the two commodities. However, for Nomi, the equilibrium point will be at Q with a demand of xq and yq amounts of the two commodities. To understand why the equilibrium point is different for both consumers, consider indifference curve IF and the point of tangency F. Now think of the question ‘where will tangency move to if we rotate this indifference curve anti-clockwise.’ Clearly, it will move towards the vertical intercept Z of budget line ZS, such as point Q. Note the important result that both consumers ended up consuming different amounts of the two commodities even though they had the same income. This difference occurs due to differences in their tastes. Since Farooq liked x highly (steeper indifference curve), he purchased more of it. Similarly, Nomi ended up consuming more y because he was fond of y. Note this very important principle: the consumer will purchase more of the commodity which he likes more. The result is highly important for its own sake because it is hoped to represent ‘consumer sovereignty’ in a market economy by showing that if different individuals having similar income levels are making different choices, then this difference is solely due to differences in their tastes. But there is another more important reason for this result to be crucial: it pretends that the theory of consumer behavior allows us to capture differences in individuals’ taste in order to understand capitalist society—i.e. the theory of consumer choice can be extended to multiple individuals with heterogeneous taste and is able to explain the variety of choices made by individuals living in a capitalist society. It is standard practice in economics text books to stress these. But in estimating the market demand curve economic theory assumes that ‘all individuals have identical taste’. This is presented either ‘a simplifying tool for analysis’ or defended tactically by saying that ‘it is difficult to predict changes in demand due to changes in taste’ hoping that students will never question this assumption. We show in the next chapter that assuming similar tastes for all individuals is not a matter of simplification, rather of compulsion. It is impossible for economic theory to allow differences in taste across individuals if it has to achieve its objective successfully—the objective of deriving the market demand curve. This will be discussed in detail later in chapter 8. It is important to understand why this is so. The similarity of tastes assumption applies to capitalist society as a whole. Every rational capitalist consumer has the same taste in the sense that he prefers preference itself to every specific preference. This is the precise meaning of utility maximization. Farooq cannot maximize utility by consuming anything he likes—his consumption pattern must facilitate total utility maximizations. It is the market, specially the financial market, which determines the value (i.e. price) of all economic activities and outputs (i.e. commodities) in terms of their contribution to aggregate utility. It is not consumer choice which directly determines goods and factor prices but financial market valuations of economic activities and customers in terms of their expected contribution to aggregate utility / profit maximization and maximization of the rate of accumulation. Consumer choice is necessarily subject to the discipline of the markets. Economic theory recognizes this in the sense that it accepts that the individual consumer has to take both the prices be forefronts and the income as given. In equilibrium he reconciles his choices with the given price ratio’s and the given budge line. These price ratios and the budget line are determined by homo economicus, not by an aggregate of actually existing consumers. The valuations of homo economicus force Farooq to:

Reject all choices—such as worshiping God as an end in itself—which impede utility maximization Subordinate his preferences for individual utility maximization to the market valuation, for these preferences are instruments for the maximization of aggregate utility / profit The assumption of identical taste in the derivation of market demand is essential because it shows the optimum tastes that capitalist consumers ought to have. It shows that utility has a very precise meaning. Farooq does not increase his utility by satisfying himself in any way he likes—by helping anti-imperialist forces—for the market cannot value this type of satisfaction. Farooq increases his utility only when he derives satisfaction from preferring preference itself (profit / capital) for the market can evaluate it. Economic theory says that Farooq is rational only when he is a subject of capital—i.e. only when he derives satisfaction from the preference of preference as an end in itself. If he drives satisfaction from the fulfillment of any other preference he is an insane, irrational and (at least potentially) very dangerous. He deserves to be shot like the 80 million Red Indian whom the Americans slaughtered in the 17th and 18th centuries. The other determinant of demand is the consumer’s income. Anything that can change the budget line can affect the consumer demand point. Let us see which factors can change the budget line, and hence, demand point. Recall that the budget line, as discussed earlier in this chapter, is determined by the prices and consumer’s income. The budget equation was, M = Px × x + Py × y (7.4) There are five variables in this equation: consumer’s income (M), prices of commodities x and y (Px and Py), quantities of commodities x and y to be chosen by the consumer (x and y). Note that the quantities of the two goods, x and y, are the endogenous (dependent) variables because the consumer himself chooses them (see the definition of endogenous and exogenous variables from the appendix to chapter 1). These two are themselves objects of his choice and cannot affect the position of the budget line. Now we are left with three variables in the budget equation, prices of x and y, and the income of the consumer (M). It is changes in these factors that can change the position of budget line. To see this clearly, recall that the vertical and horizontal intercepts of the budget line are given respectively by: and while its slope is given by. If income and prices remain constant, neither the intercepts nor the slope of the budget line can change. So, any change in these three factors can also change demand or equilibrium point of the consumer (we will see this in detail in next chapter). Therefore, we can say that the demand for a commodity depends upon the variables, Px, Py and M, written as: (7.13-a) (7.13-b) where shows the demand function for commodity x and shows the demand function for commodity y. These equations are simply a symbolic way of saying that the choice of x and y depends on prices of all commodities in the consumption bundle of a consumer and the total amount of income that he has available to spend. A single demand function represents the functional relationship between the quantity demanded of a good and all factors that can influence its demand, the price of that good, the price of other goods and the size of income. If you compare equation (7.13) with that of (3.1) in chapter 3, you will see that they are exactly the same. We introduced this demand function in chapter 3 while this chapter has shown how this demand function is derived. These demand functions tell us how much of a good will be demanded given these exogenous variables.

Homogeneity of Degree Zero: A Property of Demand Functions Economists derive an important property of demand functions, called homogeneity of degree zero. This property simply states that if all prices and income change by the same proportion, consumer choices will remain unchanged. To see why, suppose that all variables in the demand function are multiplied by a positive constant, say, 2, then the two budget equations, Px × x + Py × y = M 2Px × x + 2Py × y = 2M are the same because we can obtain the original budget line just by dividing the second equation by 2. This means that the two budget lines are exactly the same (plot these two budget equations to convince yourself choosing Px = Rs. 1, Py = Rs. 2 and M = Rs 100). Since the budget lines are identical, nothing has changed, so the demand point will also not change. More technically, we can write this result as that for any commodity x: for all > 0 (7.14) Hence, we have learnt that the demand functions are homogenous of degree zero in all prices and income. Changing all prices and income in the same proportion will not change the physical quantities of goods demanded. The underlying assumption again is about the invariance of talent. One of the important implications of this property is that money illusion is not a property of the demand functions. What does this mean? Income and prices are, of course, denoted in some monetary unit such as rupees. But does it matter which unit we choose? The simple answer is that according to economic theory designating the monetary units as rupees or dollars will not affect the result if the right rate of exchange is used. The units in which we measure each commodity has no effect on the consumer’s decision. Similarly, whether x is measured in pounds or kilograms or in any other unit of weight, the same budget set and trade-off is available to the consumer in terms of physical quantities. Another important implication of this property is that introduction of money in the model of consumer choice model does not affect results derived without money. In other words, a money economy is equal to barter exchange economy. 7.3: Consumer Theory and Utilitarianism We have seen at several places in the last two chapters that most of the concepts employed by economists in consumer behavior analysis are unobservable. For example, it is impossible for the consumer to estimate MRS for goods in a typical capitalist market. Information processing requirement for doing this are so formidable that no one can base his choices on such estimation (not even with the help of the latest computer technology). We have also seen that indifference curves cannot be directly observed. They are assumptions about consumer behavior and most empirical studies have shown (as psychologist economics emphasizes) that consumers do not seek utility maximization and do not normally behave as economic theory expects them to—Abdullah Zhaghazai reacts with horror and repulsion when the World Bank sponsored Consumer Council of Pakistan informs him about his ‘sovereignty’ as a consumer. Even in America, where greed and selfishness is greater than at any other time or place in history, consumer right activists continue to complain about the apathy of the overwhelming majority of consumers who are basically impulse buyers and care little about their “rights”. Actually existing capitalism does not function as economists expect it to.

Why then do economists raise such ballyhoo about indifference curves, marginal rates of substitution, total and marginal utility? This is because economics is essentially an ideology. It’s positive analysis in functional only if one seeks to realize the norms it sanctions. If these norms (utility / profit maximization as ends in themselves) are rejected, the positive analysis becomes useless. Indifference curves, MRS, utility and marginal utility are ideological concepts. They have been developed not on the basis of observation of the behavior of actual consumers at a particular time and place but on the basis of the acceptance of an ideology—the ideology of utilitarianism. The concepts of the indifference curve, the marginal rates of substitution, the utility function and marginal utility show how consumer behavior should be modeled if utilitarianism is accepted as an ideology. Utilitarianism is one of the two enlightenment ideologies which provide a philosophical basis for capitalist social sciences. Utilitarianism is the philosophy underlying economics. Deontology provides the ideological grounding for political science and mainstream sociology. Utilitarianism was born in the eighteenth century. It’s founder was David Hume, one of Britain’s most famous atheists of that time and a close friend of Adam Smith. Two other leading utilitarians—Jeremy Bentham and John Stuart Mill—exerted great influence on the founders of neoclassical economics; Jevons, Walrus, Manger, Edgeworth and Marshall, all of whom were utilitarians. Utilitarian ideology says that all acts and rules should be assessed on the basis of the consequence they produce in increasing or decreasing total consumption over a defined time period. Consumption is regarded as the main activity which increases pleasure and reduces pain and according to utilitarian ideology the moral person seeks to maximize net utility (the excess of pleasure over pain) for all persons capable of experiencing pleasure and pain. Maximizing consumption—you can call it utility or welfare for the ‘welfare function’ is identical with the utility function—is an end in itself. Utilitarian moral agents seek maximization of aggregate consumption irrespective of the wishes of those whose consumption is being maximized. Thus the IMF expert advising the Government of Pakistan ignores Abdullah’s preference for helping Madrassah as against maximizing the consumption of the people of Pakistan, for maximizing consumption is an end in itself. Utilitarian ideology does not allow Abdullah to prefer anything over the maximization of aggregate consumption—for maximizing aggregate consumption is the preference for preference itself. The IMF specialist is the World Agent who tells Abdullah that he must prefer preference itself (maximization of aggregate consumption) over all specific preferences. Utility must be defined as maximization of aggregate consumption, anything which reduces aggregate consumption is dis-utility and cannot therefore be the subject of rational choice. Thus the World Agent (the IMF specialist) has the correct preferences and therefore he should determine both the valuation of all acts and rules and the conception and articulation of policy. The World Agent is thus a legitimate “second guesser”—he has a right to tell Abdullah what yields the maximum net pleasure. This is necessarily the act and the rule which facilitates the maximization of profit for maximization of profit necessarily maximizes value added and minimizes costs over the long run.

Thus based on utilitarian ideology, consumer preference theory and its conceptual tools (indifference curves, MRS, the utility function, marginal utility) tell us how Abdullah ought to behave as a capitalist consumer. He should be indifferent to all those combinations of goods he is consuming which yield the same net pleasure (utility) He should prefer more consumption to less consumption for increasing consumption is the only way to increase welfare (net utility) He should not prefer the infinite consumption of any one good, his indifference curve should be convex to the origin and the marginal utility he derives from the consumption of any one good should decline as he consumes more of it. He should prefer preference for itself—i.e. the ability to consume more of all goods—to the preference of any particular set of goods Indifference curves should be additive. We should be able to derive community indifference curves and Abdullah should accept policies as rational which seek aggregate profit maximization, for this alone ensures the minimization of costs and the maximization of net aggregate welfare (consumption) Abdullah should accept the legitimate authority of the World Agent (the IMF economist) who has the expertise to devise policies for the maximization of profit / aggregate welfare. Abdullah should subordinate his preference to the preference of the all knowing, perfectly judicious capitalist World Agent Suppose Abdullah rejects all these ‘oughts’ and ‘shoulds’. He rejects consumption maximization, both for himself and for Pakistan as an end in itself. He refuses to prefer preference itself to all specific preferences. He rejects to accept as legitimate the authority of those who seek to impose the preference for preference itself (profit / welfare maximization) as criteria for valuing acts and rules. What will the economist do in these circumstances? He can either pretend that Abdullah is insane, irrational, ignorant or even that Abdullah does not exist. But doing that is dangerous for Abdullah may prove his existence by obstructing the capitalist organization of the economy. The economist must therefore force Abdullah to accept capitalist discipline. The economy must be so organized that Abdullah cannot survive unless he acts as a capitalist consumer, producer, trader and regulator. That is where policy is needed. As a normative discipline economics is concerned to transform all existing systems of consumption, production and exchange into capitalist economies. Its theories outline what a capitalist economy is and how it functions. These theoretical descriptions of ideal capitalist consumption, production and exchange provide the criteria on the basis of which all existing patterns of production, consumption and exchange can be evaluated in terms of their correspondence with capitalist ideals. Economics is capitalism’s ideology—it is useful for capitalism not because it shows how actually existing capitalist markets function but because it spells out the logical implications of a complete organization of economy and society along capitalist lines. Other capitalist disciplines—e.g. political science, sociology, psycho analysis, jurisprudence, management—have proved more effective in transforming actually existing societies into capitalist ones, but the abstract model of a fully articulated capitalist order is most rigorously presented by economic theory. That is economics’ great contribution to the emergence and sustenance of capitalism as a (potentially) universal life world. Therefore, the capitalist theory of consumer preference:

does not tell us much about Abdullah or Nomi’s actual behavior as a consumer nor does it tell us how to induce Abdullah to accept capitalist consumerist norms and rationalities but it does tell us how to organize the markets in such a way that if Abdullah refuses to accept capitalist norms and rationalities he will starve to death, as did the eighty million Red Indian in North America during the seventeenth to nineteenth centuries. In that lies its supreme usefulness to capitalism. What is Next? This chapter has explored how preferences and opportunities interact to determine consumer choices in the market. We also learnt how choices can be shown by demand functions. The next chapter will show how the demands for goods undergo changes due to changes in opportunities. It is again necessary to state that consumer choice theory is ideological, not functional. It is useful for capitalism not because it tells how consumers’ choices are determined in the real world. As we will see in later chapters it is usually impossible to derive a “well behaved” (i.e. downward sloping all the way) marks demand curve from individual demand curves. Consumer choice theory is useful because it shows how ideal consumers ought to behave and thus forms a basis for developing policies to force consumers to behave in this ideal way. Regulating consumer behavior in this way facilitates capitalist social dominance. Key Concepts Absolute price is the price of a commodity in some monetary terms Budget constraint or budget line shows the largest available bundles of two commodities with given prices and income. Its slope measures the relative price of x Budget set shows the set of all income feasible consumption bundles Cardinal utility function contains information about utility differences as well as preference ordering that it represents Consumer equilibrium is the consumption bundle that shows a consumer doing the best that he can do. It is the point where indifference curve is tangent to the budget line reflecting the fact that subjective valuation of a consumer for a commodity is equal to that of market Corner solution shows that the consumer purchases zero amount of one of the two commodities and he specializes in the consumption of other one Demand function shows the relation between consumption of a commodity and all factors that can change its demand, the prices of all goods and income of a consumer Diminsihing marginal utility says that the utility derived from the consumption of a commodity decreases as more of it is consumed Equi-marginal principle states that at consumer equilibrium, the ratio of marginal utilities to prices is equal for all goods consumed. Verbally, it says that marginal utility of the last rupee spent on one good should be equal to the marginal utility of the last rupee spent on another good Homogeneity of degree zero is the property of a function which says that if each of the arguments of a function is multiplied by a positive number, the value of the function remains unchanged. Demand functions are also homogenous of degree zero in prices and income meaning doubling all prices and income changes only the units by which we count, not the physical quantities demanded

Interior solution occurs when consumer opts to consume positive amounts of both the commodities. Optimum bundle is that combination of (x,y) which lies on the highest indifference curve. It is that bundle for which the utility of the consumer is maximum Ordinal utility function represents a consumer’s taste showing only the order of the preferences, not the utility differences Price-taker is a consumer who does not have any control to determine market prices and accepts them as given information by the market for making his choice decision Relative price is the price of one good in terms of another. It is the rate at which one must give up another commodity to obtain one good in terms of specific good. Unique solution is that which has only one solution value. Consumer utility maximization problem has a unique solution if indifference curves are strictly convex. The tangency condition shows the only one point at which utility is maximized Utility-maximization is a hypothesis about consumer behavior which says that the objective of a consumer is to maximize utility subject to his income constraint Chapter Summary Consumer behavior theory assumes that the consumer has (a) given tastes (b) given resources (income). Capitalist society begins with a given distribution of resources The consumer is also assumed to know all prices. He is a “price taker” The budget constraint gives the different quantities of x and y that can be purchased given the prices of x and y and the income of the consumer. Points outside the budget line are not affordable to the consumer; points inside the budget line leave some of his income unspent The slope of the budget line is negative because it shows a trade off between amounts consumed of the two commodities. The value of the slope of the budget line is equal to the ratio of the price of the two commodities. The slope of the budget line is constant because expenditures are fixed and the price ratio of the commodities consumed remains constant The budget line shows the opportunity cost of consuming one commodity in terms of not consuming the other Consumer choice theory seeks to show how the consumer can maximize his utility given his limited resources. His utility function measures the utility he derives from the consumption of the goods for which he has preference. If scarcity does not exist and men voluntarily limit their consumption the theory of consumer choice cannot explain consumer behavior The consumer whose behavior consumer choice theory can explain must be greedy, jealous and accumulative. He must accept the Enlightenment conception of truth— i.e. the purpose of knowing the world is to dominate it and that the pursuit of accumulation is an end in itself which should be attained through an appropriate organization of individual and social life The capitalist consumer chooses that combination of goods which maximizes his utility given his income. This is the combination of goods shown by the tangency of the budget line (showing the consumer’s income) and the highest indifference curve (showing his tastes)

The convexity assumption implies that the consumer will choose that combination of goods which lies on the highest indifference curve touching the budget line—a combination on the budget line at every other point will necessarily be on a lower indifference curve The consumption of a good is not an end in itself. It is a means for the maximization of utility—the only end in itself. The maximization of utility as the only ‘end in itself’ reflects the commitment of the consumer to the preference for preference itself rather than to any specific preference At the point of tangency (i.e. the goods combination the consumer chooses) the slope of the budget line and the indifference curve are equal. This is the point at which the choice of the consumer’s substitution of two goods (MRS) equals the market valuation (price ratio) of these goods. The optimum (utility maximizing) combination of goods to purchase is that at which the consumer’s valuation equals the market valuation of the purchased goods. In equilibrium the market valuation of commodities will determine the combination that the consumer must choose to maximize his utility given his income In equilibrium the individual chooses what the market allows him to choose. He cannot choose what the market is not offering (to be a mujahid for example) and yet act rationally. In this sense in equilibrium the choices of all individual capitalist consumers are determined by market valuation. Moreover, the consumer’s ability to maximize his utility depends on his income—which in turn depends upon the valuation of the individual’s labor by product markets In capitalist order income is the concrete form of freedom. The greater the income the greater the individual’s freedom to choose. Freedom is maximization of utility made possible by higher levels of income. The rational individual’s ultimate choice (‘end it itself’) is for higher and higher levels of income and wealth through participation in capital accumulation. Every other choice is a mean for achieving higher levels of income which is the same thing as maximization of utility and maximization of freedom A unique utility maximizing equilibrium point cannot be identified on non-convex indifference curves. This unique equilibrium point is described as interior solution since positive amounts of both commodities are consumed If indifference curves are concave we have a corner solution showing that there is consumption of only one good. Maximum utility is achieved only in the convex region of the concave indifference curve; i.e. at the point the indifference curve touches the axis. This shows that for utility to be maximized indifference curves (i.e. tastes) must be convex. Utility is maximized when the utility derived from the expenditure of the last rupee on each commodity purchased is the same. This result is based on the theory of diminishing marginal utility which states that utility decreases as the quantity consumed of a commodity increases. This is simply a statement of the assumption that indifference curves are convex to the origin. The law of diminishing marginal utility implies that the consumer purchases more than one commodity. Resources should be so allocated that the ratio of marginal utility to price is equalized on expenditure with respect to each commodity. This is the law of equi-marginal utility

The law of equi-marginal utility cannot be used to determine the allocation of resources if the purpose of this allocation is anything other than utility maximization MRS cannot be observed as prices can ne and therefore the equi-marginal principle can neither be validated nor refused. Economics says that this is how people ought to allocate resources since they ought to maximize utility. Economics cannot justify the view that everyone ought to maximize utility. It is for this reason that economics is a normative science Applications of the equi-marginal utility principle require that utility be measured cardinally. Indifference curve analysis requires only ordinal measures of utility The equi-marginal principle and the indifference curve approach identify the same criteria for the allocation of scarce resources. This is so because both are based on the same objective of maximizing utility. Neither of the approaches can be used if the purpose of resource allocation is some thing other than utility maximization The point of tangency between an indifference curve and the budget line is a point on the capitalist consumer’s demand curve. At this point marginal utilities and the prices of the purchased goods are assumed to be equalized. We can observe what combination of goods is purchased in the market at different price levels. We cannot observe whether this equalizes prices and marginal utility of the purchased goods to specific purchasers The demand changes when there is a change in tastes or prices or income. The capitalist consumer will purchase more of the good he (arbitrarily) likes more. Economists usually assume that all consumers have similar tastes. This they do, not for simplifying the analysis, but because without this assumption it is not possible to derive the aggregate market demand curve. The aggregate market demand curve reflects the presumption that every rational capitalist consumer prefers preference itself (capital accumulation) to every other specific preference. The similarity of taste assumption applies to capitalist society as a whole In capitalist society consumer choices which do not contribute to aggregate capital accumulation (preference for preference itself) cannot be valued on the market. Such choices are thus not available to individual consumers. Consumers choose only among choices which contribute to capital accumulation and are valued by (especially financial) markets. Consumers are not sovereign to choose anything they like Utility has a very specific meaning. It is derived only from acts which lead to utility maximization and can be evaluated on the basis of capital accumulation. Capitalist markets and capitalist states cannot recognize utility in any other form The determinants of the demand function are (a) income, (b) the price of the commodity being demanded and (c) the price of compliments and substitutes Demand functions are assumed to be homogeneous of degree zero—i.e. if all prices and incomes change by the same proportion, consumer choice will remain unchanged. This assumption reflects assumptions about tastes being similar. It also assumes that capitalist consumers do not have money illusion

Consumer behavior theory is useful because it shows how an ideal capitalist consumer ought to behave. This provides a basis for developing policies which can force consumers to behave in this desired way. Consumer choice theory is therefore normative and ideological Review Questions What assumptions underlie the theory of consumer choice? What is the budget constraint? What is meant by the “budget set” of a consumer? What is meant by the “relative price” of a commodity? Show that the conception of the budget line is based on the presumption of universal scarcity. What problem does consumer choice theory seek to solve? Define the utility function of a consumer. Why cannot the theory of consumer behavior explain Abul Bashar’s pattern of consumption? Does Abul Bashar have a utility function? Contrast the characteristics of Abul Bashar and Mr. Bill Grates. Formally state the utility maximization condition. What does it mean? Demonstrate graphically the attainment of equilibrium by a capitalist consumer. Why cannot he choose to go to (a) a higher indifference curve or remain on (b) a lower indifference curve? What is the economic meaning of consumer choice being determined at the point of tangency of the indifference curve and the budget line? “Market valuation determines consumer’s choice in equilibrium”. Do you agree? “Rationality requires that personal preferences be subordinated to market valuation”. Do you agree? Who is sovereign, the market or the consumer or both or neither? What is the meaning of freedom in capitalist order? With the help of a diagram show that a unique equilibrium position cannot be identified on non-convex indifference curves. What is “the corner solution”? Illustrate with the help of concave indifference curves. Why is the corner solution a realistic situation only if we regard capital as the only good that is being consumed? Describe the theory of diminishing marginal utility with the help of a numerical example. Why can the principle of equi-marginal utility not be empirically validated? Show that application of the equi-marginal principle and the indifference curve approach yield the same result. Why is this so? Show diagrammatically that in the case of perfect substitutes with equal prices, indifference curve analysis cannot determine a unique consumer choice solution Why do economists usually assume that tastes are similar? “Consumer preference theory shows actually that consumers cannot be sovereign”. Discuss. What is utility? Can we derive utility from giving zakat? What are the determinants of the demand function? Draw a diagram to illustrate that the demand curve is homogenous of degree-zero. What purpose does consumer choice theory serve? Chapter 8 CHANGES IN DEMAND The concept of consumer equilibrium, discussed in chapter 7, is very important in economics. Consumer equilibrium is determined by the interaction between the consumer’s taste and his market opportunities. But the problem is that the taste of a consumer is not observable, therefore, the point of his equilibrium cannot be identified in actual existing markets. Then, of what use is this equilibrium in analyzing the behavior of the consumer? In other words, if equilibrium can never be observed, what can this concept of ‘consumer-equilibrium’ tell us about consumer behavior? The necessary assumption needed to use the concept of ‘consumer-equilibrium’ is to keep the taste of not only one consumer but of all consumers constant over a period of time. As we see in this chapter it is this assumption that allows economists to study the effects of changes in opportunities on consumer behavior. This can be observed; i.e. some observable changes in the behavior of the consumer can be noted in response to the changes in his opportunities. The underlying idea is that if some changes are observed in consumer demand, you can attribute these changes in demand to changes in market opportunities. This is the general methodology used by economists. Instead of trying to use the results from a single equilibrium point, economists are more interested to know how equilibrium changes when variables that determined the equilibrium undergo some changes. This analytical technique is called comparative-static-analysis.

It is important to note what this method of analysis rules out of its scope. Suppose John Hall was a member of the American Republican Party in 2006. In 2007 he became a Muslim and joined the Black Panthers of Islam. Economics assumes that his tastes and his pattern of consuming, say, wine will not change as a consequence of John Hall becoming Sheikh Yahya Hall. This means that if an Islamic revolution—e.g. in Iran in 1979—takes place, patterns of consumption will not change. This means that Iranies will continue to eat pork and drink whisky, while consumption of pork and wine will continue to change only in response to changes in prices and incomes. This means that economists rule out both changes in individual identities and social change in their comparative static analysis of consumer behaviors. We discussed in the last chapter that variables that can change the demand point of a consumer are income and prices of the goods, while his taste is held constant. This chapter analyzes how changes in these variables affect the demand of a consumer and how economists derive relations among these effects. But note that none of the variables are expected to change the taste of a consumer; rather they will change only his budget set. Also recall our definition of the demand function of a consumer for some commodity, say, x: it was said to be a function of income, price of x and the price of y. We take changes in these variables one by one and see how they affect the demand for a commodity. We will show in this chapter the impossibility of extending this model to more than one consumer without involving contradictions. This illustrates an important, but often un-mentioned weakness of economics. 8.1: Income Changes and Demand As the income of the consumer changes, so does his purchasing power. Suppose that his income level increases, this means that now he can afford to purchase more of all commodities. First understand how his budget line will change due to this increase in his income. We discussed in the last chapter that increase in income will shift the budget line of the consumer outwards. To see this again, recall that the vertical and horizontal intercepts of the budget line are given by: and With given prices of x and y, the larger the income of the consumer, the farther away will be the intercepts of the budget line from the origin. This situation is again shown in figure 8.1 where budget lines for two different levels of income, Mo and M1, are shown, where M1 (say Rs 200) > Mo (say Rs 100). The original budget line shifts out from ZS to RT. Figure 8.1: Effect of increase in income on budget line y 0 xZSRT Figure 8.1: Effect of increase in income on budget line y 0 x Z S R T As an example, suppose that income has increased from Rs 100 to Rs 200 while the prices of x and y have remained constant at Rs 1 and Rs 2 respectively. This means that now the consumer can afford to buy 100 units of y if he spends all his income on y and similarly 200 units of x. The vertical as well as the horizontal intercepts have shifted by equal proportions, so we see a parallel shift in the budget line. Since the slope of the budget line is given by the ratio of prices and prices have not changed, therefore the slope of the new as well as the old budget lines must be the same; i.e.

Now think what happens to the equilibrium point after this shift in the budget line. It is expected, due to the assumption of more is always better than less, that the quantity of each good purchased will also change after an increase in income. Why? Recall that the budget equation of the consumer was defined as, Px × x + Py × y = M If the consumer has more income to spend at fixed prices, it is impossible for him to buy the same amount of the two goods because his expenditures must also increase by the amount of increase in his income for the budget equation to hold. This means that demand for at least one commodity must increase for total expenditures and income to remain equal after increase in income. The answer to the question ‘where will the equilibrium be on the new budget line’ depends on the nature of goods in question. Let us explore this a little further. 8.2: Normal and Inferior Goods Consider point E in the right hand panel of figure 8.2, the initial demand point of Nomi at budget line ZS with xo and yo amounts of x and y demanded. We have to determine his new equilibrium or demand point at budget line RT created due to increase in his income. To see where equilibrium can move, consider points A and B on the triangle AEB at point E. The budget line RT has now been divided into three segments; RA, AB and BT. Look at point A first. If equilibrium moves to point A, this means that the demand for y increases to y1 while that of x remains unchanged. On the other hand, if equilibrium moves to point B, only the demand for x increases. Recall from chapter 3 that if demand for a commodity increases due to increase in income, then such a commodity is said to be a normal good in capitalist order. If x and y both are ‘normal’ goods for this capitalist consumer, then demand for both must increase. Figure 8.2: Determination of new equilibrium point after increase in income (new budget line)ynormal y 0 0 xnormal xI1EABSRTxox1yoy1ZEABRTxox2yoy2I2FI1S Figure 8.2: Determination of new equilibrium point after increase in income (new budget line) ynormal y 0 0 xnormal x I1 E A B S R T xo x1 yo y1 Z E A B R T xo x2 yo y2 I2 F I1 S Z Z This implies that the new equilibrium will lie in between points A and B in this case as shown in the left hand panel of this diagram at point F. Demand for both goods has increased from xo and yo to x2 and y2 respectively on the new budget line. Thus, we see a positive relationship between income and demand for these goods. This can be stated as: If xnormal and ynormal tangency or equilibrium point will lie between AB Mathematically, we say that the demand-function of, say, x is increasing in income; that is an increase in income leads to an increase in demand for x. Algebraically: (8.1-a) The same also holds for y, if it is also a ‘normal’ good: (8.1-b) But the demand for all goods does not increase after an increase in the income of the individual. Consider the demand for potatoes or second hand shoes as an example. As the capitalist consumer becomes richer, he may reduce the purchase of these goods, and hence we see a negative relationship between income and demand for such goods. Recall from chapter 3 that goods with negative relationship between income and their demand are called ‘inferior goods’ in capitalist order. Suppose that x is an ‘inferior’ good. In this case, equilibrium will move between RA in the right panel of figure 8.2 which means that demand for x falls as the income of the consumer increases. This phenomenon is illustrated in figure 8.3 where x is assumed to be an ‘inferior’ good. Algebraically, it can be stated as:

(8.2) Figure 8.3: Equilibrium after rise in income in case of ‘inferior’ goods ynormal 0 xinferiorI1I2EGy3y0xox3 Figure 8.3: Equilibrium after rise in income in case of ‘inferior’ goods ynormal 0 xinferior I1 I2 E G y3 y0 xo x3 ICC ICC If xinferior and ynormal tangency or equilibrium point will lie between RA Similarly, If xnormal and yinferior tangency or equilibrium point will lie between BT Finally, it is straight forward to understand that both x and y cannot be inferior (assuming that they are the only goods the consumer can buy). We leave the explanation of this proposition to you. This fact explains the necessary-positive-relation between income of a consumer and demand for at least some commodities for a consumer—the one who maximizes utility as an end in itself. This tells us something very important about capitalist society—in such a society the consumer always wants more; i.e. ‘more’ is always better than less. 8.2.1: Income-Consumption Path and Engel’s Curve We have shown equilibrium only at two income levels in our previous diagrams, such as at points E and F in the left hand panel of figure 8.2. However, it is also possible to show equilibrium at more than two income levels as indicated by points E, F and G in the right hand panel of figure 8.4. And not only three points, we can trace out equilibrium points at many possible income levels. If we join all such equilibrium points by a curve, such curve is called the income-consumption-path (ICP) or income-consumption-curve. This curve shows the position of the equilibrium point at all income levels; e.g. if the budget line is ZS, then equilibrium will be at E; if it is RT, equilibrium will be at F and so on for any income level. Figure 8.4: Income-consumption-path and Engels curve Income ynormal 0 0 xnormal xnormalZGEFIncome consumption curve or pathRPSTQEngel’s Curve Figure 8.4: Income-consumption-path and Engels curve Income ynormal 0 0 xnormal xnormal Z G E F Income consumption curve or path R P S T Q Engel’s Curve In this diagram, both goods are ‘normal’ since demand for both of them is increasing due to an increase in income. This implies that every equilibrium point will be above and to the right of the previous equilibrium point. If both the goods are ‘normal’, as it is the case here, then the income-consumption-path must be positively sloped. If we now plot this ICP in commodity-income space placing income at y-axis and demand for xnormal’ on x-axis, the resulting curve is called Engle’s curve, (named after Ernest Engel), as drawn in the left hand panel of figure 8.4. This curve gives the same information of consumer equilibrium points at all income levels as ICP but in income-commodity space. Remember that ICP shows consumer-equilibrium-points in the ‘commodity-space’; i.e. ICP is drawn with commodities at both axes while the Engel’s curve is drawn with income on one axis and commodity demand on the other.

Shape of ICP or Engel’s Curve and Flaws in Economic Reasoning Let us look closely at how the spending of a consumer changes as his income changes. This analysis will reveal an important pitfall in the economic theory of consumer demand. To begin with, note that for the ‘normal’-goods case, ICP can take any positively sloped-shape at all; it needs not necessarily be a well-behaved straight line curve. In standard microeconomics text-books, economists pretend to allow this possibility in principle. However, we show in the third section of this chapter that this degree of freedom holds as far as they are analyzing the demand behavior of only a single consumer. When demand for more than one individual is involved, then ICP must be a straight line positively sloped curve. To understand the meaning of the shape of the ICP curve, look at figure 8.5 which depicts four different shapes of ICP curve. Keep in mind that the shape of the ICP shows the rate at which demand for a commodity increases as income increases. Consider panel (a) first. This is the case of an inferior good. Recall that for inferior goods, consumption (demand) falls as income increases —some commodities may be substitutes for better quality products for the capitalist consumer when he is poor but their demand disappears as he becomes wealthier. Hence, ICP must be negatively sloped if x is assumed to be an ‘inferior’ good which shows that as the income of the consumer is increasing, he is reducing the demand for x. Now consider panel (b) depicting the case of a necessary good. We discussed in chapter 5 that necessities are goods for which demand remains more or less fixed or increases marginally as the income of the consumer increases (demand for necessities is income inelastic). This means that as the consumer becomes wealthier, the share of spending on a ‘necessary’ good decreases in his total expenditures. In terms of panel (b), this means that the demand for x increases at a decreasing rate as income increases; i.e. each time a smaller proportion of additional income will be devoted to the purchase of more units of x as it is a ‘necessary’ good. Therefore, ICP takes on an increasing slope shape. In other words, it gets steeper. On the other hand, demand for luxury goods increases at an increasing rate after a rise in income; i.e. most of the additional income is spent on luxuries after the consumer has reached a certain level of affluence. This means that ICP will get flatter as drawn in panel (c). Thus, there is a particular name that can be associated to x in these three cases. But consider the final case of panel (d) where ICP is a straight line. Such a shape means that consumption or demand for x increases at a constant proportion every time income of the consumer rises. Such a commodity is termed as a representative-commodity by economists—according to economics, this is a commodity whose consumption pattern represents the most common consumption behavior in this world and which fits almost all of the cases. The share of spending on such a ‘representative’ commodity would remain the same in total income even if a person rose from miserable poverty to unimaginable opulence.

Figure 8.5: Shape of ICP determine the nature of commodity in questionICPa) x is Inferiorynormalxinferior0ICPb) x is necessaryynormalxnormal0ICPc) x is luxuryynormalxnormal0d) what is x?ynormalxnormal0ICP Figure 8.5: Shape of ICP determine the nature of commodity in question ICP a) x is Inferior ynormal xinferior 0 ICP b) x is necessary ynormal xnormal 0 ICP c) x is luxury ynormal xnormal 0 d) what is x? ynormal xnormal 0 ICP Can you give any example of such a commodity in capitalist society? Think again! Not surprisingly, there is no commodity in capitalist order whose consumption follows such a uniform pattern of consumer expenditure. But interestingly enough, it is exactly this non-imaginable commodity that economists describe as the ‘representative of all’ to model consumption behavior and all the propositions discussed in chapter 3 assume the existence of this representative commodity! In fact, there is no commodity in capitalist society except in economics text books to which this commodity refers. Don’t lose your head; there is more to be surprised at in the coming sections. Here, read Application Box 8.1 to know the exact nature of this mythical ‘representative’ commodity. Application BOX 8.1 The Non-Sense of ‘Representative-Commodity’ We said that consumption of the ‘representative’ commodity remains a constant proportion of income as income increases. This can be the case only if: The consumer’s taste for it remains the same no matter what age-group he belongs to The consumer’s taste for it remains the same no matter how much his income increases Every additional rupee of income is spent exactly the same way as all previous rupees; i.e. if out of each one rupee the consumer spends, say, 20 paisa on pizza, 30 paisa on clothing, 10 paisa on bananas and 40 paisa on housing, then this proportion must remain the same no matter how poor or rich he becomes. These are absurd statements which can never be true in capitalist society. They simply say that when, say, Bill Gates earned $100 a week, he spent $10 on pizza (10% of total income). Now that he earns $100,000,000 a week, he must spend 10% on pizza. Do you know how much does this amount to? It requires that Mr. Gates must spend $10,000,000 each week on purchasing pizza! If the price of a typical pizza is assumed to be $10, it means that he must eat 10,000,000 (10 millions) pizzas per week or almost 1,428,571 (more than fourteen lacks) pizzas per day! Similarly, this proportion must remain the same irrespective of whether he is 25 or 90 years of age. Does it make any sense? Of course not. As suggested by these conditions, there is simply no commodity in capitalist society expenditure on which equals the same proportion of a homeless person as it does of a billionaire. As the age and income of a capitalist consumer rises, his consumption pattern will change. In reality, a typical consumer is going to have the majority of his ICP curves like a, b and c, but no curve like d. You might be tempted to believe that the choice of such a commodity by economists is a ‘scientific-abstraction’ adopted in order to simplify the nature of the analysis. Well most of the text books on microeconomics, and probably your teachers, will try to satisfy your discontent with economic analysis by making you belief in this type of scientific dogmatism in the name of ‘simplification’. However, the choice of ‘representative-commodity’ is not a matter of simplification. It is a matter of compulsion. The major objective of consumer theory is to justify the negatively sloped market demand curve which, can be derived only in the case of the mythical representative-commodity. Economic theory fails to justify its desired negatively sloped market demand curve in case of all goods which are not representative-commodities. But in order to understand this fact, you need to understand how economists derive the individual demand curve from its consumer choice model. We now turn to this issue before exposing a fundamental contradiction in this model.

8.3: Own Price Changes and Demand Let us analyze how changes in the own price of a commodity are going to alter its demand. You will see that the effect of a price change on the quantity demanded of a commodity is somewhat more complex than the effect of an income change. This is due to the fact that changing price does not only change the position of the budget line but also its slope. To see how, look at figure 8.6 where the initial budget line is ZS and the price of x Px = Rs 1. Now suppose that the price of x drops to, say, = Rs 0.50. How will this change the budget line? Since the price of y and income is the same, the vertical intercept will not change; the consumer can still afford to purchase the same amount of y as before, 50 units. But after the reduction in the price of x, the consumer can purchase more units of x, say 200 units; so the horizontal axis moves out from S to T. You can see that the slope of the budget line has gone shallower after lowering the price of x. Figure 8.6: Effect of fall in price on budget lineZSTNew budget line after fall in Price with slope -0.25Old Budget line with slope -0.5yx0 Figure 8.6: Effect of fall in price on budget line Z S T New budget line after fall in Price with slope -0.25 Old Budget line with slope -0.5 y x 0 This can be seen from the fact that the slope of the budget line before change in price was: while after decrease in price of x, it is: Since < , the slope of the initial budget line is steeper than that of the budget line after price-change. The decrease in price has rotated the budget line anti-clockwise around its y-intercept showing that now the consumer can purchase some bundles that were previously unattainable for him. A price increase in x, on the other hand, would rotate the budget line inward in clockwise direction. What about the new demand point on the budget line ZT? At this moment, we can say at least one thing for sure, irrespective of the taste of the consumer. Because the new budget set includes the entire original budget set, if the consumer was initially consuming both the commodities on budget line ZS, it is certain that he would increase the consumption of at least one of the commodities. If consumption of both commodities remains the same or decreases, then the consumer would not be using all his income. 8.3.1: Price Changes and Demand for ‘Normal’ Goods Now let us see where will be the equilibrium point on the new budget line, ZT. Assume that x is a ‘normal’ good—its demand increases with income. To answer this question, first we need to understand what happens when the price of a commodity changes. Remember that when the price of a commodity changes, it creates two effects: (1) The substitution effect and (2) The income effect. The Substitution Effect When the price of x, decreases, the rate of exchange between the two commodities, x and y, also changes. How? Suppose that the price of x goes down. Thus means that now the consumer has to sacrifice less units of y in order to purchase an additional unit of x. For example, initially, when the price of x was Rs 1 and the price of y was Rs 2, the consumer could purchase one unit of x by sacrificing half a unit of y (recall table 6.1 from chapter 6). But suppose that the price of x has dropped from Rs 1 to 0.50 while the price of y is still the same, Rs 2. How many units of y are to be sacrificed in order to purchase one unit of x at this new price ratio? Obviously, 0.25 y because reducing the consumption of y by 0.25 amount will free Rs 0.50 for the purchase of x (since 1y costs Rs 2, so 0.25y costs Rs 0.50). This can be calculated from the value of the slope of the budget line and can be seen in Table 8.1:

Table 8.1: Rate of Exchange between x and y at Different Prices At Old Prices At New Prices Px = Rs 1 Px = Rs 0.50 Py = Rs 2 Py = Rs 2 Rate of exchange 1x = 0.50y 1y = 2x Rate of exchange 1x = 0.25y 1y = 4x The reduction in the price of x has made it cheaper in terms of y its relative price has decreased from 0.50 y to 0.25 y. On the other hand, the relative price of y has increased from 2x to 4x (recall that the reciprocal of the slope of the budget line gives the relative price of y). So, y has become expensive in terms of x. Economists expect that the consumer will substitute the cheaper x for the expensive y. This increase in demand for x due to decrease in exchange rate between the two goods after a price fall is called the substitution effect. But this is only part of the story. The Income Effect The second effect is somewhat more complex. The change in price of a commodity also changes the real income of the consumer. What is the real income? It is given by nominal income divided by price: (8.3) It is the purchasing power of nominal income. Suppose that you have Rs 100 in your pocket while Px is Rs 1. At this price, you can purchase 100 units of x in the market. Suppose that Px decreases to Rs 0.50. Now, you can afford to purchase 200 units of x with the same Rs 100. This means that the purchasing power (the amount of x that can be purchased by Rs 100) of your nominal income (income expressed in monetary units, such as in rupees or rials) has increased. Thus, decrease in the price of a commodity raises the real income of a consumer. This increase in real income can be spent on any good, not just the good whose price has changed. But if x is a ‘normal’ good, then at least some of the increase in real income must be spent on x and the quantity demanded of x will increase due to this income effect. Look at figure 8.7 now. Px decreasesRate of exchange falls Demand for x increasesReal income increases Demand for x increasesFigure 8.7: Income and Substitution EffectSubstitution EffectIncome Effect Px decreases Rate of exchange falls Demand for x increases Real income increases Demand for x increases Figure 8.7: Income and Substitution Effect Substitution Effect Income Effect Note that after a reduction in price of x, its demand has increased both due to the substitution effect (demand for x increased when rate of exchange of x for y decreased) and the income effect (demand for x increased when real income of the consumer increased). Therefore, the demand for x must increase if its price decreases. Thus, we have discovered how demand for x will respond to change in its own price: (8.4) This is an important result: demand for a commodity is negatively related to its own price—a fall in price has lead to an increase in demand for x, so both are moving in the opposite direction with respect to the movement of price change. We can now translate this whole information into a graph. Figure 8.8 plots the new as well as the old budget lines.

To see where the equilibrium point will move on the new budget line, consider point d (exactly vertically up to point a) on the new budget line ZT. Ask yourself: can the new equilibrium point move to point d? Of course not because at point d, the demand for x is unchanged (xa) while the demand for y has increased. Since price of x has decreased, the demand for x at the new tangency point should increase on the new budget line, as we just discovered that there is a negative relationship between demand and price. Therefore d cannot be the new equilibrium point. Can equilibrium be between Z and d? Clearly not because demand for x will fall if the equilibrium moves to this region. This means that the new tangency point will be to the right of d on the budget line ZT, such as point c in this diagram. You can see that the demand for x has increased at this point from xa to xc as described by equation (8.4). Thus, c is the equilibrium point. In fact, there is nothing special about point c; we can have tangency at any point in the region dT. Figure 8.8: Determination of new equilibrium after fall in priceI2I1adcNew budget lineOld Budget lineZTSyaxaxcxy0 Figure 8.8: Determination of new equilibrium after fall in price I2 I1 a d c New budget line Old Budget line Z T S ya xa xc x y 0 Price Consumption Curve and Individual Demand Curve This logic allows us to derive a negatively sloped demand curve for x in case of a single capitalist consumer. Note that points a and c are the equilibrium points at only two different price levels. If we join these two points by a curve, we will get the price-consumption-curve (PCC) as drawn in the upper panel of figure 8.9. This curve is very similar to income-consumption path with the difference that it shows consumer-utility maximizing points at different price levels keeping income constant while ICP shows those points at different income levels keeping prices constant. Suppose that we allow the price of x to change over all possible values. We will observe equilibrium at all these different price levels and joining all of them will give us the price consumption curve as in the upper panel of figure 8.9 (forget about the shape of this curve for the moment, we will discuss this when we look at cross-price effects later in the last section fo this chapter). We are interested to draw the price-consumption path in the price-quantity-plane. Look at the lower panel of this diagram. It shows the effects of a fall in price of x on its demand. Note that price does not appear on any of the axis in the upper panel, while it appears on the vertical axis of the lower panel. If we join all points of consumer equilibrium at different price levels drawn in the commodity-plane (as points a and c in the upper panel), we obtain the price-consumption curve (or path). But when the same equilibrium points are joined in price-commodity space, we get the demand-curve. To see how, note that the consumer demands xa amount of x at Px = 1 (or at budget line ZS in the upper panel). This corresponds to point A in the lower panel. Similarly, he purchases xc amount of x at Px = 0.50 (or at budget line ZT in the upper panel) which corresponds to point B in lower panel. When we join these points in the lower panel, we get a negatively sloped curve, called the demand curve which shows all consumer equilibrium points at different price levels drawn in a price-commodity plane. It demonstrates the negative relationship between price and quantity demanded for a commodity. This curve shows how the consumption decision of a single utility-maximizer consumer will evolve in response to changes in the price of a commodity. But deriving negatively sloped demand curve for a single consumer is not the end of the story; rather it is merely the first step towards the goal of the economists. But before that, let us study the slope of this demand curve.

Figure 8.9: Derivation of individual demand curveI2I1acNew budget lineOld Budget linePCCCPx = 1P =.50yaxaxcx0y10.5xaxcxPrice0AB Figure 8.9: Derivation of individual demand curve I2 I1 a c New budget line Old Budget line PCCC Px = 1 P =.50 ya xa xc x 0 y 1 0.5 xa xc x Price 0 A B Slope of Demand Curve: Graphical Analysis of Substitution and Income Effects Our previous analysis has enabled us to derive a negatively sloped demand curve for a single consumer. We now translate the verbal discussion of substitution and income effects into a graph to consolidate this result. This will enable you to see under what conditions the demand curve can have a negative slope for a single consumer. To begin with, consider figure 8.8 where the consumer has moved from a to c after a fall in the price of x. Let us call this movement from a to x the total effect of a price change. We have seen above that a change in price brings two changes at the same time, therefore, we can think of the movement away from a to c as divided into two parts: some movement due to change in the rate of exchange (substitution effect) and some movement due to change in real income of the consumer ( income effect). The problem is to separate the total effect or total movement from a to c into these two movements. This problem can be solved only if we can somehow manage to stop the two changes (change in the rate of exchange and change in income) occurring at the same time; that is if we allow only one change to occur at one time and the other later. To do this, consider figure 8.10 with two solid and one dashed budget lines. The budget line ZS is the initial budget line drawn at initial income and initial price ratio representing the initial rate of exchange (ROE) between x and y. We call this the old budget line showing the old income and the old rate of exchange. When the price of x falls, both the rate of exchange and the income level of the consumer changes, so ZT is the new budget line drawn at new income and new price ratio representing the new rate of exchange (ROE) between x and y. So far is so good. Graphically, we can think of a movement from ZS to ZT broken up into two steps: first a rotation of the budget line from ZS to MN (the dashed line) such that it becomes parallel to ZT and then a shift from MN to ZT. The dashed line thus created shows the new exchange rate (or price ratio) but not the new income level. Figure 8.10: Visualizing substitution and income effects y 0 xZSTOld budget line with old income and old ROE (or prices ratio)New budget line with new income and new ROE (or price ratio)MNNew budget line with reduced income and new ROE (or price ratio) Figure 8.10: Visualizing substitution and income effects y 0 x Z S T Old budget line with old income and old ROE (or prices ratio) New budget line with new income and new ROE (or price ratio) M N New budget line with reduced income and new ROE (or price ratio) At this budget line, the rate of exchange is new but income may be at the initial level (we will see below how to find with certainty the old income level). To see why income on the budget line MN is not the new income, note that the only difference between the budget lines MN and ZT is of income level, the rate of exchange is the same at both (they are parallel to each other and hence their slopes are equal). Another way to construct a budget line like MN is to reduce the income level of the consumer from budget line ZT (recall that a fall in income brings a parallel inward shift in the budget line). So, we can think of MN showing the same rate of exchange as ZT but shifted inward due to reduced income. Thus, we have found a way to separate change in the rate of exchange from change in income. For a complete solution of this problem, we need indifference curves in such a diagram.

To separate the income effect from the substitution effect, we reduce the income of the consumer to its initial level. Graphically, we shift the budget line downwards. But how much shifting is required to bring income to its initial level? To know this, draw an indifference curve on the old budget line and mark the equilibrium point, such as a in figure 8.11. We shift down the new budget line ZT such that it passes through this equilibrium point a. The idea behind this is to give the consumer only that much income so that he can afford the old bundle a at the new rate of exchange or price ratio. Thus budget line MN uses the new rate of exchange but gives first enough income to the consumer to purchase the original bundle. By allowing the consumer to purchase the old consumption bundle a at the new price ratio, we are in principle holding the real income (purchasing power) of the consumer constant. The tangency on this budget line will tell us how much of x the consumer would have bought at the new price ratio, if his income had remained unchanged. We can see that the lower price of x creates a set of affordable preferred bundles at a with the new budget line MN (this is shown by the fact that indifference curve Io is crossing the budget line MN). Figure 8.11: Separating substitution effect from income effect for xnormalZTMNabceIoI2∆xsub∆xIncI1∆xTotxaxbxcxy0S Figure 8.11: Separating substitution effect from income effect for xnormal Z T M N a b c e Io I2 ∆xsub ∆xInc I1 ∆xTot xa xb xc x y 0 S The consumer can reach a higher indifference curve, I1, by choosing point b which was above the initial budget line, ZS, and hence was beyond the reach of the consumer at the old price ratio or rate of exchange. The consumer would have chosen point b if he had faced the new prices at initial income level. Thus, the move from a to b is the substitution effect. Why is b chosen? Simply because it lies on a higher indifference curve. We can clearly see that as long as indifference curves are drawn convex to the origin, any budget line flatter than ZS (such as MN) cannot be tangent to the indifference curve Io. This is so because tangency means that the slope of the budget line and indifference curves are equal. Given the three facts that (i) the slope of the indifference curve decreases, (ii) the budget line MN has a smaller slope than ZS (as it is flatter) and (iii) indifference curve Io is tangent to ZS, it cannot be tangent to MN as well. The tangency point must move to the right of a (the budget line MN with a smaller slope than ZS can be tangent to an indifference curve with a smaller slope than Io at a). Such a point is b where the consumer wishes to substitute more x for fewer y because the rate of exchange between x and y has been reduced. The xSub = xb – xz amount increase in the consumption of x can be attributed to the substitution effect: change in the demand for x purely due to change in the rate of exchange, holding income constant. Recall that when price of a commodity decreases, the real income of the consumer increases, so we should take some income away from him to keep his purchasing power constant. On the other hand, an increase in price implies a fall in real income; the consumer should be given some additional income to purchase the old consumption bundle. Thus, the substitution effect is separated by holding the income of the consumer constant such as allowing him to buy the old demand bundle at the new prices. Note that the direction of change in quantity demanded of x and in its price is opposite due to the substitution effect—a fall in price has caused the demand to increase. Therefore, it is said that the substitution effect is negative—it produces a negative effect on quantity demanded of a commodity with respect to its price change. This can also be confirmed by looking at diagram 8.7 which shows that decrease in price of x increases its demand due to the substitution effect.

Thus far, we have explained the increase in demand for x from xa to xb. What about the rest of the increase in the consumption of x, from xb to xc? As we know that when the price of x drops, the real income of the consumer increases as now his purchasing power will increase. To separate the substitution effect, we reduced the income of the consumer to its original level. Now to find the income effect, we give back this income to the consumer. This result can be viewed as a shift of the budget line from MN to ZT where the consumer attains point c, at the tangency of the new budget line with the new indifference curve I2. Because x is a ‘normal’ good, the tangency must be to the right of point e (just above b) on the budget line ZT to ensure that increased income has resulted in increase in demand for x. Therefore, xInc = xc – xb amount increase in the consumption of x is due to the income effect. Thus, we have distinguished the magnitudes of both the effects. Again, we see a negative relationship between quantity demanded and price of x due to the income effect. If we put both these effects together, we find that a price drop causes an increase in quantity demanded for a ‘normal’ good. Remember that with ‘normal’ goods, both the substitution and the income effect of a price change must be negative with respect to price change—the quantity demanded and price must move in the opposite direction due to substitution and income effects (see figure 8.7 again). The move from a to c is the total effect of a price change. Thus, we have shown that the demand curve must be negatively sloped for ‘normal’ goods in case of a single consumer. Algebraic treatment of the slope of the demand curve We have seen that the total effect of a price change can be decomposed into substitution and income effects which can be written as: (8.5) We have to find the sign of this expression. To determine its sign, note that in terms of figure 8.11, the move from a to b is showing the substitution effect expressed as: (8.6) that is, change in quantity demanded for x is positive—demand has increased after fall in price due to the substitution effect. Recall that we assumed that the price of x decreased from Px = Rs 1 to = Rs 0.50, so the change in price is negative, that is: (8.7) dividing (8.6) by (8.7) gives: (8.8) With the numerator positive and the denominator negative, the expression (8.8) turns out to be negative. This is an important equation which says that the substitution effect of a price change is always negative. Let us now pick up the second part of expression (8.5). Since x is assumed to be a normal good, the change in demand for x should be positive due to the income effect: and again the change in the demand for the commodity divided by the change in price is negative [because ΔPx is negative as shown above by (8.7)]: (8.9) Since the numerator is positive while the denominator is negative (Read FYI Box 8.1 to avoid confusion about the negativity of this income effect). Thus, we have determined the signs of the two effects in equation (8.5): for normal goods, both substitution and income effect must be negative and adding two negatives must give a negative result

(8.10) which is exactly what economists want to prove: the demand curve of a normal good is negatively sloped for a single consumer. Read carefully FYI Box 8.2 so that you may not run into another type of conceptual mistake. FYI: B O X 8.1 Meaning of Negative Income Effect of Price Change The statement that the income effect of a price change is negative in case of normal goods is a potential source of confusion for students. It is so because we have learnt in the previous section that there is a positive relationship between income and demand for normal goods, thus income effect should be positive in case of normal goods. However, both statements are correct. To see this, consider this diagram. The upper diagram refers to what we learnt previously. The lower diagram shows that the change in demand due to income effect arising out of price change is negative; i.e. when price falls, income increases and demand increases, hence there is a negative relationship between price and demand due to income effect. The income effect when viewed in terms of the relation between income and demand is positive. But its effect on demand is in the opposite direction to change in price. That is why it is stated as: ‘the income effect of a price change is negative with respect to movement of price change for normal goods’. Income increasesDemand for xnormal increasesIncome increasesDemand for xnormal increasesPrice fallsIncome Effect is positive Income Effect of price change is negative Income increases Demand for xnormal increases Income increases Demand for xnormal increases Price falls Income Effect is positive Income Effect of price change is negative FYI: B O X 8.2 A Precautionary Note on the Law of Demand Suppose that you want to test the law of demand for, say, milk; i.e. whether or not a rise in price of milk reduces its demand. How would you do this? You might collect data on the price of milk over time and the quantity demanded of it. You will observe that the money price of milk has been rising since August 1947 and its consumption is also increasing. Does this observation refute the law of demand or that individuals do not maximize utility subject to the income constraint? The answer is no, because the data and methodology are not correct. A careful statement of the law of demand says that it is the changes in relative prices, not absolute money prices, which produce the law of demand. In addition to that, the income of the individual as well as prices of related goods are also held constant. If you want to test any hypothesis in the real world, you must take into account its assumptions because assumptions are the conditions under which that law or hypothesis is supposed to hold. 8.3.2: Price Changes and Demand for Inferior Goods A similar type of analysis can also be undertaken to study the effects of price change on the demand for an ‘inferior’ good. We have seen while discussing the effect of changes in income on demand that all goods are not ‘normal’. The preceding sub-section has shown that demand curves for normal goods are necessarily negatively sloped because both substitution and income effect have the ‘right sign’ for the demand curve—both are negative. Now think what will happen in the case of an ‘inferior’ good in capitalist society, say second-hand clothing. Recall that the slope of the demand curve is the sum of two effects, substitution and income effects. We have seen that the substitution effect must always be negative as long as the indifference curves are convex to the origin whether x is a ‘normal’ or an ‘inferior’ good, that is:

But consider the income effect. Suppose that x is ‘inferior’ and its price decreases. This will lead to an increase in the real income of the consumer. But the increase in income will not increase the demand for x, second hand clothing, rather it will reduce it because it is assumed to be an ‘inferior’ commodity. This means that demand for inferior good decreases due to income effect after a fall in its price. So the expression (8.11) will be positive because changes in both variables are negative—both have decreased. Thus, we see that the slope of the demand curve for an inferior good is the sum of the negative substitution effect and a positive income effect: (8.12) The sign of the total effect depends on the magnitudes of the two effects: it will be the positive if positive income effect is greater than the negative substitution effect and vice versa. This discussion suggests that the demand for inferior goods can be positively related to their prices if the income effect is strong enough to outweigh the substitution effect. Do all ‘inferior’ goods have positively sloped demand curves? The clear answer is no because it depends on the degree of income ‘inferiority’ of a commodity. If a commodity is so much income-‘inferior’ that the positive income effect is greater than the negative substitution effect, it is termed as a Giffen good (named after Robert Giffen). Graphical Analysis of Inferior Goods Let us use indifference curves to graph the case of Giffen goods. Consider the demand for, say, second-hand clothing. Will the capitalist consumer buy more and more of it as its price decreases? Perhaps not, because he might want to shift to the purchase of finer clothing and reduce the demand for second-hand clothing. Look at figure 8.12 to understand this effect. It shows a fall in the price of second-hand clothing by pivoting the budget line from ZS to ZT. Again, MN is drawn to let the consumer buy the old bundle at new prices. The move form a to b is again the substitution effect. You can notice the negative relationship appearing between price and demand due to the substitution effect. Now think in which direction demand will move due to the income effect. Begin with giving the income back to the consumer which we had taken form him to separate the substitution effect from the income effect. This will increase his income to ZT. Suppose for this consumer, the demand for second-hand clothing is highly income inferior. Where should he move to find his equilibrium on the new budget line? Surely to the left of point d (exactly above b) because second-hand clothing is an ‘inferior’ good and therefore a fall in its price implies increase in real income and, hence, a fall in its demand due to increased income. So we are left with region Zd on the budget line ZT where equilibrium can fall. Where will it be in this region? Consider point e (exactly above a) to the left of d on budget line ZT. With this point, we have two regions on segment Zd: Ze and ed. Figure 8.12: Separating substitution effect from income effect for xinferior∆xsubZSTMNabcdeI2∆xInc∆xTotxcxaxbSecond hand clothingy

Figure 8.12: Separating substitution effect from income effect for xinferior ∆xsub Z S T M N a b c d e I2 ∆xInc ∆xTot xc xa xb Second hand clothing y Whether equilibrium will be in region Ze or ed depends on whether the substitution effect or the income effect is greater. If the negative substitution effect is greater than the positive income effect, the total effect will be negative [see equation (8.12)] and demand for x will increase when its price falls. In this case, tangency will be on the region ed. However, if the positive income effect is greater than the negative substitution effect, the total effect will be positive [again see equation (8.12)] and demand for x will decrease due to fall in its price. In this case, tangency will be in the region Ze, as shown in this figure at point c. You can see in this figure that the income effect is greater than the substitution effect (look at the length of the arrows). What does point c show? It reflects such a strong income ‘inferiority’ for second-hand clothing that the income effect surpasses the substitution effect and pushes the consumer back to basket c which contains less amount of second-hand clothing than his earlier basket of a. The above analysis has made it clear that it is the magnitude of the two effects which matters in case of ‘inferior’ goods. It could be the case that the negative substitution effect was larger than the positive income effect and we might have had equilibrium at some point f, somewhere in between points d and e. In this case, the demand curve would have been negatively sloped. Therefore, we conclude that all Giffen goods must be ‘inferior’ but all ‘inferior’ goods are not Giffen. ‘Inferior’ goods that have negatively sloped demand curves are called Non-Giffen-inferior goods. Remember that the actual response of quantity demanded to change in price is from a to c. Point b is just a hypothetical one and can’t be observed in the real world. However, its importance lies in terms of policy evaluation is the subject of welfare economics. The fact that the own-price-substitution effect is negative is one of the very few landmarks economists have made in the theory of consumer behavior during the whole twentieth century. We find that consumer choice theory can also justify the possibility of a positive relationship between price and quantity demanded in case of Giffen goods—there is always a possibility of positively sloped demand curve even in the case of a single consumer. Economists dismiss this possibility by holding that examples of Giffen goods are rare in capitalist order. However, this is merely an empty claim. In reality, most market demand curves are not going to be negatively sloped as we discuss in the next section. But you must clearly understand the discussion of this section before moving on to the next one. 8.4: From Individual to Market Demand: An Untold Story About the Contradictions of Economics The acid test of economics comes while deriving market demand curve — the curve representing the consumption decision of the whole of capitalist society—from individual demand curves. The demand-supply model of price-determination makes sense only when economists are able to prove that market-demand and supply curves are of the ‘right shape’—the demand curve is negatively sloped while the supply curve is positively sloped. The negatively sloped demand curve drawn in chapters 3 and 4 were reflecting the behavior of the whole of society, and not of any single individual. One of the major objectives of consumer choice theory is to provide theoretical justification for such demand behavior for capitalist society as a whole; i.e. economists claim that this behavior is a natural outcome of human self-interestedness—the tendency of individuals to maximize utility. But what if economists fail to derive a negatively sloped market demand curve from individual demand curves? This failure means that:

The economists contention that all people are by their nature freedom / utility maximisers is a fundamentally flawed presumption about mankind Capitalist social choice is not merely a sum of individual preferences We begin by showing how economists pretend to have derived the negatively sloped market demand curve from consumer choice theory. Then we explain its underlying problems. From One to Infinity Economists hope that they can prove that capitalist society acts like ‘one big consumer’. This means that when society chooses a particular set of commodities at any given prices and income, this bundle will necessarily maximize ‘social utility or social welfare — the sum of the utility of all individuals. To them, social utility or welfare can be obtained by simply adding up the utilities of all individuals. Since the indifference map represents the utility or welfare level of a single consumer, therefore, if we add up the indifference maps or preferences and choices of all individuals living in a capitalist society, we will be able to construct the social indifference map—set of indifference curves representing the preferences of all individuals living in that society. This is shown in the upper part of figure 8.13. The left hand panel shows the preferences and choices of a single ‘representative’ consumer. Economists argue that since each individual has preferences and makes choices in a similar way—i.e. he maximizes utility—therefore if we sum up the preferences and choices of all individuals, we obtain a social indifference map in the right hand panel which will have similar properties as that of an individual’s indifference map. Figure 8.13: Economists’ vision of deriving market demand from individual demandI2I1ACyaxaxcx0y10.5xAxCxPrice0ACSocial Indifference Map and ChoiceSocial or Market demand curveIndividual Indifference Map and ChoiceI2I1acyaxaxcx0y10.5xaxcxPrice0acIndividual demand curveSum of all individuals tastes and choicesSum of all individuals demands Figure 8.13: Economists’ vision of deriving market demand from individual demand I2 I1 A C ya xa xc x 0 y 1 0.5 xA xC x Price 0 A C Social Indifference Map and Choice Social or Market demand curve Individual Indifference Map and Choice I2 I1 a c ya xa xc x 0 y 1 0.5 xa xc x Price 0 a c Individual demand curve Sum of all individuals tastes and choices Sum of all individuals demands In the same way, as we can derive the individual demand curve from this utility maximization behavior by changing prices, a similar procedure will allow us to derive negatively sloped market demand curve by summing up all individual demand curves as shown in the lower panel of Figure 8.13. Economists hope that the market demand curve obeys the same laws that they had derived for the individual demand curve—i.e. it must necessarily be smooth and negatively sloped. This statement involves two claims: If capitalist society prefers bundle A over B at any price and income level, then this choice will necessarily maximize the utility of capitalist society and of all individuals living in it, and

It is possible to derive a consistent set of social preferences by summing up individuals’ preferences Interestingly, it has been proved that both of these claims are impossible to prove. Instead, it has been proved that this consistent summation from individual to society can not be achieved. The issue is that if all individuals are allowed to have any taste they want that satisfies conditions of individual rationality (as discussed in chapter 5), then in general it will not be the case that collective behavior is rational. More specifically, individual rationality does not imply social rationality—i.e. if all individuals are maximizing their own welfare, then there is no guarantee that social welfare will also be maximum! Let us first see why economists are keen to derive social welfare from individuals’ welfare (note that maximizing ‘welfare’ is simply maximizing consumption in capitalist society). Economist’s Vision of Human Being and Society According to economists, their model of the utility-maximizing-consumer is based on the core intuition of ‘human being’. This vision of the ‘human’ has already been outlined in chapter 6 (see the description on ‘who is a consumer?’). Maximizing freedom / utility is the only rational end in itself and all other objectives must be subordinated to this end. And when every one maximizes his personal utility or seeks his own self-interest, the utility or welfare of the whole of society is also maximized. This means that the best society will be one where each individual is left free to pursue his own interest the way he wants to without any intervention by any authority—even if it is the authority of religion because the human being alone is recognized as soverign and rational. This is mainstream economics’ vision of ideal society. Economists preach free markets because free markets are supposed to provide the maximum opportunities to citizens for maximizing utility / freedom. However, to provide any kind of rational ground for such a free-market model, economists must be able to show that the desire to maximize utility / freedom is universal and can be expressed in a negatively sloped market demand curve which is a simple aggregate of similarly sloped individual demand curves. But we will see why it is impossible to add up individual demand curves in this way to yield a ‘well behaved’ market demand curve. Unfortunately, the full proof of this requires advanced mathematical logic; however, its essence can be visualized graphically. 8.4.1: The Collapse Begins: The Problems of Aggregation This argument is developed in three stages. In reality these stages are not separate but occur simultaneously. The Social Indifference Curve is not Smooth: To begin with, recall that the social indifference map was said to be the sum of all individuals’ tastes and a negatively sloped market demand curve could be derived from this map only if it had the same properties as individual indifference maps (see figure 8.13). However, there is in general no guarantee of the existence of a ‘well-behaved social indifference map’ when individuals have heterogeneous or diverse tastes.

Look at figure 8.14 which shows the nature of the problem involved in adding up individuals’ tastes. Concentrate on the left hand panel first which shows the preferences of two individuals, the solid line representing the preferences of Farooq while the dotted line that of Nomi. Though the indifference curves of a single consumer cannot intersect, this is possible when we are considering more than one consumer each having different and distinct tastes. Note from the left hand panel that in this case, the point of tangency between the indifference curve and the budget line for one individual will not necessarily be same for another. Once price changes, income will also change and the income-effect of the price change may work in opposite directions for the two consumers (one might consume less of a commodity as its price falls, the other more). The total effect of the price change on quantity demand will in general be quite unpredictable when there are many consumers. Figure 8.14: Direct Summation of two different sets of preferences is impossiblePreferences of FarooqPreferences of NomiIqIFyx0yx0ABCDEIqIFSocial IC Figure 8.14: Direct Summation of two different sets of preferences is impossible Preferences of Farooq Preferences of Nomi Iq IF y x 0 y x 0 A B C D E Iq IF Social IC Also remember that the two sets of indifference curves are incomparable because there is no rule to assign weight to each individual’s indifference curve as each individual ranks and derives utility from his preferences in his own way. To understand what this means, let us assume that utility can be measured in some scale or units called utils. Suppose you give Rs 100 to a beggar and ask him to assign some numerical value to ‘how much utility will he derive out of this Rs 100’. Suppose he says, ‘20 utils’. Then you see Bill Gates having a KFC burger for Rs 100. On your asking him, ‘how much utility did he derive from this Rs 100’, suppose he replies, ‘50 utils’. Now if you are asked the question: ‘which of the two individuals is better-off with Rs 100’, what would you say? If you think it is Bill Gates because he derives 50 utils as compared to the beggar who derives 20 utils, then you are wrong. How can you compare the number 20 utils of the beggar with Bill Gates’ 50? The problem is that numbers like 20 and 50 utils are merely arbitrary numbers expressing the mental states of two different individuals and there is no guarantee that both of them use the same barometer to measure the intensity of their wants and satisfaction. It is quite possible that the number ‘50 utils’ of Bill Gates turns out to be only ‘3 utils’ when measured from the barometer of the beggar. On the other hand, the intensity of the beggar’s wants may be measured as ’90 utils’ on Gates’ scale. The issue is that the utility derived by one individual from a consumption bundle cannot be compared with that of another with the same consumption bundle. Numbers attached to indifference curves are arbitrarily chosen to rank the preferences of individuals (see the last section of chapter 6 again) and it is not possible to compare these numbers. Technically speaking, interpersonal comparison of utility is not possible. This is called impossibility of interpersonal comparison of utility.

What problem does this issue pose for economists? It means that any ‘social’ indifference curve derived by summing up ‘well behaved’ individual indifference curves will neither be smooth (as shown in the right hand panel of figure 8.13) nor will they even show some unique preference ordering. This aggregate indifference curve can take any shape. Look at the right hand panel of figure 8.14. According to this diagram, the bundle C is indifferent in terms of A and D, but D is clearly preferred to A (you should be able to work out that D I B and B P A, so D P A). Moreover, to Farooq, B and D should be preferred not only to A but also to E [B P A and B I D (to Farooq) while A I E (for Nomi), so B and D P E as well). On the other hand, Nomi says that bundle E should be preferred to D and, hence, to B on the ‘social’ indifference map. Clearly, it is impossible to sum these preferences without assigning some weight to the preferences of each individual. Now which bundle is preferred to the other depends upon the particular weight it carries in the social indifference map. Any change in these weights will change the ordering of these bundles. You can sense the kind of problem when you consider this case. These complexities increase as the number of consumer preferences to be considered in the social indifference map keeps on increasing. In general with many consumers, the social indifference curve will look jagged instead of smooth, as shown by the thick line in figure 8.14. Change in prices changes distribution of income: Recall from chapter 4 that prices of commodities also determine the amount of income individuals can earn. In other words, they determine the distribution of income among individuals. When relative prices of commodities change, then, according to economics, the distribution of income also changes, and this fact further complicates the problems at hand. Suppose that you produce bananas. If its price falls, then the amount of income you receive by selling bananas will also change (it may increase, decrease or remain the same depending upon the price elasticity of demand for bananas) which means that your share in total national income can change in any way. Since any change in relative prices changes the distribution of income, it therefore changes ‘who consumes what’. The redistribution of income might effectively transfer one banana from someone who gets very little utility from it to someone who gets a great deal of utility—since what gives great utility to one may give very little to another as taste is purely a subjective phenomenon. This means that the ‘sum of subjective utilities of all individuals’ will also change as the distribution of income changes after price change. Since utility is subjective, there is no way to determine whether one distribution of income produces more or less total utility than any other pattern of income distribution. Therefore, there are many different ‘social indifference maps’, one for every distribution of income.

We have learnt above that in order to derive a market demand curve, you have to alter prices. As long as there is only one consumer, you need not consider the consequences of change in distribution of income after change in prices. But prices cannot be changed without changing distribution of income when there are more than one individual. In the analysis of individual consumer demand, economists can safely assume that ‘taste is independent of income’—it is this fact which enables economists to draw independent indifference curves and budget lines. But ‘social budget lines’ and ‘social indifference curves’ are interdependent because each different set of prices will generate a different social indifference curve. Result: The possibility that the market demand curve can have any shape. One important implication of such a social indifference curve is that there is no guarantee of the existence of a smooth negatively sloped market demand curve. To see that, consider figure 8.15. The budget line ZS is passing through point E in this diagram. As the price of x falls, budget lines flattens which means that demand for x must rise in order to make its demand curve negatively sloped. However, with kinks in ‘social’ indifference curves, it is possible for the slope of the budget line—the price-ratio of x in terms of y or the rate of exchange—to vary substantially at these kink-points in the curve without any change in the quantity demanded of x as shown in this diagram where the price-ratio has fallen from ZS to MN but the equilibrium demand point is unchanged. This means that the market demand curve derived from this ‘social’ indifference curve will also be jagged—and not smooth—at these kink points. More importantly, there is nothing which prevents the possibility of positively sloped market demand curve. Figure 8.15: Possibility of demand not responding to price changesZMNESocial ICDemand point remains the same even after fall in the relative price of xxexy0S Figure 8.15: Possibility of demand not responding to price changes Z M N E Social IC Demand point remains the same even after fall in the relative price of x xe x y 0 S This failure in deriving smooth negatively sloped market demand curve is most bluntly stated in Varian’s Microeconomic Analysis—a book all academic economists must read in their Masters or M. Phil / Ph.D. programs: “Unfortunately…the aggregate demand function will in general possess no interesting properties…The neoclassical theory of the consumer places no restrictions on aggregate behavior in general” Solution: One for All and All for One—the representative consumer What is the way to deal with this problem? We have seen that economists have failed to derive negatively sloped market demand curves recognizing that individuals have heterogeneous tastes and preferences. They derive well behaved market demand curves by subscribing to the myth of ‘representative consumer’—he has the tastes each consumer ‘ought’ to have. However the problem remains that altering the distribution of income also changes the measurement of ‘social’ welfare—the sum of utilities of all individuals. If economists could somehow avoid this problem—i.e. if they could show that distribution of income did not alter social welfare—they could be able to derive smooth negatively sloped market demand curves on the basis of the ‘representative’ consumer myth. Over time, they have worked out that at least two conditions are necessary for market demand curves to at have the ‘right shape’,

that each individuals’ tastes remains the same as income changes, so that every additional rupee of income is spent exactly in the same way as all previous rupees—effectively every commodity is a ‘representative commodity’ that all people living in society must have the same tastes—effectively every individual is a ‘representation consumer’ Let us understand the economic meaning of these conditions. The first statement requires that all income-consumption-curves must be straight lines, like panel d of figure 8.5 so that all commodities are neither luxuries nor necessities. Note that ICP for any single consumer can be of any length because incomes may vary among individuals—the length of ICP will be larger for the individual having more income because his equilibrium will be farther from the origin and vice versa—but all curves must be straight lines. In other words, all goods existing in the market must be representative commodities. We have already seen in Application Box 8.1 that representative commodities do not exist. Yet economists pretend that increasing the income of the single consumer by, say, 100% increases his consumption of all commodities by the same factor. The economic meaning of the second statement is even more extreme. It says that every consumer must spend the same proportion of each additional rupee of income in the same way—which means that all individuals must have the same tastes. These conditions imply that individuals are not allowed to have any taste they desire. In other words, individual indifference curves cannot take any allowable shape because this does not permit economists to treat society as the sum of all individuals in it. Figure 8.17: The only allowable ICs if individual utilities are to be added to obtain social ICyx0ICPIIICPIICPIII Figure 8.17: The only allowable ICs if individual utilities are to be added to obtain social IC y x 0 ICPII ICPI ICPIII Instead, they all must take shapes which generate income consumption curves like those shown in Figure 8.17 by the lines ICPI, ICPII and ICPIII. These lines meet the two restrictions imposed on consumers’ tastes. The small dashed lines are budget lines with different relative price ratios. The idea is that no matter what the price ratio, preferences should be such that they always generate straight lines income-consumption-curves. Read Application Box 8.2 to see their ridiculous meaning in practical terms. A P P L I C A T I O N B O X 8.2 All of You Need to be Clones The absurd practical meaning of the first statement has already been discussed in Application Box 8.1. Here we consider the second statement. It means that your propensity to use each extra rupee must be the same as that of Bill Gates! To see the implications of this, let us imagine that Bill Gates, being a very rich person, spends 10% of his additional income on purchasing luxurious cars and renovating his drawing room. The assumptions thus requires not only you but all individuals, even those in abject poverty having no cars and drawing rooms in their houses, to spend the same proportion of income on cars and drawing rooms. Clearly, this is an impossible condition to hold in reality. But once these conditions are violated, as they always, the results derived by consumer choice theory cease to appear.

Though these restrictions are obviously absurd, they seem very ‘scholarly’ when expressed in mathematical language in advanced microeconomic text books: ‘preferences are assumed to be homothetic and affine in income’, instead of saying ‘we assume all consumers are identical and never change their spending habits’. The use of mathematical language by economists to derive their results makes it difficult for students to see how absurd the assumptions needed to sustain the aggregation process are because it mesmerizes them by its mathematical ‘elegance’. However, things are not as elegant as they might seem to be. According to neoclassical economics, if: the tendency to consume a commodity is the same for all consumers, and the tendency to consume a commodity doesn’t change with income only then market demand curves will be negatively sloped. In other words, to guarantee that a market demand curve slopes down like an individual demand curve, all consumers effectively need to be identical (clones) and have tastes that don’t change with income. This is the solution economic books impose on their students on the name of ‘intuitively reasonable assumptions’. Is it a Solution or Contradiction? Let us consider the meaning of the assumptions about the invariance and similarity of tastes. The similarity assumption actually amounts to saying that there is only one person in society (or that society is composed of a multitude of identical individuals)—how else could every one have the same taste? One of the important senses in which people are differentiated in capitalist societies is in terms of their consumption preferences; to assume that all have the same preferences is to assume that there is only one individual in society whose preferences must be followed by all! On the other hand, the ‘constancy’ assumption says that there is only one commodity—since otherwise spending patterns would change as income rose. One of the key features of capitalist individuality is supposed to be variability—the consumption pattern of youth is supposedly quite different from the expenditure habits in old age. This statement that ‘taste remains the same’ is to say that individuals will never change! Thus, the scope of the theory of consumer behavior effectively boils down to this: If capitalist society has only one (representative) consumer, and that consumer only consumes the one (representative) commodity, then individual utility can be added to obtain social utility, and hence a ‘well behaved’ market demand curve Pause here for a moment and go back to the economic vision of society. Economics attempted to prove Adam Smith’s vision according to which a self-interested individual is led by an ‘invisible hand’ to promote society’s welfare so that if all individuals pursue their own self-interest, social welfare will necessarily be maximized. Moreover, social welfare is nothing more than the sum of all individuals’ utilities (consumption). In other words: the postulate of self-interested hedonism captures the essence of individual behavior; i.e. each action is motivated solely by the desire for utility, and by nothing else

the collective behavior of capitalist society can be derived by summing the behavior of this self-interested multitude (See figure 7.1 again in chapter 7) However, to prove these propositions economists they had to aggregate from a single individual to the sum of all individuals in capitalist society. This means that they had to prove that: a ‘social indifference curve’ could be constructed as the simple sum of all individuals’ utilities which would accurately capture the preferences of all (heterogeneous) consumers and enable economists to show that a capitalist society composed of a multitude of self-interested, utility-maximizing individuals would give rise to an outcome which maximized the welfare (consumption) of all individuals But the two assumptions required to derive these results clearly contradict the case economists are trying to prove, since they are necessarily violated in actually existing capitalist societies—apparently consumer theory is of no use to understand capitalist society which is composed of individuals having heterogeneous preferences as explained in this section. Unfortunately, after two-centuries of search, economists have ended up showing that it is impossible to go beyond the one-individual-one-commodity model of society—technically termed as ‘1×1’ (one by one) model of society. In other words, they have shown that it is impossible to obtain a ‘social’ indifference curve by summing up individuals’ utilities unless we assume that there is only a single consumer and only a single commodity consumed by all individuals in society—and that commodity must also be a representative commodity! Read Application Box 8.3 to see how economists deal with such problem. A P P L I C A T I O N B O X 8.3 Analyzing Class Behavior on the Basis of ‘One for All’ Assumption Suppose that you opt for a course in psychology, may be because you want to understand what determines the behavior of people. Assume that there are 30 students in this course. When your psychology teacher comes to take your first class, he makes the following interesting claim: ‘well students, if you want to understand the behavior of this class during this whole semester, then I can teach you a magical methodology by which you will be able to explain the behavior of all your class mates at any time you want by simply summing up their behavior!’ Oh! You are now waiting to learn this important principle and you request your teacher to present it immediately. Then he asks you to stand up and apply the following ‘golden-principle’ of economists: ‘the rule is very simple to work with. Just assume that the taste of all individuals is exactly the same as that of yours and that their taste remains the same through out this semester. This will allow you to explain what they will do by simply looking at what you will do’. What is the teacher asking you to assume? Effectively, he is saying that there is only one student in this class; and not 30 different students because the rule will explain the behavior of only one student (yourself) and not that of 30 different individuals if their tastes are not the same as yours. Is this rule of any use to explain the behavior of the other 29 students? The only sensible reply is NO. But economists illogically insist that such a non-sensible rule is good enough to understand the behavior of millions of individuals living in a capitalist society.

The failure of economics to prove the existence of the negatively sloped market demand curves means that: the economic picture of an individual as fundamentally a self-interested creature is both fallacious and misleading guide to policy making even in capitalist societies self-interested pursuit of individual welfare does not necessarily maximize the welfare (consumption) of all capitalist society is conflict ridden—maximizing A’s welfare usually occurs at the cost of B’s welfare These facts are exactly the opposite of what economists actually set out to prove initially. Equilibrium in Question One of the most important problems arising from this analysis is the possibility that the market demand curve may intersect with the supply curve at more than one point as shown in figure 8.18. Figure 8.18: Non-unique multiple equilibriumsSxOne possible shape of market demand curvePriceQuantity of x0 Figure 8.18: Non-unique multiple equilibriums Sx One possible shape of market demand curve Price Quantity of x 0 Even if we assume that the supply curve is positively sloped (which is in fact not the case as we see in the next section of the book), economic theory cannot rule out the possibility that a market demand curve may have the shape as drawn here. This possibility strikes at the heart of economic theory: it undermines one of the fundamental ‘articles of faith’ in economics that ‘everything leads to equilibrium and, hence, to harmony in capitalist society’. The equilibrium methodology is adopted to pretend that capitalism is a natural and rational and conflict-less state of human living (see discussion in the last section of chapter 3), which is in fact not the case as shown even by economic theory itself. If there are multiple points of intersection between demand and supply, there will be multiple points where ‘everything happens’ in capitalist society. How can then you determine which point or state prevails—or should prevail—in practice? Why Consumer Theory at All? There is even more to surprise At this point, any reasonable person would abandon the initial theory that individuals maximize utility and that society can be treated as a simple sum of these utility maximizing agents in it. Instead, economists actually prefer to accept the two assumptions mentioned above—that all individuals are identical and never change in their life! Despite its illogical contradictions, economists insist that their vision of society as well as its theoretical derivation using consumer choice theory is valid and intuitively reasonable. Thus Gorman a well known economist, maintains: “The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given” These assumptions have become part of the standard advanced economic education (where they are known as the Sonnenshein-Mantel-Debreu (SMD) conditions, named after three economists who originally invented them to get around the failure in deriving the negatively sloped market demand curve). These conditions are normally taught without even discussing how manifestly unrealistic and absurd they are.

The main reason for this is to defend capitalism as a natural and harmonious state of human living. All social science disciplines, including economics, try to articulate theoretical foundations for justifying capitalism. However, two centuries later when the proof came that this vision is internally inconsistent, the commitment to the vision had become too strong to be broken. The attitude of the economists was that of the typical scientist: better to search for special conditions which could let the theory survive—no matter how ridiculous they might be—than to admit failure. The great irony of this particular critique of economics is that it was developed by its supporters. Therefore, there is no rejoinder to this criticism by any segment of economists. Instead, there are only ‘rationalizations’, such as assumptions about representative consumers / commodities. The uninformed majority of economic professionals in countries like Pakistan believe that their ‘religion of economics’ bears the ultimate truth that all humanity must choose to follow in the long run! Economists make these assumptions because economics is a moral science. It does not seek to explain how consumers behave in actually existing capitalist societies. Conversely, it lays down the rules on the basis of which ideal consumers ought to behave in ideal capitalist markets. The nearest thing we have to an ideal capitalist market is of course the market for capital. The representative commodity is capital and the representative consumer is the agent-of-capital. It is preference for capital is everlastingly maximum. Only irrational—hence non representative—consumers can prefer other commodities—non representative commodities—to capital (which is the preference for preference itself see chapter 7). Every one must have the same taste; he must regard everything as simply a means for the accumulation of capital. This everlasting preference for capital (i.e. preference for preference itself) provides the standard for measuring choices of all other (non representative) commodities, hence it must remain invariant, constant—like the ruler or the scale. Both beggar and Bill Gates must have the same constant preference for capital accumulation as an end in itself. The beggar does not become a capitalist by acquiring as much wealth as Bill Gates. The beggar becomes a capitalist by becoming as infinitely and insatiably greedy (accumulative) and as infinitely and insatiably jealous (competitive) as Bill Gates. We will see why these assumptions are so crucial to economic theory when we discuss the micro foundations of macroeconomics in chapter 17. A lot of ground has been covered in this section. FYI Box 8.2 summarizes the major points. FYI: B O X 8.2 Summary of the Untold Story about the Failure of Economics The great appeal of economics lies in its apparently coherent picture of a complex system where: Individual preferences generate demand curves Profit maximisation generates supply curves (to be discussed in the next part of this book)

Intersection of well behaved supply and demand curves determines prices and outputs Markets harmonise in general equilibrium Welfare (consumption) of society is maximised by free markets The vision of society as the sum total of individuals’ utilities seems valid Great weakness of economics All steps in the above process have logical flaws Firstly, a recap of the economics vision of consumption behaviour Consumer’s demand is determined by preferences A rational consumer Does not let his income affect his tastes Always prefers more to less Gets less utility out of each additional unit (diminishing marginal utility) Can always tell which bundle he prefers Is consistent in his preferences End result Tastes can be represented by indifference maps Prices and incomes determine budget Interaction of these determines demand curve Fall in price necessarily increases consumer’s welfare Adding lots of consumer preferences together entails problems Economists pretend to get a downward sloping market demand curve where all consumers welfare rises as price falls However, adding lots of consumers together… With one individual unambiguous link between preferences (ICs) and demand curve Fall in price unambiguously benefits consumer With more than one individual, two different incomparable sets of indifference curves exist Point of tangency for one won’t be that for the other Income effect may work in opposite directions for two consumers (one might consume less as price falls, the other more) Income effects of changing prices Change in relative prices changes income distribution One-person analysis assumes that prices can be changed without affecting income Can’t alter prices without affecting incomes of individuals within the economic framework With two consumers, even if their tastes are identical, we can no longer separate prices from incomes Social budget lines and social indifference curves are interdependent Market demand curve can take any shape The sources of problems in economic theory lie in the belief that: Each person’s utility is unique, and hence subjective, because each individual is autonomous (self determined). This makes interpersonal comparison of utility impossible The price system determines income distribution Thus, any change in prices changes income distribution and therefore changes the sum of subjective utilities of all consumers Many outcomes of these dilemmas: The belief that an ‘individuals maximize utility’ is false Self-interestedness is not socially rational behavior Standard individual “law of demand” (that demand rises as price falls) does not apply at market level Multiple equilibriums are possible. The harmony assumption of capitalist order is not proved To guarantee that a market demand curve slopes down like an individual demand curve, consumers effectively need to be identical and have tastes that don’t change with income Conditions to avoid this outcome in effect amount to saying that: All consumers are identical; i.e. clones All commodities are identical the model only works with one (representative) consumer and one (representative) commodity

Contradicts the very task economists set for themselves Capitalist society cannot be treated as merely sum of the preferences of agents living in it Yet economists accept it as intuitively reasonable Due to their strong commitments to human autonomy / freedom and capitalist order Commitment to capitalism as a moral order showing how every one ‘ought to behave’ Every individual should have the same taste of preferring capital to every other commodity Capital is the only representative commodity and contribution to its accumulation should provide the standard for evaluating all non representative commodities The fact that such a standard cannot be developed or applied unequally shows the irrationality and internal incoherence of capitalism both as knowledge and practice Does Capitalism Allow Heterogeneous Taste and Cultures? There is widely held belief that liberal capitalism allows the maximum range of individuals’ preferences and ways of life to co-exist in a peaceful state. However, this belief is false because there is one and only one way of life that capitalism is capable of sustaining—the life and culture which is based on the principle of ‘ever increasing and never ending accumulation of capital’. Capitalism can flourish only when all of its citizens behave in a particular way and subordinate themselves to a particular type of preferences. The same idea is also reinforced by consumer theory in the sense that equilibrium or harmony prevails in capitalist order only when all individuals have the same kind of preferences and never change their attitudes. There is only one representative-individual whose taste or preferences must be followed by all and only his taste is allowed to dominate everyone living in capitalist society. Moreover, it has been shown in the context of Social Choice Theory (which is also based on Consumer Choice Theory) by Arrow (1963) that under certain conditions, an overall social-ordering of individuals’ preferences possessing any reasonable properties cannot exist. This negative theorem, called Arrow’s Impossibility Theorem, states that no decision rule based on the sum of individual preferences can be completely satisfactory to choose among different alternatives. Any social decision rule that is chosen on the basis of majority voting must be dominated by the preferences of a single consumer—social choice must be based on the rule of the dictatorship of the representative consumer (i.e. the capitalist) and his eternal preference for the representative commodity (i.e. Capital). In other words, social choice theory says that economists must relinquish either the desire for transitive preferences (the very basis for rationality) or democracy (the very basis for capitalist society). Sen has shown even a more perplexing impossibility-dilemma having more disturbing consequences for economic theory. According to this theorem, the frame work of rational consumer choice does not permit even minimal liberalism. Sen says, “the society cannot let more than one individual be free to read what they like, sleep the way they prefer, dress as they care to, etc., irrespective of the preferences of others in the community”.

Capitalism has internal inconsistencies not because economists have treated it ‘badly’ in their theory, but because it is an irrational way of life. Its irrationality is clearly manifested in the very objective it sets for itself—the unachievable task of ‘fulfilling infinite wants’, and hence infinite accumulation of capital. 8.4.2: The Possibility of Discontinuous Individual Demand Curve We have learnt up to this point the difficulties involved in deriving market demand curves from the utility maximizing behavior of an individual. Here we discuss that even the demand curve for a single individual can also take an ‘inappropriate shape’ if his preferences do not take a specific form. To see what lies behind the individual demand curve, recall from chapter 7 that for a unique solution to the utility maximizing problem—or for the demand point to be unique — the indifference curve of an individual must be convex to the origin. We saw in chapter 7 how non-convexity of indifference curves creates problems in establishing a unique solution to the problem of utility maximization (see figure 7.8). In this section, we extend that idea to examine the implication of non-convexity for the shape of the demand curve. This will give you a better understanding of the reason why economists insist on imposing the assumption of convexity on consumer preferences or tastes. Most economic text books pretend that this is merely an extra assumption imposed to simplify the analysis. However, we will see that this assumption is very important for deriving the desired shape of the individual demand curve. Non-Convex Preferences and Individual Demand Curve The left panel of figure 8.19 reproduces from figure 7.8 the situation where the consumer was making his choice on the basis of concave preferences (see chapter 7). Facing the budget line ZS, the optimal bundle is at point Z because it is on the highest indifference curve, I1. The result is a corner solution as discussed earlier. The consumer maximizes his utility by spending all his income on only one commodity. Figure 8.19: Non-smooth individual demand curve if preferences are concaveI2I1SZaTxx*y0TQuantity of xPrice of xDxDiscontinuity in individual demand curve resulting from non-convex taste0x* Figure 8.19: Non-smooth individual demand curve if preferences are concave I2 I1 S Z a T x x* y 0 T Quantity of x Price of x Dx Discontinuity in individual demand curve resulting from non-convex taste 0 x* To get a clue of the problem with such demand curves, try to read this demand curve closely. It says that there is no uniquely determined or definite quantity demanded at price ; any amount of x could be demanded from zero to x*: either the consumer will not consume any amount of x or he will suddenly start purchasing a lot of it at a certain price. The smoothness of the demand curve has been lost. Such types of indeterminacy about the amount of quantity demanded create problems while discussing the possibility of markets. Now suppose that the price of x starts decreasing from, say to and the budget line pivots from ZS to ZT. Where does equilibrium move? The demand point jumps from Z to T because now this point is on the highest indifference curve, I2. At this point, the consumer consumes only x. Note that for all prices below this price level, the consumer will continue to consume increasing amounts of x. This switching from one commodity to another generates a strange looking demand curve as shown in the right hand panel. The demand for x is zero as long as its price is greater than , therefore the demand curve is on the vertical axis in this price range. However, when its price is right at , the demand jumps from zero to x* (at the horizontal axis in the right panel corresponding to point T in the left panel). If price further falls below this level, the quantity demanded increases and the demand curve is negatively sloped (as the equilibrium keeps on moving out at the horizontal axis in the left panel). With such taste, we will see jumps in the equilibrium point of the consumer. Such preferences generate jumps in the demand curve even in case of a single consumer. Such jumps in demand curves create problems for economic analysis, especially, when we discuss the existence of competitive markets. Markets simply fail to exist if we assume that people have non-convex preferences. This situation has some serious negative implications for the analysis of general equilibrium framework.

Figure 8.20: Dilemma of non-smooth demand curveSoOne possible shape of market demand curvePriceQuantity of x0S1T Figure 8.20: Dilemma of non-smooth demand curve So One possible shape of market demand curve Price Quantity of x 0 S1 T Figure 8.20 shows the essence of the dilemma associated with this case. You can see that there is no guarantee that the supply curve will intersect with the demand curve in its negatively sloped range. Even if the supply curve is assumed to be positively sloped, there will be no unique equilibrium point. Interestingly, even a shift in the supply curve from So to S1 cannot produce any effect on the market price of a commodity in this case. It is for this reason that non-convex preferences are ruled out by economists in consumer choice theory. Strict convexity of preferences is required to guarantee that: the demand curves will not have jumps; that is they will be continuous, and they show a unique quantity demanded at every price 8.5: Cross Price Effect and the Slope of Price Consumption Path Let us now briefly examine the last factor remaining in the demand function, the price of related goods, Py, within the consumer choice framework. Figure 8.9 above showed how we could derive the price-consumption curve or path by varying the price of the good and determining the corresponding quantity demanded. Joining all those equilibrium points in the commodity-plane gives us the price-consumption curve. We did not say anything regarding its slope at that point. Here, we discuss the relationship between the shape of PCC and the demand relationship between the two goods. The slope of the price-consumption curve is closely related to the nature of the relationship between the two goods; that is whether the two goods are substitutes or complements can be seen by its slope. Consider figure 8.21 where we have drawn the PCC as we did in figure 8.9. Figure 8.21: Shape of PCC and relations between two goodsI2I1acPCCCZSTyx0 Figure 8.21: Shape of PCC and relations between two goods I2 I1 a c PCCC Z S T y x 0 Note that economists prefer not to name any goods that are placed on the two axes in this diagram; they pretend that these could be any commodities—however, we saw above that in case of more than one consumer, both goods must be representative-commodities. A typical price-consumption curve takes the shape as drawn here. Note that it originates from the vertical intercept showing that the demand for x is zero when price of x is very high and the consumer is spending all his income on y. As the price of x starts decreasing, the consumer increases the demand for it along the price-consumption curve. The important thing to note is that as long as the price-consumption curve is negatively sloped, the demand for x is increasing while that of y is decreasing. This indicates that the two goods are substitutes since we see a positive cross-price effect, i.e. fall in price of x causes the demand for y to decrease in this range of PPC. However, when the slope of the price-consumption curve becomes positive, the demand for both the goods are increasing at the same time showing that the two goods are compliments. Remember that the price-consumption curve drawn in this diagram is just a typical one and its exact shape is determined by the relationship of the two goods in question.

Key Concepts Comparative-static-analysis is analytical technique in which results of two static equilibrium states are compared with each other Demand curve shows all consumer equilibrium points as does the price consumption-curve but drawn in a price-commodity plane. It demonstrates the negative relationship between price and quantity demanded of a commodity due to negative sign of substitution and income effects Engels curve represents all points of consumer equilibrium at all positive income levels, but in income-commodity space as opposed to ICP which is drawn in commodity-space Giffen good is a commodity which has positive segment of demand curve due to the positive income effect larger than the negative substitution effect Income effect is the change in demand due to change in income holding the final price fixed. It has a negative sign for normal goods and positive for inferior goods with regard to price change Income-consumption curve (or path) is a curve showing all points of consumer equilibrium at positive income levels, drawn in the commodity-plane Interpersonal comparison of utility refers to the idea that in order to obtain social welfare function by adding up the utilities of more than one individual, one must be able to compare and rank the utility scales of all individuals (which is impossible because utility is a subjective phenomenon, known as impossibility of interpersonal comparison of utility) Market demand curve relates the price of a commodity to the total demand for that commodity by all individuals in the market. Economists wrongly claim that such a negatively sloped curve can be obtained by horizontal summation of all individuals’ demand curves Non-Giffen inferior good is an inferior good but has a negatively sloped demand curve. Price-consumption curve (or path) is a curve showing all points of consumer equilibrium at all relative prices Representative commodity always shows a proportional change in its demand as income of consumer increases. This holds only if taste of consumer always remains unchanged for a commodity as income increases Representative consumer is a mystical consumer in economic theory whose taste is supposed to be followed by all individuals living in capitalist society; i.e. his taste represents the taste of all consumers Social indifference map ranks the sum of all consumers’ preferences in a consistent manner and is expected to have same properties as individual indifference map Social utility or welfare is the sum of all individuals’ utilities or welfare living in a capitalist society Substitutions effect shows change in demand for a good due to change in its own price keeping real income constant. It always moves opposite to the price change and, hence, has a negative sign Total effect is the observed effect of a price change on the quantity demanded of a commodity. It is the sum of substitution and income effects. Chapter Summary Since tastes are unobservable so is the point of consumer equilibrium in actually existing markets. In order to study the effects of changes in prices and income on demand, economists have to assume that the taste of all consumers remain constant. Changes in demand are thus attributable to changes in market opportunities only

Comparative static analysis involves studying changes in the equilibrium position due to changes in market opportunities (i.e. prices and incomes). Change in prices and incomes are not seen as effecting tastes Change in income shifts the budget line of the consumer outwards—i.e. to the right of the diagram. The slope of the budget line is given by the ratio of prices; if prices remains the same then the slope of the budget line does not change when the budget line shifts outwards Since economics assumes that “more is better”, increase in income with prices remaining unchanged leads to a change in the consumption of both commodities depending on whether they are ‘normal’ or ‘inferior’ goods. Demand for ‘normal’ goods increases and for ‘inferior goods’ decreases as income increases in capitalist order All commodities in a consumer basket of goods cannot be inferior goods because this violates the “more is always better” assumption of capitalist order The income consumption path (ICP) shows the equilibrium points of the consumption of the two goods at different income levels. ICP is positively sloped in the case of ‘normal’ goods The Engel’s Curve shows increase in the consumption of a single commodity at different income levels in income-commodity space ICP can take any positively sloped shape for ‘normal’ goods. It need not be a ‘well behaved’ straight line curve ICP is negatively sloped for ‘inferior’ goods in capitalist order. In the case of ‘necessary’ goods ICP takes an increasing slope shape. In the case of luxuries ICP takes a decreasing slope shape In the case of a ‘representative’ good demand increases at a proportionate rate every time income increases. Economists assume that most goods are of this character but representative goods do not exist in capitalist order. However this absurd assumption is necessary for deriving most of the results of consumer choice theory. The choice of a ‘representative’ good for consumer behavior analysis is not a matter of simplification. The negatively sloped market demand cannot be derived without assuming that the good for which it is drawn is a ‘representative’ good Changing the price of a good changes both the position and the slope of the budget line. Demand for the good changes due to this shift in the budget line and due to the change in relative prices of the goods consumed. The increase in the demand for a commodity due to decrease in its relative price is known as the substation effect. Increase in demand which is caused by the increase in the income of a consumer due to the decrease in the price of the goods he is consuming is known as the income effect of the price change In the case of ‘normal’ goods both the substitution and the income effects of price change move demand in the same direction. As fall in price will lead to an increase in demand for a ‘normal’ good due to both the substitution and the income effect of this full in price The price consumption curve (PCC) shows consumer utility maximizing points at different price levels keeping income and taste constant

The demand curve is derived from the price consumption curve by joining all points of consumer equilibrium at different price levels in the price commodity plane. The demand for a single utility maximizing consumer is shown to be negatively sloping in the case of ‘normal’ goods. This means that as the price of a good falls, more of it is demanded both because price fall has led to an increase in the real income of the consumer and because this good has become cheaper relative to other goods being consumed by the consumer. In the case of ‘inferior’ goods the substitution effect of price change (assuming that indifference curves are convex to the origin) is negative but the income effect of its price change is positive and whether the demand curve of such a good will have the ‘right’ shape, i.e. whether it will have a negative slope, will depend on the sum of the substitution and the income effects A ‘Giffen’ good is an ‘inferior’ good in the case of which the positive income effect of a change in its price outweighs the negative substitution effect. Giffen goods have positively slope demand curves. All ‘inferior’ are not Giffen goods Economists claim that by adding up individual demand curves they can obtain a negatively shaped demand curve. This is the claim that when an individual behaves rationally—i.e. in a self-interested manner—maximizing his utility, this leads to the maximization of the utility of capitalist society as a whole If a “well behaved” market demand curve cannot be derived by adding up individual demand curves this means that either consumers are not behaving “rationally” or that social choice is not simply an aggregate of individual rational preferences. A consistent set of social preferences cannot be obtained by simply summing individual preferences If adding up individual negatively sloped demand curves can yield a smooth negatively sloped market demand cure then the lesser the interference with individual choices the better for the maximization of total social welfare / consumption However if we agree that individuals have different tastes, two individuals’ indifference curves can intersect. The point of the tangency of the budget line and the indifference curve may not be the same for both individuals. The income effect of price change may work in opposite direction for the two consumers and the effect of price change on aggregate demand will be indeterminate. Furthermore indifference curves can’t be added up for there are no rules for assigning weights to consumer choices. Interpersonal comparison of utility is impossible. Aggregate (i.e. community) indifference curves cannot show uniquely rational social preference ordering Change in prices also changes the distribution of income among consumers. Utility derived from different consumption bundles will change as the pattern of income distribution changes. It is not possible to rank different income distribution patterns in terms of the utility they generate. There is a different social indifference map for every pattern of income distribution. Social budget line and social indifference curves are interdependent, and not independent

This means that the market demand curve can take any shape. Usually it will be neither smooth nor downward sloping Well behaved market demand curves are derived on the basis of the myth of the representative consumer—he has the tastes every consumer “ought” to have. They also have to ignore the impact of changes in prices on changes in the pattern of income distribution and hence on the social utility (indifference) map to derive smooth negatively sloped market demand curves on the basis of the representative consumer myth Smooth negatively sloped market demand curves can be derived on the basis of two assumptions (a) that every consumer has the same taste and (b) that tastes do not change as income changes. Assumption (b) implies that every commodity is a ‘representative’ commodity while (a) implies that every commodity is a ‘representative’ consumer. They also imply that all income consumption curves are straight lines Economists make these assumptions because economics is a moral science. The representative commodity is capital and the representative consumer is the capitalist. Consumer preference theory says that a ‘well behaved’ market demand curves can be obtained by adding up individual demand curves if and only if there is one representative consumer consuming one representative commodity It is technically impossible to go beyond the one individual— one commodity one individual model—to derive a well behaved market demand curve. This means that the self-interested pursuit of individual welfare does not lead to the maximization of total social welfare (consumption) and that capitalist society is characterized by conflict It is impossible to establish a unique market equilibrium if the market demand curve is not ‘well behaved’. It may intersect with the supply curve at more than one point. This shows that there is conflict not harmony in capitalist society—non unique equilibrium points benefit particular consumers not society as a whole Markets fail to exist when individuals have non convex preferences. There is no uniquely determined quantity demanded at the ‘equilibrium’ price in such a situation. There is no uniquely defined equilibrium point, nor can changes in supply effect price. Convexity is required to guarantee that demand curves will not have “kinks” or “jumps” and that they show a unique quantity demanded at every price The slope of the price consumption curve (PCC) shows whether the two goods being consumed are substitutes or complements. It has to be assumed that both goods to are representative goods. When ICC is negatively sloped the two goods are substitutes and there is a positive cross price effect. When the slope of PCC is positive both goods are complements. Review Questions Why must economists assume that tastes remain constant in their analysis of consumer demand? Explain comparative static analysis methodology. How is the slope of the budget line defined? Why do economists expect change in income to lead to change in demand? Is it possible for both goods on the axes of a consumer equilibrium diagram be ‘inferior’? Why or why not?

Define ICP. Illustrate with the help of a diagram. Derive the Engel’s Curve” from your previous diagram. What does it show? What are the normal shapes of ICP? Why do economists assume that all goods are ‘representative’ goods? Can there be any commodity that falls in this category? Define “the substation effect” and the “income effect” of a change in the price of a good and illustrate your answer with the help of a diagram. Define and draw a price consumption curve. Why does the demand curve for a “normal” good slope downwards? With the help of a demand curve isolate (a) the substation effect and (b) the income effect of the increase in the price of a good on its consumption. Will the demand curve of an inferior good always have a negative slope? What is a ‘Giffen’ good. When is an ‘inferior’ good not a ‘Giffen’ good? What is the implication of the claim that negatively sloped individual demand curves can be added up to yield a similarly negatively sloped market demand curve? What are the implications of accepting difference in tastes and the recognition of the impossibility of interpersonal comparisons of utility for the derivation of community indifference curves? What is the impact of price changes on the pattern of income distribution? What are the implications of taking account of income distribution for the derivation of the market demand curve? The market demand curve can take any shape in general. Explain. What assumptions or conditions are required to derive “well behaved” market demand curves? Explain the meaning of ‘representative consumer’. Why do economists assume the existence of the “representative consumer” and the “representative commodity”? “Consumer theory shows that capitalism is an irrational system”. Discuss Show that the determination of unique market equilibrium depends on the existence of a “well behaved” market demand curve. Use a diagram to illustrate your answer. Non-unique equilibrium points show that there is conflict not harmony in capitalist society. Why? “Markets fail to exist when individuals have non convex preferences? Explain. What does the slope of the PCC tell us about the relationship of the two goods being consumed? Chapter 9 FIRM AND PRODUCTION IN CAPITALIST SOCIETY The model of demand-and-supply is the central conceptual tool of economics for understanding society in terms of its ‘theory of self-interest’. However, to prove that representation of society by this model is valid, economists must show that the standard demand and supply curves can be derived from utility and profit maximizing behavior of economic agents. We have seen in the last chapter that the demand-half of micro economic analysis is unsound—economics cannot derive a smooth, negatively sloped market demand curve from its theory of utility maximizing consumer behavior. In this chapter and in the next part of this book, we will try to see whether or not the ‘obviously appealing idea that to induce a larger supply of a commodity, a higher price must be paid’ makes any sense. We will see that there are alternative propositions which hold that price is set by cost of production which results in horizontal (and even downward sloping) supply curves! We will show that although the economists’ position seems superficially attractive, there are logical problems with it. This will confirm the fact that despite its logical contradictions, the major reason for the survival of economics is the commitment of Enlightenment social theory to the justification of freedom—the ultimate end of enlightened moderation and of capitalist order. It is for this reason that understanding economics as a moral science is so important.

As the consumer is the central figure in demand theory, the firm is the central agent in the theory of supply. To fully understand the supply decision of a firm, it is necessary to understand the nature of the firm. We begin this chapter by doing this. We then look at how capitalist production came into existence and how it affects society. And finally, we turn our attention to a discussion of the role of technology within capitalist society. 9.1: Firm: The Agent of Production in Capitalist Order Whenever you start analyzing the behavior of any individual, you have to begin by explicitly stating his objective because his behavior can only be understood in terms of the ultimate ends he is pursuing. To take a simple example, suppose you want to explain and predict the expected behavior which a student is going to display during his stay in college. Whatever you say about what this student is going to do depend upon what you think is the objective of this student. For instance, if the objective of this student is to have fun, then the following typical activities related to this objective can be predicted. Bunking classes Sitting in the canteen for long hours Playing cards Not submitting assignments Having a long list of friends And finally, failing in the exams On the other hand, if he sets himself the objective of ‘getting maximum knowledge’, then the predictions characterizing his behavior will be exactly the opposite of the above so: The behavior of an individual cannot be studied in isolation from his objective, and The behavior of one individual resulting from pursuing a particular objective may not necessarily apply to another person who has some different objective. In terms of our example, the objective of having fun cannot explain the behavior of the student who wants maximum knowledge. Similarly the typical activities resulting from having the fun objective’ do not apply to the knowledge maximizing student. Anyone having a little common sense would agree that a ‘research methodology’ which ignores objectives is fallacious. But it is exactly this methodology which economists tend to use. Economists analyze the production behavior of the firm which has a specific objective (i.e. profit-maximization) and then come up with the suggestion that the behavior of firms pursuing this objective is universally valid and therefore all units of production should be forced to follow this course of action. When economists pretend that their theory of the firm is ‘universally applicable’, they actually claim that ‘all ends or objectives of organizing production other than a specific one (profit-maximization) are irrational and therefore outside the theory of knowledge. We have seen that economists do this because economics is a moral science. Its own purpose is to justify capitalist order and the behavior patterns that produce this order. If production is undertaken for any purpose other than profit maximization (i.e. the maximization of the rate of accumulation) capitalist order is undetermined. Therefore economists insist that it is irrational to undertake production for any purpose other than endless profit maximization. The question ‘profit maximization for what’ cannot be raised within any branch of capitalist knowledge—science, philosophy, sociology, psychology or economics.

9.1.1: The Firm Some economics text books begin the analysis of the firm by defining it as an entity or organization that undertakes the activity of production—i.e. combining and processing goods, called inputs, in technological processes to convert them into some other goods, called output. This definition tries to define the firm in purely technical terms—production activities—by abstracting from the objective pursued by the producing unit. The definition tends to imply that a firm derives its nature from its technical function (production activity) and not from any particular objective that it seeks to pursue. But, as explained above, the behavior of a social agent cannot be explained without explicating (taking account of) its objective. Similarly, it is impossible to speak of the ‘activity of production’ without understanding its presupposed objective. There can be several objectives for productive activity. For example, production can be carried out: to fulfill needs of the people in order to earn reward from God to serve consumption needs of a particular community. to enhance national defense capabilities to maximize profit to serve some other social objective In principle, one may organize production to serve any of these objectives. The achievement of these ends will not, as economists insist, be the unintended consequence of profit maximizing behavior. Profit may have to be sacrificed for achieving these objectives. For example building a nuclear capability for jihad may involve producing fewer cars and fridges although producing cars and fridges may be much more profitable and producing what is most profitable to produce now is no guarantee that we will be able to develop our nuclear capability even in the future. According to economics, the only legitimate and rational objective for undertaking production activity is the maximization of profit. It is the pursuit of this objective—and it alone—that defines the role of the firm within capitalist society—a firm is an entity that undertakes the activity of production or trade for the sake of maximizing profit and for it alone. A production or trading unit which seeks some other objectives is not a firm. The garden of Fidak owned by the Prophet (Peace Be Upon Him) and the trading business of Hazrat Usman (RA) were not firms because their objective was not the maximization of profit but the attainment of Allah’s approval. Maximization of profit is the only reason why a firm exists in capitalist society. Economics asserts that the welfare of society will be maximum when all firms are producing output for the sake of making maximum profit. In other words, when all production activities are organized on this basis, then society maximizes consumption. As capitalist society matures, all activities taking place in society are connected to the maximization of profit—accumulation of capital—in such a way that pursuit of any other objective becomes increasingly difficult. Read Application Box 9.1 to see how profit-maximization directs social activities.

A p p l i c a t i o n B O X 9.1 Is KFC Serving Society or Maximizing Profit? KFC has opened an outlet at University Road, Karachi, where most of the waiters are deaf-and-dumb. Many people believe that KFC is serving an honorable national cause by providing economic support to one of the marginalized groups of society. The reality is otherwise. What KFC is trying to do is to win public sympathy in order to increase its profit. That KFC is maximizing its profit is evident from the fact that it tries to create the impression that ‘if services at this outlet are a bit slow, more people should visit this outlet so that KFC may not shut it down due to loss’. The idea of hiring deaf-and-dumb staff seems ethically appealing because it corresponds to the religious values of Pakistani society. However, remember that profit-maximizing thinking may sometimes take the form which is consistent with the moral values of a religious society, such as in this case. In such cases, people tend to confuse profit-maximizing behavior by tracing it to their own (not the firm’s) social values. But when it takes the form which goes against well-established social norms, people abuse profit-maximizing behavior, such as in the case of increasing prices of tents and medicines during the time of the earthquake in Azad Kashmir. But there is fundamentally nothing wrong about increasing prices during the earthquake according to economic theory because profit-maximizing behavior requires firms to increase prices at such times because increase in demand must bring forth increase in market price. Similarly, when KFC hires deaf-and-dumb staff, it is serving a social objective simply to maximize profit. If KFC sales increase, other firms, such as McDonalds, will also come up with deaf-and-dumb serving outlets shortly. If not, then KFC will say ‘bye bye’ to social objectives. All activities are tied to the maximization of profit in capitalist society. In a fascinating book The Corporation, an eminent lawyer Joel Bakar has shown firms such as Microsoft, Coca Cola, Pfizer, Nike and Nestle under philanthropic projects only when the costs involved can be shown to generate profits somewhere else within these empires. Microsoft preside free hardware to Harleem schools because software sales thus generated exceed costs of the hardware handed. Pfizer used to provide free AIDS treatment in Malaur and Switzerland in the hope that this will lead to a more than proportionate increase in medicines. When this did not happen, Pfizer abandoned its free AIDS program. The Firm and the Entrepreneur Note that the firm is more than a cooperating group of producers; it is a group with a particular organizational structure and a particular set of property rights. For example, it is possible to think of a ‘Producers’ Cooperative’ in which assets are owned in common—with no individual having the right to the exclusive use or disposal of any of the equipment, output, cash reserves, etc. of the cooperative and decisions being taken on a majority voting basis. This produces co-operative would clearly not be a firm. The essence of the firm is the existence of a central figure: the owner, employer chief executive manager or entrepreneur—a critically important character in capitalist society. He is the one who:

enters into a contract with each of the individuals who supplies productive services has the right to profit from production has the right to direct the activities of the suppliers of productive services (specially labour) can change the membership of the producing group not only by terminating contracts but also by entering into new contracts Thus, there is a similarity between the function of a firm and the role that an entrepreneur plays. Both of them combine resources for producing commodities in order to make profit. This similarity is not coincidental. The firm simply constitutes the organization used by the entrepreneur to combine inputs—land, labor and capital—in the production process. Conventionally, the entrepreneur is defined as a person who undertakes and operates a new enterprise or business venture to offer a new or existing product or service in a new or existing market and assumes some accountability for the inherent risks. In the context of the creation of for-profit enterprises, the entrepreneur is often synonymous with the founder. He is a person who takes the risks of finding new channels of profitable investments for the sake of further accumulation of capital. However, as we see below this view of the firm—as held by the classical economists who saw the entrepreneur as a heroic figure —is not an appropriate description of the ideal capitalist property form, i.e. the corporation, the distinguishing feature of which is a separation of ownership from control (this issue is discussed below). Plant and Industry This relation between the firm and the entrepreneur brings us to an important distinction between the firm and the plant. A plant is the physical capital at a particular location used for producing commodities—i.e. it is the unit of production in a firm. On the other hand, the firm is the unit of ownership and control. Common examples of plants are factories, offices and farms. Remember that the plant comprises of only a part of the capital organized by the firm and thus represents only one of the factors of production; i.e. capital and that too partially. A firm may have more than one plant, e.g. production facilities of General Motors are scattered across many countries. Conversely, a single plant can also be part of the capital shared by more than one firm, e.g. a gas and petrol exploration plant jointly owned by Pakistan Petroleum Limited and OGDCL. Moreover the growth of E-business shows that firms may exist almost without having a plant—you may run your E-business from a computer on a table sitting on a chair; and the chair, the table, the computer and the software will be the only fixed capital (plant) you need to run a Rs 100 billion share trading firm. Finally, an industry is the collection of all firms concerned with a particular line of production. Pakistan Economic Survey lists 21 industries; including textile, transport, chemicals, food manufacturing etc. However, it is difficult to give a rigorous definition of ‘industry’ because one firm may operate in more than one ‘industry’ at a time.

9.1.2: Legal Forms of the Firm Firms can be classified in many ways: by size, type of competition or by legal forms. We begin with this last classification. In a capitalist country, firms exist in three legal forms: proprietorship, partnership and corporation. As we see below, capitalist production takes place most efficiently when the firm takes the form of a ‘corporation’—the typical and dominant property form in capitalism. Proprietorship A proprietorship is a firm which is usually owned and managed by a single person—that is why it is often called sole proprietorship. In this case, the owner is himself the boss who makes all decisions, receives profits and is responsible for all losses. In many cases, the proprietor also provides and owns a large share of the assets; including labor, building, land and equipments. Agricultural production is a typical example of proprietorship. A very large proportion of the total number of farms in Pakistan can be described as proprietorships. The farmer owns the land, and farming equipment and uses his own labor to do most of the work. At the end of the production year, the farmer receives a profit or incurs a loss. Another major commercial activity in Pakistan for the sole trader is retailing. Note that most of the business forms that are typically organized under proprietorship are characterized by low capital-intensity—i.e. they require little capital. In terms of the share of total capital and total employment, sole traders are of limited importance in mature capitalist countries. Remember not to equate proprietorship with ‘one-man-business’. Sole proprietorships are indeed owned by one person but the business may employ many people. As we see in the next section, proprietorship is not usually a suitable form of business organization to carry out capitalist production and trade. Sole ownership becomes increasingly difficult to manage a capitalist production and trade because of the intensified competition created by large corporations. There are many reasons why proprietorship is regarded as an inefficient way of carrying out capitalist-production and trade. The major reason is its inherent limits to growth. Financial: Capitalist growth ultimately depends upon the availability of capital. Sole ownership is restricted to the amount of money that can be provided from its own resources or raised from banks or other lenders. The proprietor always faces a potentially vulnerable financial position in capitalist society. The profits accrue to a single person but so do the losses which force most sole traders to go bankrupt. Limited capital resources often make the sole trader particularly vulnerable to sustained competition from large business units. Organizational Skills: Even if a person is able to acquire large amounts of capital, he has only limited ability to exercise effective control and manage an organization. As capitalist business grows specialized management skills increase in importance and complex business forms replace the sole trader.

Partnership A partnership is similar to a proprietorship, with the main difference being the number of owners. It is a firm owned and operated by two or more persons. Each partner generally shares in the risks, profits and liabilities of the firm. Partnerships may be formal organizations, but two or more people running a stall in a local Jumma-Bazar would almost certainly be in partnership with each other although they have signed no formal contracts. The maximum number of members possible in most partnerships is often fixed by law. Partnership depends upon mutual trust between partners—each one of them must rely on the others for the success or failure of the firm. The responsibilities may or may not be divided among partners: one partner in charge of management, another of production, and the third of accounts. The division of responsibilities could also extend to one partner operating the firm and a limited partner providing only financial capital. This form of business became increasingly popular with the emergence of capitalism because it is more suited to management of capitalist production. Most management consultancy firms in Pakistan are organized as partnerships. Corporation A corporation is a distinct legal entity that exists independent from its owners. Since it is separate from its owners, it can sell ownership shares, called stocks. The term joint-stock company is also often used in place of corporation. This is a business form consisting of persons who contribute money to a common stock used in business for making profit. This common-stock is the capital of the company and the persons who contribute it are its members. The share of each member is the proportion of capital to which he is entitled. The ability of a corporation to sell stocks allows it to raise far greater amounts of financial capital than a partnership and a proprietorship. But keep in mind that the shareholder in a corporation risks only the initial amount invested in the firm, called the principle of limited liability ownership. This means that an investor’s liability to debt is limited to the extent of his shareholdings in the corporation. For example, if you own Rs 1,000 shares in a corporation and if it goes bankrupt, then the most you can lose is the Rs 1,000. This system encourages investment because it limits the risk investors take to the amount they have actually invested in the corporation. In contrast, the owner of a proprietorship has unlimited liability which means that all of the owner’s personal assets can be used to pay the firm’s liabilities in case it becomes insolvent. Unlimited liability also applies to partnerships, with the exception of limited partners who, like shareholders, risk only their initial investment. The need for more and more capital partly explains the development of joint stock companies. In mature capitalist countries, joint stock companies are the dominant form of business organization in terms of capital and manpower employed. An important and heatedly debated issue in this form of business organization is the separation of ownership from control—he who ‘owns’ capitalist property has no control over its use. The legal owners of the firm are the shareholders, who may number in thousands, and each of them has a very small proportion of the total equity of the company. They bear the risk in the sense that fluctuations in the profits of the company imply fluctuations in their income and wealth (dividends and shareholders value). However, as corporations become larger, the management functions also grew. The growth of management control over corporations and wide spread share ownership distributed among many small and powerless owners has meant that managers now control corporations. In principle, the directors of a firm are supposed to be ‘stewards’ for the shareholders to look after the operations of the company on behalf of shareholders. But the boards of directors are dominated by the senior executives of the company which means that senior executives of the company, rather than shareholders, effectively control the decision making activities within corporation. Thus, if there is any conflict between managers’ and shareholders’ interests, the separation of ownership from control permits managers to pursue their own interests rather than those of shareholders. There is, therefore, a great deal of theoretical disagreement on ‘who runs the corporation and for whose interest’.

It is important to stress that this is one way in which capitalism abolishes private property (just like socialism) in the sense that control of property is denied to its owners. This abolition of private property is necessary for the effective domination of profit-maximization orientation at the mass level. This is so because as long as property remains under the control of non-economic men, there is every possibility of using it for non-profit-maximizing purposes—man can anytime repent from the so-called rationality of profit-maximization. Abdullah Zhagzai never thinks of profit-maximization when he enters a business transaction. On the other hand, the corporation is legal entity which exists solely for the accumulation of capital. This is its only moral and social duty according to law. No share holder can legally question the nature of business, Halal or Haram, conducted by the corporation. The ownership of a company is so widely and weakly dispersed among shareholders that the maximum a shareholder can actually do is to withdraw from business by selling its shares only to be purchased by someone else in the market. Thus, when property is organized in the form of a corporation, ‘capital’ is the uncontested owner. The corporation first appeared at the beginning of the seventeenth century—the East India Company was among the first corporations to be established—and during the seventeenth and eighteenth century it was universally regarded as a corrupt and fraudulent form of business. It acquired legal legitimacy in the first half of the nineteenth century in Britain, France and America and about half a century later stock markets were formally and legally organized in all countries for the regular trading of company share. The law requires the corporation to conduct its business for the over riding purpose of capital accumulation. It is literally illegal for the corporation to regard any purpose other than profit maximization as its primary objective. Every activity must ultimately be justified in terms of its impact on the bottom line and every activity is ruthlessly priced by the stock market on this basis and on this basis alone. A company which is judged by the stock market not to be effectively seeking profit maximization goes out of business—it becomes bankrupt or is taken over by its rivals. This compulsion to maximize profit effectively establishes the ownership of capital. Capital is not owned by anyone in the sense that he cannot continue to own it without using it for its own accumulation. Share “ownership” is a legal fiction. In capitalist society capital is the real owner—the corporation reflects the real personhood of capital. Capital owns labor, management, land, technology, knowledge and all “factors of production” must continue, for ever, to work for capital accumulation. Any money or other resource withdrawn from this circuit of capital ceases to have value for it is no longer capitalist property. The separation of owner from control raises the question of ‘who runs corporation and for whose interest’. Within a corporation, three groups can be identified for whose interest it is run: shareholders, wage-laborers and salaried managers. As stated above, although shareholders have the formal (fictional) ownership rights, they are so dispersed and have so little information about the firm that it is impossible for them to control the corporation and determine the use of its profit. No doubt wage-laborers have some power and organization to withdraw their labor collectively, but their economic vulnerability to long-term loss of income limits their ability to exercise control over the corporation. Thus, corporations are largely controlled by managers. Large offices, plush carpets, large expense accounts, and executive dinning rooms and cars are evidence of corporate conspicuous consumption. Off course, if managers do posses economic rationality—of maximizing utility—then their utility depends upon their salaries and other prerequisites, such as company car, expense accounts, subsidized food, drink and housing, status, prestige, power and security. However, the managers cannot ignore the interests of shareholders. Baumol, Marris and Williamson have argued managers aim to increase the sales of the corporation as fast as possible subject to the constraint that some minimum profit or dividend must be paid to shareholders in order to avoid take over.

However this obscures the fact that managers’ salaries are ultimately determined by the profits that their corporation makes and stock markets are continuously valuing its share on this basis and this basis alone. Moreover in the 21st century a major proportion of managers’ own earnings are generated as dividends and capital gains on stocks they hold. This fact plus the increasing dominance of the institutional investor—the ‘mutual fund’ which is controlling billions of dollars of shareholders funds—has meant that profit maximization has become a managerial policy imperative and the inclination to sacrifice profit for conspicuous consumption has become increasingly unaffordable. As long as stock markets provide the barometer for assessing firm performance, managers are compelled to seek profit maximization as the ultimate end in itself. 9.2: Dynamics of Production in Capitalist Society Having understood the nature of the firm and its social objective, we now take up the issues of the nature and process of production activity and its relation to social institutions in capitalist society. The importance of the issue lies in the fact that only after discussing the dynamics of capitalist production process can we appreciate the essence of capitalism. Let’s begin with a brief historical account. 9.2.1: How it All Got Going: Transformation to Capitalist Production In the 1780s ‘M‘Connel and Kennedy, two Scotsmen traveled south and became apprentices in the Lancashire cotton industry. After gaining some experience and earning some money, they started their own firm in 1795 with an initial capital of £1,770. They made good profits. By 1800, their capital had increased to £22,000, by 1810 to £88,000. The company had three mills by 1820 and had established itself as the leading cotton spinning unit in Manchester, the global metropolis of cotton spinning. But high profit rates could not be maintained over a long period of time as they induced other firms to enter the market. By 1819, there were already 344 cotton mills and this number increased to 1,815 by 1839. Technological improvements brought about huge increases in productivity in the 1830s and competition forced companies to invest increasing amounts of money in new machines. M‘Connel and Kennedy’s labor force grew from 312 in 1820 to approximately 1,500 by 1830, an increase of about 380% over a decade. Not surprisingly, much of this labor was cheap child labor and nearly fifty percent of those employed were under the age of 16. There were 100 children under the age of 10, including some as young as 7, who were made to work from 6 am till 7:30 pm. The mill owners tried to keep wages as low as possible because the total wage bill was rapidly increasing as the number of workers grew. Replacement of craft workers with less skilled and cheaper labor and invention of new automatic machines reduced wage costs. But such practices gave birth to wage-conflicts which became increasingly organized over time. Labour resisted wage reductions through their unions. We will have more to say on the issue of conflicts among laborers and agents of capital (i.e. manager) in the last part of this book while discussing economic theories of income distribution.

As business ventures became larger, the size of investment needed to operate business also became greater. This led to market domination by the corporate property firm—the joint stock company. However the joint stock form of organization largely developed not from the local requirements of the size of industry, but from foreign trade booms of the colonial era—the era of the worst form of mass exploitation and butchery ever known in the history of mankind. At first, there were regulated companies, e.g. the Muscovy Company (1553), which were established for a single business venture. However, one of the most important joint stock companies which had a continuous existence for two and a half centuries and was run and controlled by a board of directors was the British East India Company, founded in 1600. In April 1601, the company sent its first expedition to the East Indies. After some 18 months, four of its ships; Ascension, Dragon, Hector, and Susan, had returned from Sumatra and Java. The success of this venture led to a second voyage by the same ships which left London in March 1604. This time Ascension, Dragon, and Hector could make it back to England in May 1606 while Susan was lost at sea. The shareholders in these two voyages made a profit of 95% on their investment. A very large amount of capital was needed for this type of trade. An East Indianman—as the ships engaged in this trade were called—had to be built, fitted out, armed with cannon against Dutch and Portuguese rivals, and repaired, when it returned. The Company’s capital was obtained largely but not entirely from rich London merchants who controlled and administered it. Aristocrats were another welcomed source of income because of their influence at Court. The Company’s privilege depended upon Royal favor. Foreign money was also involved. The first 12 voyages were financed separately. This was, however, a risky way of financing long-distance trade because it exposed capital to a long period of uncertainty in far away and unknown places. Risk could be spread by sending several ships on each expedition, so that not all eggs were in one basket. Thus the company shifted to a method of finance that spread risks over a number of voyages and then became a full fledged joint stock company in 1657, and in 1688 trading on its stock was formally organized. Since prices, when left to market forces, tend to fluctuate in capitalist society, therefore every capitalist market provides opportunity for making money through speculation. This occurs when something is purchased in the expectation of selling it at a higher price in the future without increasing its value by processing it in some form. Speculation can occur in relation to almost any commodity: it may be grain, currency or a derivative—the sophisticated financial instruments that derive their value from the value of something else, such as oil or coffee. Speculation is an unproductive and freeloading activity that is wholly separable from the real economy where production of goods and services takes place. However, when speculation is based on real goods and services, its scope is limited by the fact that goods must physically exist to speculate on. This limit is relaxed in stock markets which provide a perfect opportunity for speculating on company shares without having much concern with its production activity. The existence of markets for capital—something that has never existed in the whole history of mankind—is central to the functioning of capitalism because capital markets bring together those seeking to finance economic activities by taking risks and those with money to invest. Since the stock prices (of company shares) change, sometimes due to changes in their profitability and most of the time due to artificially created bubbles, there are opportunities for speculating on future price movements. Because share price fluctuation has very little to do with actual production, money can be made by speculating on prices of company shares—nothing more than pieces of paper! Speculation is not something separate from capitalism but an inevitable and integral part outgrowth of its essence.

There is another sense in which stock markets are essential to capitalism. Capital is money that is invested solely to make more money. In other words, it is a means for converting a given amount of money into a ‘larger amount of money’ by passing through a production or trade process. It is easy to see that the rate of expansion in capital depends upon the speed at which money is circulating in the economy—the rate at which it changes hands, called the velocity of money. The slower the production process, the slower will be the circulation of money and vice versa. One way of increasing the circulation of money is to increase the speed of the production process, say by producing and promoting the use of products, such as glass-ware instead of metal utensils or earthenware. However, the circuit of production, no matter how fast it becomes, places an upper limit on the growth of capital. Another way of increasing the circulation of money is to bring money into financial markets, such as stock markets and money markets, so that money can now change hands with greatly reduced dependence on the production cycle of a specific commodity. Thus, stock market trading provides an ideal opportunity for never-ending expansion of capital—the material form of freedom. It is also interesting to note that at the time, when industry and commerce were finding it necessary to adopt the joint stock company property form, the government was also finding it necessary not to interfere in the economy. It was also in 18th century Britain that typically capitalist ways of thinking about the economic basis of society were first put forward. The merits of the division of labor, competition, free operations of markets and generation of ever increasing profits were clearly spelled out by Adam Smith. The key thinkers of this time were examining the mechanisms and principles of capitalist society that they saw emerging all around them. The question ‘why capitalist production became so extensive in 18th century Britain’ is itself worth investigating. However, the scope of this book does not allow us to go about tracing its historical causes. 9.2.2: Impact of Capitalist Production on Society Trade has existed in all civilizations. There were merchants who used to invest money in goods and sell them at a profit throughout history. But except for Jews and money lenders, profit maximization was not the objective of the enterprise. That is why growth in trading stock remained limited and merchants played a major role in sustaining religious institutions such as the mosque, khanqah (خا نقاہ) and mazar (مزار). Trading profits were a major source of the resources mobilized for all Ghazwat (غزوات) after Uhud (especially Ghazwa-e-Tubuk) and the Prophet (Peace Be Upon Him) has said “the honest merchant will accompany the Prophets, the martyrs and the truthful in Paradise”. In pre-capitalist societies most people’s livelihood did not come from economic activities financed by the investment of profit maximizing businesses. Private property was universal, self-employment was common and wage labour was rare. In fact, wage labor was stigmatized in such societies. Being an employee was often considered a menial activity even when it yielded higher income than being self-employed or working for one’s family (خاندان). Since the societies were dominated by the religious virtues of contentment and love, as opposed to ‘more is better’ (accumulation) and ‘competition’, people spent little time to earn their livelihoods because only a small basket of goods was enough to support their families. Imam Ghazali recommends that working for one’s living should be structured to the time between Ishraq (اشراق) and Zuhr (ظہر) prayers (roughly 8 am to 1 pm) in the Arabic speaking countries. With the emergence of capitalism, things changed dramatically. Greed and envy became the dominant expressions of social rationality and people started searching for meaning of life in consumption and investment. This tendency was socially reinforced by the fact that in capitalist production the whole economy depends upon the investment of money for making profit, and this occurs when not just trade is financed in this way but production also. Capitalist production requires the universalization of ‘wage-labor’. Labor is treated like a commodity, similar to any other that can be sold and purchased in the market at its going ‘equilibrium’ price. Labour markets are more like the ancient ‘slave-markets’—capitalism develops ‘labor-markets’ with the majority of the population in society having no option except that of selling their skills and time to some capitalist firm in order to earn their livelihoods. The only other choice is ‘to starve’. Commodifying labour is the beginning of a process of comprehensive social change as discussed below.

Capitalist Production Imposes New Social Discipline As capitalist production speeded up through the expansion of new industries, increasing number of citizens were turned into wage-laborers. Therefore, the efficient working of such a system of production needed a new kind of ‘discipline’ among workers. Industrial production requires continuous and regular work in order to reduce cost. Expansive machinery cannot be left unused. This means that idleness and wandering around, even conversation, among workers could not be tolerated during work hours. Initially British cotton mills faced a great deal of trouble recruiting labor because people simply hated long, uninterrupted shifts and close supervision. Employers had to find ways of enforcing a discipline that was quite alien to the first generation of industrial workers. Corporal punishment (especially for children), fines or the threats of dismissal were common. Gradually more sophisticated and apparently ethical ways of controlling workers were developed by some of the mill owners. Read Application Box 9.2 which discusses an interesting way of maintaining work discipline developed by Robert Owen. A p p l i c a t i o n B O X 9.2 Owen’s Factory Discipline Many so called ‘ethical’ ways of monitoring workers were developed by mill-owners in the eighteenth century. Robert Owen usually thought of as a utopian socialist reformer introduced ‘silent monitors’ at his New Lanark mills. In this system, each worker had a piece of wood, with its sides painted with different colors standing for different performance appraisals: black for bad work, blue for indifferent, yellow for good, and white for excellent. Every morning when workers came back to their work station, the side turned to the front provided them a constant reminder, visible to all, of the quality of the previous day’s work. Each department had a ‘book of character’ recording the daily color for each worker. Discipline was not only a factory matter, because Owen also controlled the community. He sent round street patrols to report drunkenness and fined the drunks next morning. He also insisted on cleanliness and set detailed rules for the cleaning of streets. There was even a curfew that required everyone to be indoors after 10:30 p.m. in the winter. As the Owen case shows he was not only controlling factory matters, but also the community at large. Community control was necessary because disciplined work not only required regular performance at the factory, but also timely work. It meant turning up early every day, starting on time, and taking breakfast of a specified length at exactly a specified time. Employers had to battle even against some of the well established traditions, such as turning up late on Monday mornings. Time turned into a battleground and some ruthless employers put clocks forward in the morning and back at night. There are stories of watches being stolen by workers so that employee’s control of time could not be challenged. Ownership of timepieces and watches became widespread during the Industrial Revolution in Europe. Much of the organization of institutions which evolved at this time, such as hospitals and schools, was modeled on factory discipline. The leading twentieth century French philosopher Foucault provides fascinating details of these in his book Discipline and Punish!

Capitalist Production Producing New Social Networks Not only did capitalist production create a new form of work; i.e. wage-labor, it also created leisure as the most important part of modern life. This statement might seem surprising given the fact that cotton masters wanted to keep their machinery working for twenty four hours a day. However, the practice of continuous work during work hours ruling out all types of non-work activities separated out leisure from work—a distinction unknown in non-capitalist societies. In capitalist production, work became monotonous and boring as one did not feel ‘at home’ in the work place. Only in leisure time did workers feel ‘at home’ and in control of their lives. This leisure activity normally took the form of holidays, week-ends, and evenings. It was the disciplined and bounded work created by capitalist production that gave birth to the idea of leisure as a distinct ‘non-work time’ activity. As a result, workers wanted more and more leisure and leisure time became an agenda item to be negotiated by unions. This started initially in the cotton industry and eventually new laws were passed to limit working hours and to provide holiday-entitlements to workers. The importance of the idea of leisure, and the universalization of wage labour, can only be appreciated by understanding its role in the enhancement of capitalist production through the commercialization of leisure. Capitalist enterprises started organizing leisure activities. Traditional sports and pastimes, even religious ceremonies, were managed to generate profit and an entire separate entertainment industry blossomed. The new railway companies offered cheap excursion tickets and Lancashire cotton workers could visit resorts for the day. 1841 saw the first excursion tour by rail from Leicester to Loughborough organized by Thomas Cook. Tourism emerged as a distinct industry. Commercialization of leisure made it possible to charge people for entry in activities ranging from mass travel to spectator sports. The lure to make profit gave birth to the idea of providing entertainment through T.V. and radio at home. These ideas inspired a new range of paid professional singers donors and musicians to emerge in society—characters that were traditionally regarded as immoral and base. A whole range of new industries were developed to exploit and promote leisure markets creating a huge source of consumer demand, employment and profit. This commercialization of leisure gradually converted the lives of people into a never ending hunt for pleasure which become the sole purpose of existence. This dynamic interaction of production and consumption explains why capitalist production expanded so very rapidly once it got going. Capital now has a wide range of activities to move through depending upon which of them suitably rewards it—i.e. offers higher and higher profitability. Capitalist Production Eliminates the Natural Order of Life The introduction of rapid means of traveling is another outcome of capitalist production that drastically changed people’s life. Rapid expansion in communication and transportation were necessary as capital needed to be transferred quickly from one place to another in order to speed up its accumulation for the sake of further accumulation. Though the speed of travel was increasing from year to year, yet more and more time was devoted to traveling itself. The commercialization of the vehicle industry brought about one of the most troublesome by-products of industrialization: the terrible traffic congestion in towns, cities and suburbs. One consequence of this is that strolling along the streets of a city is now a forgotten memory. Lorries, motor-cycles and taxi fumes, filth and snarling engines and visual disturbances have compounded to make movement through the city a nightmare for the pedestrian. Towns and cities have been rapidly transformed into roaring work-shops. This has forced authorities to come up with the policy of road-widening, tunneling and bridging. Such policies soon resulted in the development of cities where the greater part of the metropolis was converted to road space with massive signs, bypasses, and weirdly shaped junctions and circuses across which traffic flows from several directions. Ask any person who belongs to the previous generation how difficult urban life has become.

Many other important features of the natural order of life have also been corrupted by capitalist production. Erosion of the country side ‘Uglification’ of coastal towns Pollution of the air and of rivers with chemical wastes Accumulation of thick oils on our coastal waters Sewage poisoning of beaches Destruction of wild life Change-over from animal farming to animal factories Spread of pandemic diseases resulting from environmental depletion and sexual immorality (especially AIDS and homosexuality) And visible to all who have eyes, a systematic destruction of natural beauty and a rich cultural heritage In short, to preserve what little is left from capitalist production requires a major revision in the vision and purpose of life beyond growth. Capitalist Production Destroys Family Institution But the story does not end here. Capitalist production has also destroyed one of the most important and strong social institutions even in the Christian Europe, namely the family where women used to play their part as house wives and men as bread winners. Capitalist production could not afford to tolerate strong family sentiments. On the one hand, increasing number of industries meant even greater demand for workers. On the other hand, as pointed out above, high profit in any industry, such as spinning, attracted new entrants which depressed prices and, hence, profits. One way to maintain high profits was to hire cheap labor, such as children and women. Companies competed against each other to offer jobs to women. However, the traditional family structure and prevailing public conceptions of ‘normality’ and ‘appropriateness’ related to social responsibilities of women were effective barriers to women’s participation in labor markets. Therefore, deceptive slogans, such as ‘women-rights’ and ‘gender-equality’, were popularized to expand women labour market-participation. Firms were willing to provide flexible working hours and other fringe benefits to women in order to increase their participation in capitalist production because they were found to be more disciplined and unthreatening and ‘union apathetic’. Advertisement firms saw women as an effective instrument for promoting their products. The existing home responsibilities of women had to be reduced so as to facilitate and maintain their commitments to their jobs. This opened up an entirely new avenue of production possibilities for capitalist firms including: Fast and canned food, paper-glasses and plates and soft drink industries (which heavily reduced the burden of kitchen activities) Baby nappies or pampers industry Dry milk and feeder industries Washing and drier machines etc. Women’s participation in the work force and their unrestricted social interaction with men has led to the inevitable break-down of the family as divorce, fornication and nudity spread throughout society. Capitalist production has transformed not only people’s work and leisure preferences and activities; it has invaded the most ‘private’ aspects of social life.

There is another important dimension in which capitalist production has forced people to change their living habits. In capitalist order a large number of workers are concentrated in factories and offices where they have to work in a continuous and disciplined manner under the supervisor’s watchful eye. Residence of workers close to their work places had to be planned to reduce traveling costs as well as to enforce work discipline. Industries are often located in urban conglomerations to exploit location advantages. Residential and industrial concentration produced modern metropolitan life styles in which urban residents know a lot about the world’s business from minute to minute, but nothing about people who live in their neighborhood. Serious environmental depletion was another consequence of modern urbanization. Sanitation, water management and sewerage disposal problems became increasingly severe. Joint families disappeared and the typical urban residence is a flat designed for four people to live away from their relatives, such as brothers and sisters. This separate and private living reinforced the whole ideology of individualism—to be the master of one’s own life. Thus, destruction of family is a necessary result of industrialization, urbanization and emancipation of women. All of these three tendencies operate simultaneously and go hand in hand. The promise of high wages and other material benefits resulting out of modern industrialization lures large numbers of the able-bodied from close-knit, well integrated society of village to anonymous city life. With industrialization the family ceases to be a self-sufficient economic unit. Capitalist Production and Capitalist Individuality Capitalist production presumes satisfying infinite ever growing human wants as an ultimate end in itself. The law of eventually diminishing marginal utility—as discussed in chapter 7—means that continuous growth cannot be sustained by a system of producing ever larger quantities of the same commodities. This facet of the capitalist life system highlights the importance of product innovation. New and more expansive goods and services must be continuously brought into the market. When new kinds of goods appear, the older ones are removed from production. And in order to ensure that people keep on changing their wants as rapidly as product innovation requires; the social and economic network is geared to creating dissatisfaction. As pointed out in chapter 6, producers—e.g. through advertisement—continuously persuade consumers to choose that which is being produced today and ‘unchoose’ that which was produced yesterday. Thus, the market is not a want-satisfying mechanism; rather a want-creating system. The share of national resources devoted to creating new wants keeps on increasing. The success of this system is symbolized by the emergence of ‘pace-setters’—an ideal type, hyperconscious of being in the van of fashion and filled with unlimited ambitions. Manufacturers strive to create an atmosphere which simultaneously glorifies the ‘pace-setters’ and ridicules the fashion laggards. The more affluent a society, the more covetous its citizens need to be. Keeping a man covetous and unthankful in order to maintain the pressure of scarcity is a matter of survival for capitalism. The fear of ‘falling out of the race’—created in a capitalist society by the pressures of pursing prestige, position and recognition among colleagues—is the driving force of capitalist production. Anxiety and stress spread at mass levels. Few men in capitalist societies can say that they live, in this age of accelerating change, without anxiety. The services of psychiatrics and therapists become most wanted in mature capitalist societies.

To appreciate the importance of creating new wants, note that an unchanging pattern of wants—the hall mark of non-capitalist societies—would not be sufficient to absorb the rapid growth in the flow of consumer goods coming to the market. If everyone behaves like Abdullah Zaghazai capitalism cannot flourish in Pakistan. One of the pre-requisites for the ‘take off into the self-sustained growth’ is the collapse of Islamic values—faqr, zuhd, qana’at—and the growth of dissatisfaction with the status quo. In non-capitalist Muslim societies, people lived comfortably, whether in towns or villages. Their satisfaction was derived from their closeness to each other and to the natural order of life, and not from the frenzied search for the satisfaction of infinite wants. Life was centered on the mosque, through which people of all ages and circumstances organized their social activities and became familiar with each other. Capitalist-production cannot flourish without creating and sustaining economic man—individuality committed to satisfying infinite wants. It was at the beginning of capitalist production when intellectuals and philosophers, having rejected the teachings of the Prophets, started to think what should we do on the earth now, rather than what we are supposed to do to reach heaven in the future. They tried to convince the multitude that the ‘Kingdom of God’ is to be realized here, and now, on this earth; and it is to be realized via technological innovation, and capital accumulation at an exponential rate. Science was the new deity people started to rely on for solutions to their problems. One of the major objectives of economics is to equip the state with policy tools so as to foster capitalist individuality. Briefly speaking, many of the institutions and relations that we today regard as ‘natural’ and from which we derive the meaning of our lives are merely the off-shoots of capitalist production—production organized for the sake of accumulation of capital as an end in itself. Their legitimacy depends upon the continued dominance of the capitalist production process. Capitalist production started, as pointed above, after rejecting success in life-after as the major end of life. When capitalism collapses, life will become quite simple, natural and beyond artificial disciplines needed to sustain capitalism. Key Concepts Capital is money that is invested in order to make more money Capitalist production is the organization of production of goods and services for the sake of accumulation of capital as an end in itself Commercialization of leisure means the organization of leisure time for further enhancement of capitalist production by arranging activities for the sake of making profit, such as entertainment industry, through capitalist enterprise Corporation is a distinct legal entity that exists independent of its owners Entrepreneur is a person who takes risks for finding new channels of profitable investments for the sake of further accumulation of capital

Firm is an entity that undertakes the activity of production for maximizing profit Industry is the collection of all firms concerned with a particular line of production Limited liability ownership means that an investor’s liability to debt is limited to the extent of their shareholdings or initial investment Limited partner in partnership is one who, like shareholders, risks only his initial investment in a firm Plant comprises the physical capital of a firm at a particular location used for producing commodities—i.e. it is the unit of production in a firm Partnership is a firm owned and operated by two or more people Product innovation is the practice of continuously bringing new and more expansive goods and services in the market in order to sustain continuous economic growth Production is the activity of combining and processing goods, called inputs, in technological process to convert them into some other goods, called output. Proprietorship is a firm which is owned and headed by a single person Speculation occurs when something is purchased in the expectation of selling it at a higher price in future without increasing its value by processing it in some way. It is an unproductive and freeloading activity that is wholly separable from the real economy where production of goods and services takes place. Chapter Summary The demand and supply model is the central conceptual tool used by economics to explain self-interested behavior Economics regards all objectives except the profit maximization objective as irrational. This is so because economics is a moral science The question ‘profit maximization for what’ cannot be raised in economics Economics defines the firm in terms of the technical character of its function—i.e. conversion of inputs into outputs—without recognizing that production may be and historically has been undertaken for several objectives besides profit maximization. There is no certainty that pursuing profit maximization will automatically lead to the achievement of other objectives Undertaking production for purposes other than profit maximization becomes more and more difficult as capitalist society matures The firm is an organized hierarchy in which the Chief Executive Officer takes responsibility for evolving a strategy for continuing profit maximization Proprietorship is an inappropriate form of capitalist business because the growth of such businesses is limited by financial and skill constraints which make its expansion and even survival difficult Corporations are characterized by the existence of the principle of limited liability ownership—each shareholder’s risk being limited to his own investment in the corporation. The corporation is also characterized by the separation of ownership from control with managers taking and implementing all decisions Managers are legally bound to pursue the maximization of shareholder’s value. Capital accumulation is the corporations’ sole legal purpose of existence. Therefore, neither managers nor shareholders but capital itself is the real owner of the corporation. Money withdrawn from the circuit of accumulation ceases to have value because it is no longer capitalist property

The development of the corporate property form significantly expanded scope for speculation which now takes place on stock exchanges and was not limited to speculating in commodities. Stock market speculation is only tenuously related to the production activities of the corporation and is therefore in principle unlimited. The development of speculative trading in corporate shares was thus a crucial phase in the development of capitalist property Capital is money used solely for the purpose of making money. The rate of capital accumulation depends upon the velocity of the circulation of money Non-capitalist societies organize production and trade on the basis of private property and self-employment Wage labor is universalized in capitalism. Labor becomes a commodity and it is priced in terms of its contribution to capital accumulation. Both managers and workers are employed by capitalist which is the real owner of all labour in capitalist order Universalizing wage labor requires the imposition of capitalist social discipline at the workplace and in the whole of society. It also requires the separation of ‘work’ from ‘leisure’—the time when the wage slave is in control of his own life—the commercialization of labor and nurtured capitalist individuality by universalizing the quest for pleasure The imperative for accelerated capitalist accumulation has led to rapid urban degeneration and to an increasingly serious multi-dimensional global environmental crisis The capitalist organization of production has also destroyed the family by forcing women into the labour market and commodifying female labor Capitalism requires the creation of dissatisfaction and unlimited wants for sustaining product innovation. This is the main function of the ever growing marketing and advertisement industries. The market is not a want satisfying but a want creating mechanism Capitalist society must destroy Islamic values—zuhd, faqr, qana’at—and create ‘the economic man’. This is necessary for its survival Review Questions Why must the firm maximize profits? Why cannot economics answer the question: “profit maximization for what”? What is a firm? “The profit maximization motive may conflict with the objective of serving Allah”. Discuss. Why cannot Hazrat Usman’s trading business be called a firm? Cause related businesses—such as the KFC restaurant employing deaf waiters—do not abandon profit maximization. Discuss. What is the difference between a plant and a firm? Why is proprietorship an inappropriate legal organizational form for capitalist business? Why is the corporation the dominant and the most suitable form of business in mature capitalist societies? What is the meaning of the ‘separation of ownership from control’ and why does this enhance the appropriateness of the corporation as a capitalist form of ownership? “Capital is the real owner of the corporation”. Discuss. What is capitalist property and what determines its value? How did the East India Company become a full fledged corporation?

What role does the stock market play in the development of capitalist property? What is capital? Show that the rate of capital accumulation depends upon the velocity of money. Compare and contrast capitalist property and private property. Why does Imam Ghazali recommend that working for one’s living should be limited to the time between Ishraq and Zuhar prayers? Why is wage labor universalized in capitalism? What changes did the universalization of labour bring about in the social organization of the work process and in community life? Why and how did capitalist organization of the work process create leisure? How does the commercialization of leisure promote the development of capitalist individuality? How has capitalism created the modern urban hell How does capitalism destroy the family? “Capitalism creates scarcity. It does not overcome scarcity”. Discuss. Why must capitalist order create “the economic man”? Chapter 10 NEOCLASSICAL THEORY OF PRODUCTION One of the primary objectives of neoclassical theory of production and cost is to show that there is positive relation between price of a commodity and its output produced by firms. This is so because only then it can be shown that supply curves, as drawn in chapters 3 and 4, are positively sloped. As we have pointed out at several places that this model of demand and supply curves represents the theoretical premises for postulating that capitalist social arrangements are merely sum total of utility / profit maximizing agents. It has already been shown in chapter 8 that the demand-half of this model is flawed which means that this vision of economists—both of individuals as freedom maximizers and society as their sum—is fallacious. It is now time to see the validity of the remaining-half of that model. We begin this chapter by examining the neoclassical vision of production activities that take place in capitalist societies. Section 2 and 3 then outline the standard way in which economists model production activities. We would also be pointing out side by side the fundamental short comings of neoclassical production theory. 10.1: The Production Function One of the important aspects of capitalist societies is that the majority of the population has no direct experience and knowledge of how the commodities it consumes are produced. As capitalist production (i.e. for profit-business enterprise) matures, there remains only a small and decreasing minority which is directly involved in the control of production process. To make matters worst, only a minority of that minority has direct knowledge of how factories are designed and managed. In contrast to consumption, the conditions under which commodities are produced are a mystery to most of the population. Economics attempts to unveil this mystery of production-activity. Standard neoclassical analysis of production assumes that the relation between output and input is merely technical one. This means that production possibilities available to a firm are dictated and constrained by the natural forces which are beyond its control; i.e. neither any firm has designed them nor can it alter them. This vision of production spells out the idea that production relations between labor and agents of capital—managers—are determined by physical or natural forces. More will be said on this vision of production relations in later chapters. The production function is the technical concept used to express this vision of production relations. Production function is an abstract way of discussing how the firm gets output from its inputs. It describes, in mathematical terms, the technology available to the firm. It can be written in general form as:

(10.1) This function simply says that the amount of output a firm can produce depends upon the inputs used to produce something. Such a function expresses relationship between inputs and output. As suggested in chapter 3 that production of some commodity, say y, depends not only on the available inputs but also on technology. For the purpose of this chapter, we define technology as ‘profit-maximizing method of combining inputs to transform them into output’. An automobile is not merely the sum of steel, rubber, glass, labor time management skills, etc.; rather only after the firm combines these resources in a specific way that makes it an automobile. Of course, not all combinations of inputs in any form will count as an ‘automobile’. Something is called an automobile only after inputs have been put together in a specific combination. The point to make from this example is that producing something requires not only inputs, but also technique—inputs are like ingredients of a food-recipe while technology as its ‘method’ of cooking; i.e. which ingredient to use in what combination and proportions. Thus, a production function shows how much output a firm can obtain using a specific combination of inputs in order to maximum profits, given the prices of out put and inputs.. In other words, it shows production technology available to a firm. For example, a production function for farmer’s output of wheat during one year might depend upon the quantity of machinery, the amount of labor used on the farm, the amount of land under cultivation, the amount of fertilizers and seeds used, and so on. Now any given amount of output, say 100 bushels wheat, may be produced in different ways. One way is that farmer can use labor-intensive technique that would require only a small amount of mechanical equipments and heavy use of labor (as is the case in most of the rural areas of Pakistan and India). However, it is also possible to produce 100 bushels using large amount of capital equipments (such as tractors, thrashers, etc.) with very little labor (as is the case in America and Europe). All of such combinations are represented by the general production function (10.1). For any combination of land, labor, capital equipments and other inputs, the function records the maximum wheat output that can be produced from those inputs. The important question about the production function from economists’ point of view is ‘how the firm chooses its levels of inputs or input combination’—the problem named as problem of choice of technique by economists. Before we answer this question in the next chapter, let us spell out some details regarding the nature and behavior of this production function in this chapter. Classification of Inputs Equation (10.1) says that output depends upon inputs. But what are these inputs? Typically, inputs are classified into factors of production such as land, labor, capital and entrepreneur by most economics text books. This classification of inputs leaves students wondering about ‘what about material-inputs’ because it is not only the labor and capital, but also raw material also that is needed to produce any given commodity. Generally speaking, we can classify inputs into three broader categories as listed in Table 10.1. This classification is based on (i) whether inputs become part of the output produced (embodied in output), and (ii) whether inputs are able to retain themselves in their original form at the end of production process to be utilized for producing further output, as shown by the third columns of this table. Consider the production of chairs or tables.

Table 10.1: Classification of Inputs S. No Category of Inputs Features Embodied in output Retained after production 1 Material inputs Yes No 2 Factors of Production No Yes 3 Energy inputs No No Note that material inputs, such as wood, glue, nails, foam, polish etc. become part of the output produced; i.e. chairs or tables. Since these inputs are embodied in output, therefore they are no longer available for producing more chairs—wood that is used to make one table changes its shape and cannot be used as ‘a piece of wood’ after the production process ends. On the other hand, inputs such as hammer, saw, carpenter, shop premises, etc. are no longer embodied in chairs and tables produced. The important feature of factors of production is that they, more or less, retain themselves in their original form even after the production process has ended and, hence, are ready to participate in producing more output. Inputs that fall under this category are generally called factors of production. Typically, economists categorize them into land, labor, capital and entrepreneur skill. Finally, energy inputs, such as electricity and gas used to generate power, have also emerged as important determinant of production capabilities. They have distinct feature in the sense that they are neither embodied in output nor retained after the production process. For example, electricity used to operate carpenter’s machines, such as saw, does not become part of the chair. Similarly, the electricity used to run machines is lost once for all. Economists’ Preferred Form of Production Function Our thus far discussion implies that a general production function can be written including all types of inputs, as: (10.2) This function can also be written in many ways, including different combinations of inputs such as shown in these equations: (10.3a) (10.3b) (10.3c) (10.3d) All of them are technically valid production functions and there is nothing to rule out any of them from consideration except the objective of the analyst / policy maker. Micro economists are interested only in the last version (10.3d) of these combinations. The reason for this choice is the property of retainability of these inputs—i.e. they exist at the end of production process. Note that once the commodity has been produced by combining some inputs, the question ‘to whom it belongs to’ or ‘who gets how much of this commodity’ arises. Clearly, inputs that do not retain their form cannot claim its ownership rights—so no point of discussing their share in total output, except counting them as mere expenses. However, the retainability of factors of production begs the question ‘which of them is responsible for producing how much of this commodity’? The question is important because the share of each factor of production depends upon the answer to this question. As outlined in chapter 2 that ‘distribution of income’ has been a major bone of contention in capitalist order. On the one extreme we have Marx who regards labor as the only factor responsible for producing surplus value or profit. To him, therefore, all surplus production should accrue to labor class with all other factors, including capital, receiving only the expenditures incurred upon them—i.e. they are treated just like material inputs. The theoretical foundations of this idea of Marx appeared so rigorous and sound that it generated mass political support among workers of almost all Western European Countries during late 19th and early 20th centuries—Marx made the future of market capitalism look very gloomy. Neoclassical economics was the theoretical response to Marx’s theoretical criticism of capitalist production process. One of the objectives of neoclassical theory of firm is to show that production takes place under harmonious conditions in market capitalism and each participant in this process—land, labor and capital owners—participate on voluntary basis; i.e. no one is forced to do anything for anyone. In other words, all inputs are logically and socially equal and, hence, must be treated symmetrical. Since economists want to investigate, rather formulate, the conditions which dictate the behavior of these factors of production, therefore they prefer to study the behavior of production function involving only ‘factors of production’—of the form (10.3d)—neglecting other inputs as these inputs carry no property claim over the ‘output produced’.

Given this explanation, we can now write the production function as: (10.4) You can see that this function involves five variables; output, land, labor, capital and entrepreneur. As it is difficult to plot all of them in a two dimensional graph, therefore economists write it in a reduced form involving only labor and capital, such as: (10.5) If you see early editions of Samuelson’s book, you will see the production function written with labor and land as its main arguments. It is claimed by the economists that their analysis of production with labor and capital holds no matter which of the two out of these four you put in this function. However, this is an a wing claim as discussed below in this chapter. Behavior of production resulting from land-input may not necessarily hold that for labor or capital in general due to their distinct features. Finally, note that output is normally denoted by Y, while L and K are the standard notations used to denote labor and capital respectively in microeconomics. The production function (10.5) can thus be written as: (10.5) What is Capital? This chapter will expose you to some apparently trivial concepts leaving their analytical importance to be explained to the later chapters. But you must understand and keep them all in your mind, may be at the back, so that you may recall them when asked to do it later on. One of such seemingly unimportant, but devastatingly vital, point is regarding the meaning of the term capital. This term is used to refer two different things in economics: one is a sum of money, called financial capital, and a collection of machines, called physical capital. Neoclassical production function uses this second meaning of capital in expression (10.5); i.e. K refers to the sum of all physical capital. It is in fact a grab-bag for all non-human inputs such as factory building, machines, computers, electric circuitry etc. But if capital refers to physical quantities, then it is impossible to use K as a sum of such input items. The reason for this impossibility is given by the fact that different units of capital are measured in different measurement scales and, hence, it is impossible to obtain an aggregate measure of them by summing them all. For example, it is literally impossible to add two machines and, say, one story building. Thus K can never be measured in physical terms. If not this, then it must be a value concept. The only way to sum up all differently measured units of capital is to add their values (price of capital multiplied by its physical quantity) instead of their physical quantities. That capital must be a value expression and not physical quantity is so obvious that all big neoclassical economists know it, at least, today because this issue had been decided as early as in 1960’s after a well known debate lost by neoclassical economists, namely capital controversy—a debate in economics that occurred during the 1960s concerning the nature and role of capital goods, largely between economists such as Joan Robinson and Piero Sraffa and Luggi Posunetti at the University of Cambridge in England and economists such Paul Samuelson and Robert Solow at the Massachusetts Institute of Technology in Cambridge, USA. It is thus sometimes called the Cambridge Capital Controversy (CCC).

But pick up any well known economics textbook and you will see its author interpreting K as physical quantity. The reason for this intended negligence is that once it is accepted that K is necessarily value and not quantity; then all of neoclassical theory of production as well as theory of income distribution becomes irrelevant (see chapter 16 for detailed discussion on this issue). This is one of the major and fatal short comings of neoclassical economics that capital cannot be treated as physical quantity in production function as against labor that can be expressed in physical terms (let us say in hours, or days of work). Therefore, the two inputs; labor and capital, cannot be treated symmetrical to each other—there must be a well defined hierarchy between the two factor inputs, something that microeconomics completely assumes away in order to save its fallacious ideology. But not surprisingly, economists continue with their mysterious production function to analyze the behavior of production. Short Run and Long Run for Firm Before we begin the formal analysis of the behavior of this function, we must note that it can be analyzed in two ways: changing all of the inputs at a time, and changing only one of them while keeping other constant. This distinction is important because capitalist production decisions are usually taken at two levels of planning horizon; long-run and short-run. The overall design of a production facility, the technology to be used, its capacity and location, and the types of man power to be employed are planned over the long run. On the other hand, there are also some short-run decisions that are to be taken on immediate basis; such as how many hours to work this week or month, how many workers to use, what pieces of equipment to take out of use, and so on. In brief, some factors of production are not going to be changed continually whiles others are subject to more frequent changes. The short-run is the period of time during which the firm can’t easily adjust its fixed factor(s). In a two input production function like (10.5), it is the duration of production horizon when at least one input is a fixed factor. In this time duration, adjustments to changes in production capacity could only take place by varying the use of variable factor. On the other hand, long run is the time when all inputs can be adjusted. It is highly important to keep in mind that short-run and long-run are not defined in terms of time-duration; rather they are discussed in terms of flexibility of inputs. The question ‘how long is the short-run’ can’t be answered in some clock-time; say one day, one week, one month or one year. The time it takes firms to change all its inputs is short-run time, no matter whether it takes them one day or one year. This is because the exact duration of time in which firms can change all of their inputs varies from business to business. See Application Box 10.1 to read how time-frame of short-run varies as the nature and scale of business varies.

A P P L I C A T I O N B O X 10.1 Time Horizon of Short-Run and Scale of Production Consider cars’ production plant, say of Honda or Toyota. After the easy credit-facilitation and car financing policies by banks in 2004, the demand for cars has increased rapidly in Pakistan. Such a rise in demand for cars also requires expansion in the production capacity of motor-car companies. However, it is not possible for companies to expand their plant size immediately as it requires constructing new building area for plant, buying and installing heavy and expansive machines. It takes not only money but also time for all this to happen. But how can then companies meet the extra demand in short run using their existing plant size? They might force their assembly line to work over time; or they might continue operation in two or three shifts. This is the best they can do in short run as long as one of their factors input is fixed. In motor car industry case, the duration of short run would be one to two years. But this would not be the case for all business ventures. For example, think of a Thela (ٹھیلہ) business (suppose you sell burgers on Thela) and assume that your business begins to shine. In this case, your capital would mainly comprise of thela. As the demand for your burger increases, it would become more and more difficult for you to run the business on a single thela. If you are not a profit-maximizer and do this business merely to serve your family with a given basket of goods, then you would be more than happy to see all your burgers being sold out quickly everyday leaving with you much time, say, for the service of Islam and offering Nawafil (نوافل). On the other hand, say, Laloo is running this business for the sake of maximizing profit, then he might see the success of his business as an opportunity to plug in one more thela into it. How long would it take him to bring or hire an additional thela? May be two or three days; and of course not more than a week. In other words, the short run for thela business is seven days at maximum because it is for seven days that he cannot change his fixed input. Thus, the examples in Box 10.1 show that the exact time duration of ‘how long is the short-run’ depends upon ‘how long it takes firms to change all these inputs’—i.e. how quickly they can vary their its production scale to adjust all inputs in production process. One question might be teasing you and that is ‘what are the factors that affect the flexibility of inputs in production process and, hence, prolong the time-duration of short-run?’ In other words, what are the factors that determine ‘how quickly firms can change all of their inputs in production process?’ Broadly speaking, there are two determinants of the flexibility of inputs: (1) scale of production; the larger the scale of production, the longer it takes firms to build new factories, purchase more capital equipments and hire more labor to increase its output, (2) complexity of production technology; the more sophisticated the technique and skills required for production of a commodity, the more difficult it is for firms to increase all inputs.

We now begin developing the formal neoclassical model of production technology. The simplest model involves a single variable input and single output. This model is used to study the short-run behavior of production process with other factors of production held fixed. 10.2: Production with Single Input Variable: Short Run Analysis As explained above that in the short-run one of the inputs is held fixed. Thus the production function (10.5) for short run would be: (10.6a) (10.6b) where line over K in (10.6a) indicates that capital is assumed as fixed factor of production. Additional output can be obtained only by changing the labor input. For example, each year a farmer must make the decisions about what corps to put on a given amount of land. Assume that labor is the only input used besides land ignoring the possible use of chemicals, pesticides, or machinery on the land. In this case, the short-run production relates the quantity of output that can be produced by the use of a specific quantity of labor. Since K is held fixed and cannot be changed in short-run, therefore we can write short-run production function with labor as its only argument as in (10.6b). However, the omission of K from this expression does not mean that capital is absent from production process; rather it simply means that it has been given in some fixed amount to be combined with changing amounts of labor input. Now the important question to understand the relationship between output and input is ‘how output will respond to changes in labor input; i.e. what happens to output when labor input is increased?’ Just note here that the relationship between output and input is viewed by economists as technological one—dictated by the constraints of nature and natural laws and our knowledge of that law and how to make use of that knowledge. We discuss the problems associated with this vision of production relations in chapter 16. 10.2.1: Returns to Factor Input To answer the above question, begin by thinking what if no labor is used? Obviously, no output would be obtained because labor is required to harvest corp. From here we know that the production function must start from zero: i.e. output would be zero at zero level of output. If we plot this information in a labor-output (L-Y) space of figure 10.1, then we are at the origin, 0. To draw a curve in this space, we must know what happens to output when labor is increased? It is expected that output will increase with each additional unit of labor added into the production process. In other words, if labor is changed by some positive amount (ΔL > 0), then output will also change by a positive amount (ΔY > 0); increase in labor will increase output and not decrease it. This implies that the slope of production function drawn in figure 10.1 must be positive: (10.7) It says that change in output induced by increase in labor is positive—both move in the same direction. Note that the extra output given by an extra unit of labor is termed as marginal product of labor. We encountered the term ‘marginal’ in chapter 6 as well where we discussed it in terms of marginal utility—described as extra utility given by an extra unit of consumption of a commodity. So, in terms of the slope of production function, we find that:

(10.8) which simply says that marginal product of each input should be positive—output must increase when more inputs are added to production process. One can, at this moment of analysis, pose a valid question: why is it the case that we assume output to increase after increasing input; i.e. what is the justification for this assumption? Note that the restriction of positive marginal product is no longer some physical or natural necessity that must hold in all cases. Physically, it is quite possible for an input not to produce any amount of output or even make it to fall. For example, if an additional worker just keeps sleeping all the times during work-hours, there is no way that its marginal product could be positive. The point to make is that the status of the assumption of positive marginal productivity is not of some natural law like that of gravitational force. Rather its justification lies in the fact that economic analysis of production function is carried out from the point of view of profit maximizing firm; and no profit maximizing firm would ever hire an input that has zero or negative marginal productivity. This is simply because if each labor is hired at some positive cost (i.e. if its wage is positive), then zero marginal productivity of an input means cost is increasing without increasing the value of the output of the firm and, hence, profit would fall. Thus, the possibility of zero or negative marginal productivity is not consistent with profit maximization and, hence, it is ruled out from the domain of economic analysis. See Application Box 10.2 to understand why the rule of ‘positive marginal productivity’ is necessary for sustaining capitalist production system. After clarifying the justification of this assumption, let’s go back to the concept of marginal product again. A P P L I C A T I O N B O X 10.2 Negative Labor Marginal Productivity in Labor Surplus Economies: The Lewis Model W. Arthur Lewis, a Noble prize winning West Indian economist, argued that in developing countries the marginal productivity of agricultural labor was normally negative. For example, the farmer’s seventh son in Tharparker contributes nothing to the production of the farm, he actually gets in the way of the other six sons and thus reduces aggregate production—his marginal productivity is therefore negative. According to Lewis this provides an opportunity for turning the non profit-maximizing non capitalist farm into a capitalist one and also aids the development of a capitalist economy in Pakistan. Move the seventh son to Hyderabad. He will have to work as a laborer in a capitalist firm producing, say, glass work. Moreover the output of the farm in Tharparker will also increase (because the seventh son’s MPL was negative). The farm will therefore produce a surplus which it will have to sell on the, say, grain market. The farm will thus become subject to the discipline of the market. It will be thus forced to organize production on capitalist lines, hence, becoming a capitalist farm. It will no longer permit the seventh son to return to Tharparker. This is the message of the Lewis Model.

Before considering a numerical example to understand the idea of marginal productivity, look at the slope term (10.7) again. From the positive sign of this function, we can infer that the curve drawn in L-Y space will be positively sloped—it will be a rising function. However, the mere information that the slope of production function is positive is not enough to draw the exact curve in this space. This is so because there are many possible shapes of a curve that can have positive slope, as three of them are shown in figure 10.1. Note that all of them are positively sloped but with different patterns of slope: (a) has decreasing positive slope [it is because its tangent is getting flatter], (b) has a constant positive slope while (c) has increasing positive slope [it is because its tangent is getting steeper]. So which of these curves represents the exact relation between labor and output? What other information is required to draw the exact production function? Figure 10.1: which one is the production function?(a) Positive but decreasing slope0LabourTotal Output(b) Positive but constant slope(c) Positive but increasing slope Figure 10.1: which one is the production function? (a) Positive but decreasing slope 0 Labour Total Output (b) Positive but constant slope (c) Positive but increasing slope Diminishing Marginal Product It is believed by the economists that the productivity of each input decreases as we keep on adding additional unit of an input with some fixed factor in production process. To understand this idea, suppose that a farmer has got a fixed one-hundred hectares of land to produce wheat. The only way he can produce more wheat is by hiring more laborers to work on this fixed piece of land. Now ask yourself: what happens to wheat output as more and more labor is added on fixed land? Initially, it is possible that output may increase rapidly when you add the second or the third laborer because one farmer may not to use the land properly as it is too big a piece of land for him to work on properly. This is shown in the third and forth columns of Table 10.2. Output increases from 10 to 24 kg when second labor is added in production process. The change in output (ΔY = 14) due to change in labor (ΔL = 1) is the (marginal) product of second laborer has produced 14 kg wheat. Similarly, the (marginal) product of third farmer is 18 kg—greater than that of second one. Note that marginal product is increasing up to third labor unit in this table. Economists argue that this rising tendency of output cannot continue infinitely because, if it so happens, then it implies that all of the world wheat production will be undertaken at a fixed piece of land—keep on adding more and more labor on this fixed land to obtain higher and higher output every time. This means that after a certain point, though the extra farmer will add some positive amount of wheat in total production, however its contribution will be less than that of the previous farmer. This tendency can be seen in this table from the forth laborer onwards. You can see that change in output due to each additional farmer is becoming smaller and smaller as more farmers are added onto the fixed land. In other words, marginal product of an input ultimately starts decreasing.

Table 10.2: Total and Marginal Productivities Capital K Labor L Total product Marginal product Capital-Labor Ratio 100 0 0 - - 100 1 10 10 100 100 2 24 14 50 100 3 42 18 33.33 100 4 54 12 25 100 5 62 8 20 100 6 68 6 16.66 This tendency is called diminishing marginal product of a factor which refers to the economic assumption that output obtained from each extra unit of variable input will be less than its previous unit in production process—i.e., output will increase after each additional dose of an input, but at decreasing rate. When we plot these numbers, we get the shape of production function as drawn in figure 10.2. Figure 10.2: A typical production function60Typical production function400LabourTotal Output123456102442546220306850 Figure 10.2: A typical production function 60 Typical production function 40 0 Labour Total Output 1 2 3 4 5 6 10 24 42 54 62 20 30 68 50 50 50 It should be noted that this would not be a straight line because in that case its slope would be constant at all points and this can be the case only if we assume that marginal product is constant—remember that the slope of production function (ΔY / ΔL) is also the marginal product of input. Since we assumed above that marginal productivity may increase initially and then ultimately decrease, this implies that the slope of total product curve (or production function) will increase initially for some units of labor and then start decreasing thereafter. What is the rationale for such a behavior of production function? According to standard economic justification, the productivity of each additional worker decreases because the ratio of worker—the variable input—to machinery—the fixed input—decreases as more workers are added on fixed capital. To see this, note that the capital-labor ratio is given by: (10.9) With K being fixed along the production function in figure 10.2, adding more labor means the ratio K / L decreases as shown in the last column of Table 10.2. This column measures the capital-labor ratio—the average amount of capital available to each worker. The economic plea for diminishing marginal productivity is that productivity of additional worker falls after capital-labor ratio has exceeded some optimal level. The idea is that each machine produces at its most efficient level when a particular number of workers are operating it; i.e. say productivity of machine is highest for K/L* capital-labor ratio. We can now see that when: actual K/L < K/L* → productivity of additional variable input increases because capital is underutilized actual K/L > K/L* → productivity of additional variable input decreases because capital is over-utilized actual K/L = K/L* → productivity of additional variable input is maximum In other words, it is the variability in the proportion of variable-to-fixed factor that affects the productivity of a variable input; i.e. diminishing marginal productivity arises due to diminishing capital-labor ratio. Production Functions without Diminishing Marginal Product Assumption What would a production function look like if we drop the assumption of diminishing marginal product? Recall from your intermediate mathematics course (or see Appendix to chapter 1) that the slope of a curve at any point is given by its tangent (a 90o straight line drawn) at that point. Also recall that a steeper line means a greater value of slope while a flatter line indicates a smaller value of slope. Given these relations, consider figure 10.3 which gives three possible shapes of total product curve. If marginal product is assumed to be constant, then the slope of total product curve would be constant and the resulting production function would look like a straight line as shown in panel (a). On the other hand, if marginal product is ever increasing, then the tangent of total product curve would be getting steeper which implies that the slope of total product curve would be ever increasing as in panel (b). Finally, if marginal product is always decreasing, then we get a decreasing slope production function of panel (c). All of these three shapes can be possible production functions depending upon what we assume about the behavior of marginal product and economists’ preferred assumptions about it are that ‘it increases initially but then decreases forever, other things remaining the same’.

Figure 10.3: Production functions under different marginal product behaviours(a) Constant MP production function0LabourTP(b) Increasing MP production function0LabourTPab(c) Decreasing MP production function0LabourTPcd Figure 10.3: Production functions under different marginal product behaviours (a) Constant MP production function 0 Labour TP (b) Increasing MP production function 0 Labour TP a b (c) Decreasing MP production function 0 Labour TP c d These tendencies are debugged in the law of returns to factor inputs or law of marginal productivity which states that as you increase the quantity of a variable factor while keeping other factors fixed, the returns (in terms of output) on extra unit of input may increase initially but keep on decreasing thereafter. These two tendencies are termed by economists as the laws of increasing and diminishing marginal productivity or returns to a factor input. The importance of these assumptions would become explicit when we analyze the neoclassical theory of supply in chapters 11 and 12. There we show how vital and precious the assumption of diminishing marginal product is for the survival of economic theory—once this assumption is lost, all of the economic theory of firm and production is lost into air. Deriving Marginal Product Curve If we do accept the economic argument that marginal productivity rises initially to decrease ultimately, then production function should like as in panel (b) in the initial stages of production but then takes a shape of panel (c). Combining these two segments we get a typical production function just like the one drawn in the upper panel of figure 10.4. Note that the tangent of this curve is becoming steeper initially (i.e. its slope is increasing) and then starts flattening after reaching its maximum steepness at point b. The below panel draws the resulting marginal product curve of labor against units of labor derived from the above total product curve. We can see that marginal product is maximum at point b (exactly the same point where tangent of total product curve takes maximum steepness, hence implying maximum value of slope or marginal product). It then starts decreasing after point b, such as shown at point c. Theoretically, it is quite possible that marginal product may reach zero or is negative at some quantity of labor units, but from economic point of view, the relevant range of the production function is the one where marginal product is strictly positive. This is so because after that point, total output starts decreasing as more labor units are brought into production process. We have now reached the point where it would be appropriate to spend some on evaluating how sound the assumption of diminishing marginal productivity is. Figure 10.4: Total and marginal product relationInitially rising MPL0LabourMPLbUltimately falling MPLThe typical production functionLabourTPabcLaLbLcyaybyc Figure 10.4: Total and marginal product relation Initially rising MPL 0 Labour MP Lb Ultimately falling MPL The typical production function

Labour TP a b c La Lb Lc ya yb yc 0 0 10.2.2: Evaluating Diminishing Marginal Productivity However, the justification offered for diminishing marginal productivity is not very convincing. Firstly, adding additional units of labor (variable input) to capital (the fixed input) makes little sense in reality because most machines are built to operate with a fixed number of labor units—i.e. with a given capital-labor ratio. To explore this idea fully, just reverse the capital-labor ratio (10.9) to obtain labor-capital ratio as: (10.10) which measures the number of workers operating per unit of capital. Imagine for example a firm that digs holes using jackhammers. Figure 10.5: Neoclassical story of production(a) Ideal worker-machine ratio = 1:1(b) Six Jackhammers are available to firm(c) Initially one worker is hired to operates all jackhammers(d) Ideal worker-jackhammer ratio case????(e) MPL falls when worker-jackhammer ratio is greater than 1 Figure 10.5: Neoclassical story of production (a) Ideal worker-machine ratio = 1:1 (b) Six Jackhammers are available to firm (c) Initially one worker is hired to operates all jackhammers (d) Ideal worker-jackhammer ratio case ? ? ? ? (e) MPL falls when worker-jackhammer ratio is greater than 1 There is obviously an ideal worker-to-machine ratio where productivity is maximum; say one worker per jackhammer as shown in part (a) of figure 10.5 which depicts the whole story. Suppose that firm has six jackhammers available with it for production (i. e. digging holes). The standard way in which economists model the production decision of the firm is to assume that the firm would initially hire one worker to operate six jackhammers. In other words, worker to jackhammer ratio in this case would be 1-to-6. But this would of course be very inefficient way of utilizing six machines, so firm would hire more workers. Adding additional workers might show increasing productivity per worker for a while (i.e. marginal productivity may increase initially), because, say, two workers operating 3 jackhammers each would be less messy than one operating 6; and so on for three workers operating two each. Eventually, an ideal ratio is reached when six workers are working on six jackhammers; or when worker-to-machine ratio is 1 [as in part (d)]. If firm wants to dig more holes, it has to hire more workers and, hence, operate at more than one worker per jackhammer [see part (e)]. Economist would argue that more total holes can be dug with 2 workers per jackhammer than with one, but productivity of two workers per jackhammer would be less than one worker per jackhammer. In other words, rate of increase in output would start decreasing. But does such a modeling of production make any sense to you? Clearly not, as it is merely non-sense to use all jackhammers when less than six workers are in operation and only an irrational manager would utilize his resources in this way. The only rational way for firm is to work at one worker per jackhammer: if it has less than six workers, why put all jackhammers at operation? On the other hand, operating at more than one worker per jackhammer is not a desirable combination for firm to function with because this will simply increase to its cost: why hire two people to use one jackhammer when one person can do the same job?

Piero Sraffa was the man who successfully disputed the standard economic modeling of production right back in the 1920s. He argued that a firm is likely to produce at maximum productivity right up until the point where diminishing marginal productivity sets in. Any other pattern of production means the firm’s behaving irrational (i.e. in a non profit maximizing). The crux of his criticism is that there is no sense in using every last inch of ‘fixed factor’ if demand is less than capacity—a point that neoclassical production analysis misses altogether. To understand the logic of this idea, let’s compare the production decisions of a neoclassical manager and a Sraffian manager. Consider a wheat farm of 100 hectares where one worker per hector produces an output 1 bushel per hectare, 2 workers per hectare produce 3 bushels, and so on as shown in the data given in Table 10.3. Note that marginal productivity of the variable input is maximum when workers are spread on this land such that each hectare of the farm is operated by four workers; i.e. when L/K ratio is 4. Table 10.3: Productivity Data Worker per hectare L / K Bushels per hectare Y / K Productivity of extra worker 1 1 - 2 3 2 3 6 3 4 10 4 5 12 2 Now assume that a farmer has 100 workers available to work in this farm. How should he use them? According to neoclassical manager, he should spread them out in 100 hectares which means that labor-to-capital ratio would be 1 worker per hectare (= 100 workers / 100 hectares). When operating in this way, total wheat production will be 100 bushels because one worker per hectare produces 1 bushel per hectare. This can be calculated as: On the other hand, a Sraffian manager would ask farmer to leave 75 hectares of the farm idle, and utilize only 25 hectares with 100 workers. With this combination, worker to capital ratio is 4 (100 workers / 25 hectares). What would be the output produced in this case? Note that with 4 workers per hectare, output per hectare is 10 bushels per hectare. So, output is given by the above expression as: Clearly, the farmer that behaves according to the Sraffian manager’s advice comes out 150 bushels ahead of farmer who listens to neoclassical manager. Similarly, if farmer had 200 workers, economic theory implies that he would spread them over 100 hectares so that 2 workers are now working per hectare producing an output of 300 bushels (= 3 bushels / hectares × 100 hectares). Table 10.4: Outcomes of Neoclassical and Sraffian Decision Makers With Neoclassical manager Sraffian manager Difference in output 100 Workers Hectors used 100 25 L/K 1 4 Y/K 1 10 Total Output 100 250 150 200 Workers Hectors used 100 50 L/K 2 4 Y/K 3 10 Total Output 300 500 200 300 Workers Hectors used 100 75 L/K 3 4 Y/K 6 10 Total Output 600 750 150 400 Workers Hectors used 100 100 L/K 4 4 Y/K 10 10 Total Output 1000 1000 0 But according to Sraffian manager, a sensible farmer would instead leave 50 hectares unused; utilize only 50 hectares so that L/K ratio is 4 workers per hectare again—where productivity is maximum. With this Sraffian scheme, output would be 500 bushels (= 10 bushels / hectares × 50 hectares), again getting 200 extra bushels. The same pattern continues right up to the point where 400 workers are employed after which finally the diminishing marginal productivity begins to start. Table 10.4 summarizes the outcomes of both managers in terms of total output produced. Plotting the resulting total output in both scenarios (the italicized numbers in the above table) against number of workers give figure 10.6.

Figure 10.6: Comparing neoclassical and Sraffian production functions750Sraffian PF5000LabourTotal Output1002003004002501001000300600Neoclassical PF Figure 10.6: Comparing neoclassical and Sraffian production functions 750 Sraffian PF 500 0 Labour Total Output 100 200 300 400 250 100 1000 300 600 Neoclassical PF The shaded area (area between Sraffian and neoclassical production function) indicates the output lost by a farmer who utilizes all of the fixed resource all the time, rather than leaving some of it idle until it reaches at maximum productivity. A rational firm having a fixed resource would leave some of it idle when operating below its optimum scale. This implies a straight line production function as shown by the dotted line here. Therefore, we can conclude that diminishing marginal product does not apply in the real world because modern engineering allows factories to be designed in such a way as to avoid the problem that economists believe force productivity to fall. Factories are designed with significant excess capacity, and are also designed to work at high efficiency right from low to full capacity. Only products like oil that can’t be produced in factories or farms are likely to show production behavior the way economists expect. This point might seem trivial at this point in our analysis, but we will see in the coming chapters how crucial this point is for the demolition of neoclassical theory of firm. Let’s, for the time being, return to the standard analysis of production function as drawn in figure 10.2. But before that, it would be good for you to know that if diminishing marginal productivity assumption is unwarranted in reality, then from where did this assumption come into economics? Read FYI Box 10.1 for the historical origins of this concept and then move on to the standard analysis. F Y I B O X 10.1 Origin of Diminishing Marginal Product Assumption The concept of ‘diminishing marginal productivity’ of labor, as well as of capital, has been taken from Ricardo’s application of this concept for land in order to explain the theory of rent (briefly discussed in chapter 2). The set of economic theories that were proposed in the late 19th century and were described as a “marginalist revolution” focused precisely on the generalized application of the “marginal principle”. This was introduced first to account for consumer behavior (the theory of marginal utility as discussed in the previous part of this book); then it was applied, by extension, to the theory of production and distribution (and not only to land and rent). The use of the marginal principle in the theory of production and distribution did not come about as a result of any new observations of reality by the neoclassical economists. It came about (as the economist Pasinetti puts it) merely by analogy, as a convenient, indeed as an elegant, aesthetically attractive, extension of Ricardo’s principle of diminishing returns (originally concerning land alone) to all the resources in existence. As industrialization spread from Great Britain to the continent, the emphasis of economic theory naturally shifted from agricultural to industrial production. The accumulation of capital, much more than the extension of the cultivation of land, increasingly came to be at the centre of the economists’ attention.

However, the extension of this principle into labor and capital required the formulation of a series of assumptions which gave these factors of production characteristics similar to those of land (in order for them to be treated, so to speak, as if they were land). The consequences of this “adjustment” of capital to land, though good for some fictitious analytic purposes, proved to be unexpectedly loaded with serious negative consequences that are detailed out in chapter 16. The underlying reason for these problems has already been pointed out above during our discussion on production function. It is never correct to treat capital as if it is land because both of these two types of aggregate quantities belong to two different logical classes—land and labor are expressed in physical terms while capital is necessarily expressed as value—and can thus neither be placed on the same level nor be inserted symmetrically in the same function. This fundamental mistake of neoclassical economics was for long neglected until the 1960’s when it was once and for all proved that the microeconomic theory of production and income distribution is based on fundamentally faulty assumptions. 10.2.3: Relationship between Marginal and Average Products The typical (microeconomic) shape of production function generates a particular type of relationship between marginal and average products of an input. Average product is given by total output divided by total units of an input employed in production process. Table 10.5 calculates average product of labor in the forth column using the same set of data as in Table 10.2. For example, average product of two farmers is 12 kg wheat/farmer; i.e. if two laborers together produce 24 kg wheat, then on average each of them produces 12 kg. Remember that average is a total concept (total output / total labor-units) while marginal is a change concept (change in output / change in labor-units). Table: 10.5: Marginal Average Relationship Labor L Total product Marginal product Average product Marginal-Average Relation 0 0 - - - 1 10 10 10 - 2 24 14 12 MPL > APL, APL 3 42 18 14 MPL > APL, APL 4 54 12 13.5 MPL < APL, APL 5 62 8 12.4 MPL < APL, APL 6 68 6 11.33 MPL < APL, APL For instance, the number 12 in the average product column (against two labor units) measures average productivity of each farmer, while the corresponding number 14 in marginal product column shows the additional output obtained from the second farmer. To clarify the difference between them, think of the statistics of a cricket batsman which are shown on TV screen when he makes his appearance in ground for playing his innings. Suppose his career average is 30 Run per match. This number simply indicates that if we spread his total number of runs equally on his total matches, then he has scored 30 runs in each match. This is what average stands for. However, the runs that he scores in his next match would be his marginal runs—change in his total runs / change in his matches. Be very clear about the meaning of these two concepts.

Now the formal relationship between these two magnitudes is shown in the last column of Table 10.5. You can see that as long as the next marginal number is greater than previous average number, average is increasing. On the other hand, when the next marginal number is less than previous average number, average is falling. For example, the average product of two farmers is 12 kg wheat / laborer, but the marginal product of the next laborer, third one, is 18 kg which is greater than 12 kg wheat/laborer, the average product of three laborers will increase from 12 to 14 kg wheat/farmer. The same holds for all next numbers. The general relationship between them can be expressed as: f MPL is greater than APL → APL increases (10.11a) If MPL is less than APL → APL decreases (10.11b) If MPL is equal to APL → APL is constant at its maximum point (10.11c) The first two of these two statements can be observed from the above Table. What about the last one? Consider the cricket batsman’s example again whose average score was 30 runs per inings. Now think what will happen to his average if his marginal score—runs that he scores in the next match—is more than 30 (say he scores 35 runs). Clearly, his average will increase. Similarly, if his marginal runs fall short of his previous average (say he scores 20 runs), then his average will decrease. Finally, if he happens to score exactly 30 runs in his next match, then his career average will remain unchanged. This is a straight forward logical relation between average and marginal magnitudes of any function. However, the last phrase ‘at its maximum point’ of the third statement ‘APL is constant at its maximum point’ is yet not clear from this example. This can be seen by plotting the two magnitudes, average and marginal, against labor in the same diagram, as in figure 10.7. The dotted line shows the average product curve in this graph. Note that average product curve is rising as long as marginal product curve is above average product curve. On the other hand, it starts decreasing when marginal is less than average. This means that marginal product curve will intersect average product at its maximum. Figure 10.7: Marginal-Average relationMPL curve10e0LabourMPL, APL12345651520APL curvefMPL > APL, so APL risesMPL < APL, so APL fallsMPL = APL,so APL at its maximum Figure 10.7: Marginal-Average relation MPL curve 10 e 0 Labour MPL, APL 1 2 3 4 5 6 5 15 20 APL curve f MPL > APL, so APL rises MPL < APL, so APL falls MPL = APL, so APL at its maximum This idea is further developed in figure 10.8. Panel (a) shows the situation where average product is increasing even when marginal product is less than average (look at the range above La). Clearly this cannot be the case: how can average increase while marginal is less than it? On the other hand, panel (b) shows another incorrect situation where average product curve starts decreasing when marginal product is still greater than average: average cannot decrease as long as marginal is greater than it. Finally, panel (c) draws the correct diagram where marginal product curve is intersecting average product at its maximum. The reason behind this relation is that to the left of intersection of the two curves, marginal is greater than average, so average must be rising. On the other hand, to the right of their intersection, marginal is less than average, so average must be falling. This implies that average must be at its peak where the two curves intersect each other.

Figure 10.8: Deriving correct marginal-average relation0Lc(c) Correct LTPMPLAPL(b) Incorrect0LTPMPLAPLLb(a) IncorrectLa0LTPMPLaAPL Figure 10.8: Deriving correct marginal-average relation 0 Lc (c) Correct L TP MPL APL (b) Incorrect 0 L TP MPL APL Lb (a) Incorrect La 0 L TP MPL a APL Stages of production The marginal-average relation is often used by economists to classify production into three stages: Stage 1: MP > 0 and AP rising, thus MP > AP Stage 2: MP > 0 and AP falling, thus MP < AP, but TP is increasing because MP > 0 Stage 3: MP < 0, so TP is falling These stages are depicted in figure 10.9. We saw earlier that marginal product is maximized at point a, while average product is maximum at point b where MP = AP. Note that total output reaches its maximum at c, thus marginal product becomes zero at this point in the below panel. Such a division of production process in three-stages helps identify the relevant range in which a profit-maximizing firm would try to operate. To see this, note that no profit-maximizing producer would like to produce in stage 1 or 3. This is so because in stage 1, average productivity of inputs is increasing, so they can benefit by adding one additional labor unit because this will increase the average productivity of all inputs. Figure 10.9: Depicting stages of productionaAPL0LabourMP, APLbMPLLaLCLabourTP0bLaLbLCcStage 1Stage 2Stage 3 Figure 10.9: Depicting stages of production a APL 0 Labour MP, AP Lb MPL La LC Labour TP 0 b La Lb LC c Stage 1 Stage 2 Stage 3 Therefore, it would be irrational (unprofitable) for the capitalist firm to stop producing in this stage 3, it is clear to see that it does not pay producers to operate in this region because marginal product is negative here which means total output actually decreases as more laborers are hired in this region. In fact, they can increase total output by reducing the labor inputs, and hence can save cost of hiring those extra labor units. Thus we find that the economically meaningful range of production is given by stage 2. Note that this diagram (10.9) cannot tell us anything about the non profit maximizing non-capitalist producer. Abdullah Zaghazai may produce below the point at which profit / production is maximized (Stage 1) if he is undertaking production to satisfy his very limited needs because he practices tawakkul and stops economic activities as Imam Ghazali advises as soon as he has enough earnings to meet his meager and continuously decreasing needs. On the other hand, Abdullah Zhaghzai may also produce in Stage III and cheerfully accept a loss due to revenue fall if expansion of such loss making production is necessary to sustain the jihad in Afghanistan. This shows us that the microeconomic analysis of production—like the microeconomic analysis of consumption—attempts to explain the behavior of only capitalist (profit / utility maximizing) individuals. It cannot explain the behavior of Abdullah Zhaghzai or of any member of his family—are you not one of his relatives? 10.3: Production with Two Inputs Variable : Long Run Analysis

When it comes to analyzing properties of production process by changing all inputs at a time, the first step is to obtain some graphical tool to represent this scenario. After allowing both inputs to change at a time, the production function takes the form: without bar over K this time. Note that we have three variables in this function (Y, L and K) while we have only two-axes in a two-dimensional graph. What to do now? One possibility is to use three-dimensional graph which, however, in itself is a source of difficulty for students to grasp it properly. So the problem is ‘is it possible to project three variables in a two-dimensional graph?’ Yes, the technique is to hold one of them constant at some desired level and then find the values of the other two variables that are consistent with this constant value. It is exactly the same technique that we employed while drawing indifference curves which represented all the two-dimensional consumption bundles equally valued by a consumer. To begin with, assume that a firm wants to produce some target level of output; say Yo (may be 10 or 20 units of some commodity). In order to produce this much output, the firm needs to utilize some units of labor and capital. Suppose that it can produce this much output level by combining 4 units of capital with two laborers. This information is recorded as . Point A in the left panel of figure 10.10 gives exactly the same information. Note carefully that output is not shown on any of the axis of this diagram; it comes into perspective by the idea that any given combination of inputs would produce some level of output and here it is assumed to be Yo. However, in principle, A is not the only way by which society or firm can produce Yo level of output. There could be some other ways, or technologies, as well that can produce the same level of output. One of such method is shown in the right hand panel of this figure which combines 4 capital units with 3 of laborers. Now the question is ‘which of these two techniques of production, A and B, are desirable for the profit maximizing firm (or for the society which is merely a toal of profit maximizing firms and utility maximizing individuals - i.e. civil society). It is clear that the answer to this question depends upon the objective for which the production process is being organized in any society. From the point of view of capitalist-firm—one that organizes production for the sake of maximizing profit—technique B is clearly inefficient method of production as it utilizes more inputs to produce same output level. Figure 10.10: Modeling two inputs production techniquesAL = LabourCapital = K4204 units of K and 2 of L producing Yo outputBAL = LabourCapital = K420Another method of producing Yo output3 Figure 10.10: Modeling two inputs production techniques A L = Labour Capital = K 4 2 0 4 units of K and 2 of L producing Yo output B A L = Labour Capital = K 4 2 0 Another method of producing Yo output 3 The capitalist firm will never employ such a technology of production as it argues like this: ‘why hire an extra laborer to produce exactly the same level of output when we can go without it’. From its point of view, combination B is desirable only if it yields more output profit as compared to A. If output is exactly the same at A and B, it means that no extra output is obtained by hiring an extra unit of labor. In other words, the marginal product of third labor would be zero in this case. And, as discussed above, a profit-maximizing firm would not hire the input unit that has zero marginal productivity. So, technique B is not desirable from capitalist firm’s and society’s point of view if it brings it same output as technique A. Further note that as long as we assume that a firm always employs a technology to combine inputs in such a way that the marginal product of each unit of an input is strictly positive, then it is not possible that combinations A and B yield the same level of output for this firm. If technology of this firm is such that the third unit of labor also adds some positive amount in total output (i.e. its MP > 0), output at point B must be greater than output at A.

However, if a society organizes production for some other objective than maximization of profit—as is normally the case in non-capitalist societies—then we cannot regard B as inferior to A. Moreover as our discussion of the Lewis Model (Application Box 10.1) shows moving resources out of sectors characterized by negative marginal productivity of labor in developing countries is advocated as a means for transforming non-capitalist economies and societies into capitalist ones. Some microeconomic analysis of mining investment have shown that capitalist firms tolerate profit loss in the short run to generate maximum profits in the long run. A P P L I C A T I O N B O X 10.3 Capitalist Vs Non Capitalist Technologies of Production The statement that ‘technique B is superior to A’ holds only within capitalist society where production takes place for maximizing profit. However, it does not hold in non-capitalist societies. Consider a traditional religious society where people prefer to live together in a joint family (برادری) system. In such societies, production process is normally undertaken on family-basis; the Zhaghzai tribe for example. People of such societies do not organize production for maximizing profit, rather for providing their livelihoods by involving as many of their family and community members in production process as possible. When young boys reach the age of maturity, they are supposed to go to the fields with their elders in order to help them and get trained. The objective of taking them to the fields is not perpetuating ever increasing profits, but the strengthening of the community ties and passing on the sense of responsibility among them. In such societies, working within one’s own family and community is preferred to working else where even if the latter is more productive and profitable. Working in other’s fields as wage-laborer on the grounds that ‘this gives me higher opportunities to produce and hence earn more profit’ is considered dishonorable in these societies. Production methods that allow most number of community members to participate in producing a given amount of output are preferred to those that allow fewer members, because such technologies help them socialize their desired values of love and cooperation among their communities. In other words, these societies would regard technique B as superior to A. This simply means that technological improvement that takes place within religious societies is fundamentally different from that of capitalist societies—both are meant to achieve different goals and are based on conflicting values. 10.3.1: Iso-Quant Curves: Modeling Production with Several Inputs Variable So, B is not efficient way of organizing production if technology A is available to it. Let’s determine some other technically-efficient production techniques of capitalist firm. The conceptual tool that is employed to do this job is termed Iso-quant curve. The idea is to trace those methods of production that produce same level of output—something very similar to the idea underlying indifference curve.

To begin with, note that as long as all inputs have positive marginal product, both A and B cannot produce same level of output. Combination B must, therefore, be technically superior to A in the sense that output with (3L, 4K) must be greater than that with (2L, 4K). In other words, if output is Yo (say 10 units) at A, then it must be Y1 = Yo + ΔY (say 12 units) at B. Now consider panel (a) of figure 10.11. This again is an example of technically unequal ways of producing in the sense that if output is Yo at A, then it must be less at C because it involves less amount of capital. Thus, input combinations like A-B or A-C cannot be treated technically equally efficient because output is not same at them. Stating alternatively, they cannot fall on the curve which represents combinations of inputs that produce same level of output. You can easily reason that if marginal product of each unit of an input is positive (as is assumed to be the case), then output can remain constant only if both inputs are varied in opposite direction: if you increase L, then K must be decreased and vice versa, as is shown panel (b). The intuition behind this is that when an extra labor is added, output would increase from its previous level. In order to bring it back to its previous level, amount of capital must be decreased. What is important at this moment is to understand the idea of input-substitution for identifying technically equal ways of production; i.e. ones that gives same output level. Don’t worry about the rate of input substitution here—don’t think why we have substituted one labor unit with 2 of capital to keep output constant, as this rate can be different with different technologies. Figure 10.11: Identifying technically efficient production methods(a) Two technically unequal ways of production(b) Two technically-equal ways of production(c) A third technically-unequal way of production0LKA423C0LKA422D30LK422334ADEFExtra labour in E than F Figure 10.11: Identifying technically efficient production methods (a) Two technically unequal ways of production (b) Two technically-equal ways of production (c) A third technically-unequal way of production 0 L K A 4 2 3 C 0 L K A 4 2 2 D 3 0 L K 4 2 2 3 3 4 A D E F Extra labour in E than F The challenging question is to find a third combination of inputs in this graph that is technically equal to A and D. Finding this point is important because otherwise it is not possible to obtain the exact shape of a curve that joins these two points (recall from our discussion in chapter 6 about indifference curve that we need at least three points to find out exact curvature of a curve). Consider first the combination E (4L, 3K) in panel (c) of figure 10.11. To determine whether this combination can be equally productive as A and D, note that all weighted-average combinations of A and D fall on the straight line joining these two points (recall our discussion on constructing weighted-average bundles from chapter 6). This line shows that if A and D are two ways of producing a given level of output Yo, then firm can produce the same level of output using any weighted-average combination of these two methods. F is one of such weighted-average combinations available to firm. Thus, if F can produce the same level of output, Yo, as A and D, then output must be greater at point E since it employs at least more of one input as compared to F (i.e. labor). This means that a curve that joins equally-productive combinations of inputs cannot be concave to the origin; i.e. line joining A and D cannot extend to the right of line segment AD.

Finally, it can be shown that input combinations that produce same level of output fall on a convex to the origin curve as shown in the left hand panel of figure 10.12. This curve is called an Iso-quant curve—where Iso means ‘same’ and quant stands for ‘quantity or output’. This curve shows all combinations of input that produce same level of output, a concept very similar to indifference curve introduced in chapter 6. The exact shape of this curve cab be explained using slope of this curve. Graphically, the slope of iso-quant is given by its tangent, as drawn at points A, B and C. Algebraically, the slope of an Iso-quant curve drawn in L-K space is given by: (10.12) i.e. it must be negative. The negative slope of this curve gives the idea of input-substitution as discussed above—in order to keep output constant, both inputs must be changed in opposite direction, hence negative slope. Figure 10.12: Input-combinations yielding equal output(a) Third technically equal way of production(b) Technically unequal ways of production0LKLoKoBAC0LKLoKoBAC Figure 10.12: Input-combinations yielding equal output (a) Third technically equal way of production (b) Technically unequal ways of production 0 L K Lo Ko B A C 0 L K Lo Ko B A C Secondly, note that slope of this curve is decreasing as we move down along it from A to B to C. This is so because as we move down on this Iso-quant curve, more and more labor is added into production process with ever decreasing amounts of capital. This means that each worker has less capital to work with and, hence, becomes less productive. Thus it gradually becomes increasingly difficult to substitute labor for capital as one increases the amount of labor along an Iso-quant. This is something that affects the iso-quant’s slope. To have further insight into why this curve behaves like this, let’s develop an expression for the slope of iso-quant curve. Marginal Rate of Technical Substitution What is the meaning of the slope of iso-quant? It reflects the ability to substitute labor for capital, while still producing the same amount of output. In other words, it measures the rate at which labor can be substituted for capital in production process, called marginal rate of technical substitution (MRTSLK). This rate of substitution is much like MRS for consumer’s indifference curve. The difference between the two is that MRS measures substitution in consumption bundles allowed by consumer taste such that utility remains constant, while MRTS measures input-substitution allowed by production technology such that output remains same. Just as with an indifference curve, the rate of substitution is given by the negative of the slope of iso-quant: (10.13) which means that MRTS is a positive number. For example, if slope of an iso-quant curve at any point, say A in figure 10.12, is -3, then MRTSLK is +3, which means that 1 labor can be substituted with 3 capital units in production process. To see this explicitly, note that the value of MRTS = 3 would be expressed in terms of expression (10.13) as:

where 3 refers to change in capital, ΔK, while 1 stands for change in labor, ΔL. This is exactly how we interpreted the value 3 of MRTS: production technology allows substitution of three units of capital with one labor while still producing the same output level. It can be further shown that MRTS equals the ratio of marginal productivities of labor and capital; i.e. (10.14) This result is the same graphically as well as algebraically as that developed for indifference curve. So, it would be a mere repetition to develop this expression again. However, we do give its intuitive explanation here. Consider again the value of MRTS = 3 as discussed above. Note that one labor can be substituted for three capital units at constant output level only if the marginal product of an extra labor is equal to the marginal product of three capital units—only if an extra labor can produce as much output as do three machines that firm can substitute one labor with three capital and still produce the same output. Expressing the value MRTS = 3 in terms of (10.14), we have: which is exactly what we wanted to show. Briefly speaking, the rate of substitution between two inputs shows the marginal productivities of two inputs. We have thus reached a very strong result: even when we cannot calculate the underlying marginal productivities of inputs directly, the mere information about the rate of substitution between two inputs is enough to infer their relative marginal productivities! It means that we need not worry about calculating marginal productivities of inputs, the most we need is information about the rate of input-substitution. Now go back to figure 10.12 again. Given that the slope of iso-quant equals MRTS and that the expression for MRTS is (10.14), it follows that an iso-quant cannot be straight line like the one drawn in the right hand panel of figure 10.12. This can be seen by the fact that a straight line has a constant slope, so MRTS must be constant for an iso-quant to be a straight line. Expression (10.14) shows that MRTS can remain constant only if the ratio of marginal productivities remains constant. However, we have seen above that marginal productivity of an input decreases as more of it is used, and vice versa. As we move from point A to, say, B, more labor is added and capital is decreased. This means that marginal product of labor is expected to decrease while that of capital is expected to increase. With numerator of expression (10.14) decreasing and denominator increasing while moving from A to B, the ratio of the two marginal productivities cannot remain same at point A and B. To illustrate using numbers, let MPLA = 4 and MPKA = 2 be the marginal productivities of labor and capital at point A and MPLB = 3 and MPKB = 3 at B. MRTS at two points is then given by: Hence, an iso-quant cannot be a straight line as the value of its slope (or MRTS) is expected to decrease as we move down along it. From this explanation of the slope of iso-quant, it can now be easily seen that a typical iso-quant curve would be convex to the origin. For example, at point A, the slope of iso-quant is quite steep which means a higher value of MRTS (recall that the steeper the slope, the larger the value of slope). This higher value of MRTS can be explained in terms of marginal productivities. To see how, note that too much capital is employed as compared to the amount of labor at point A. This means that marginal productivity of capital is low at this point relative to labor. In other words, MRTS would be large at point A (because the fraction is larger when denominator is small). On the other hand, marginal productivity of labor would be quite low at point C as more of it is employed as compared to capital. Thus, MRTS would be small here. The convex shape of iso-quant curve implies that MRTS tends to decrease as more and more labor is added to production process. This tendency is called diminishing marginal rate of technical substitution. The reason for this tendency has already been explained: it gradually becomes increasingly difficult to substitute labor for capital as one increases the amount of labor along an Iso-quant because each worker has less capital to work with and hence becomes less productive.

Properties of Iso-quant Curves An iso-quant has same properties as does an indifference curve. Among them are: Iso-quant must be negatively sloped Two iso-quant curves cannot intersect each other Higher iso-quant represent combinations of inputs that can produce higher level of output An iso-quant is convex to the origin We leave the justification of these properties to you, as it is a mere repetition of the same arguments presented in chapter 6. However, one key difference between indifference curve and iso-quant must be noted. Each iso-quant has a number attached with it—the level of output that can be produced with some input combinations—and that number has observational meaning in the sense that output is a real quantity. On the other hand, utility numbers attached to an indifference curve are unobservable because they are merely proxies representing the mental state of a consumer—recall that indifference curve merely orders consumption baskets in ordinal numbers. Though the geometry of iso-quant is more closely related to the real world than is of indifference curves; but this does not mean that indifference curves are ideological constructs while iso-quants are not. Both show how capitalist consumers and producers are expected to behave and measure actual market outcomes in terms of these ideological expectations. Behavioral economics how that there is as, large a gap in actual production outcomes and theoretical expectations as there is in consumption expectations and market outcomes. Changing a Single Input When Several Can be Changed The single-variable input production function of section 10.2.1 can be brought together with factor-plane diagram in this section. To see the relationship between both of them, note that convexity of iso-quant relied in part on the idea of diminishing marginal productivity of labor. The same idea was related to our framing of single-input production function. We start at point A in the upper panel of figure 10.13. Consider changing only labor from point A keeping amount of capital constant at Ko. Now the possible input-combinations different from A only in labor used are along a horizontal line through A since K is held fixed. Figure 10.13: Relating single input production function with factor plane diagramLTP0ALof(L, Ko)Y100LKKoY10LoY16Y20A Figure 10.13: Relating single input production function with factor plane diagram L TP 0 A Lo f(L, Ko) Y10 0 L K Ko Y10 Lo Y16 Y20 A A A The effect on output of changing labor alone is just like the production function analyzed above, and drawn in the below panel. If production is subject to diminishing marginal product of labor, then increase in output for each unit increase in labor would be smaller, as shown by the numbers attached to iso-quants (10, 16 and 20). We are now in a position to take up the question that we set out to answer at the start of this section: ‘how can we study the effect on output when all factors are allowed to change together?’ This is in fact the long run analysis of production function.

10.3.2: Returns to Scale Figure 10.14: Returns to scale as proportionate change in inputs0LKKoY10LoABCWhen we ask the question ‘what happens to output when we change all inputs’, we need some rule about ‘how to change all inputs’. Obviously, changing all inputs in different proportion and then studying their effect on output will make analysis unmanageable. This is because in this scenario, the question of ‘how to separate out the effect of both inputs’ would arise, and there is no way to answer this question. The only conceptually feasible way of answering the above question is to change all inputs in the same proportion. With this rule, both capital and labor are expanded by equal percentage. The idea of proportionate change in all inputs takes us to the concept of returns to scale which answers the question what happens to output when we change all inputs in the same proportion. For example, we can see what will happen to output if we double the use of labor and capital simultaneously; i.e. 100% increase in all inputs. In other words, the proportionate-change-rule in all inputs in the long run means ‘how big the production level should be’—the question of production scale. Algebraically, scale of production is denoted by factor λ > 0. To see what it means, note that returns to scale means what happens to output if we multiply all inputs by the same positive factor, say λ. Consider point A in figure 10.14, A = (Lo, Ko). Any point along the ray 0A is point (λLo, λKo) for some positive λ. Figure 10.14: Returns to scale as proportionate change in inputs 0 L K Ko Y10 Lo A B C Figure 10.14: Returns to scale as proportionate change in inputs0LKKoY10LoABC Figure 10.14: Returns to scale as proportionate change in inputs 0 L K Ko Y10 Lo A B C Point A is defined by λ = 1, and any point between the origin 0 and A, such as B, is defined by λ < 1. Beyond A on the ray, the λ must be greater than 1, such as at C. The relevant question now is ‘how does output respond to the change in scale?’ This is just like a slope type relation: Since return to scale is a percentage concept, we need to convert the slope relation into elasticity to obtain its behavior: (10.15) We can see that there can be three possibilities for the value of ε: If ε = 1, it means %ΔY = %Δλ. In other words, if we double all inputs, output also doubles. This tendency in production is called constant returns to scale (CRS) If ε > 1, it means %ΔY > %Δλ; i.e. doubling all inputs increases output by more than double. This tendency in production is called increasing returns to scale (IRS) If ε < 1, it means %ΔY < %Δλ; i.e. doubling all inputs increases output by less than double, called decreasing returns to scale (DRS) The doubling of inputs and equal, more or less than doubling of output can be seen by the expression: Let us now convert the above ideas on graph. Consider figure 10.15 which shows a set of iso-quants. Figure 10.15: Modelling Returns to Scale(a) Production technology exhibiting CRS0LKa22b44Y10Y20(b) Production technology exhibiting IRS0LKa22b44Y10Y22(c) Production technology exhibiting DRS0LKa22b44Y10Y18

Figure 10.15: Modelling Returns to Scale (a) Production technology exhibiting CRS 0 L K a 2 2 b 4 4 Y10 Y20 (b) Production technology exhibiting IRS 0 L K a 2 2 b 4 4 Y10 Y22 (c) Production technology exhibiting DRS 0 L K a 2 2 b 4 4 Y10 Y18 At point a in panel (a), 2 labor and capital (2L, 2K) units are combined to produce, say, 10 units of some commodity. Now if we double all the inputs we move out along the ray 0a until we reach point b where we have inputs (4L, 4K). If technology exhibits constant returns to scale, then at the iso-quant that point b is on, we see that output should be 20 units, exactly double of 10 units; i.e. by doubling inputs we have doubled our output. However, it is not necessary that technology always exhibit constant returns to scale. Increasing Returns to Scale In panel (b), doubling of inputs leads to more than doubling of output, which means the production technology shows increasing returns to scale. A major source of increasing returns to scale was explained by Adam Smith in the very first chapter of his book Wealth of Nations. It is the division of labor, or specialization in work. As the size of the firm and its output increases, the possibilities of dividing work in smaller parts and, hence, allowing workers to increase their productivity by specializing in certain tasks also increases. For example, if one needs to stitch one shirt a day, then a single person using an ordinary sewing machine can do the job pretty well. However, if one is going to stitch 100 or 1,000 shirts a day, then the best solution is not to have 100 or 1,000 people with 100 or 1,000 machines to make them. On the other hand, it is far less costly in terms of human effort, materials, and especially energy to use if each of the persons working in factory specializes in his activities: one might purchase raw-material; one might cut cloth; one might stitch those cut cloth; another might make button holes and yet another put on the buttons etc. Through this specialization, 10 people can easily do as much as 100 who do not specialize. A large scale of production permits a greater division of labor to be used and average costs to be lowered. Another reason for increasing returns to scale to arise is technical and/or managerial indivisibilities. Certain capital inputs do not make sense when used in small-scale production but will generate large savings in cost if used in large-scale. One of the basic features of capitalist industrial production is the existence of mass production methods which are available only when the level of output is large, like the assembly lines in cement plants or in the motor-car industry. Clearly, if the large scale process were equally productive as small-scale ones, no firm would ever use rather the firm would prefer to duplicate the smaller scale process with which is familiar. The use of computerized procedures and her mass production techniques are efficient only when the output level is large. Decreasing Returns to Scale If on the other hand, returns to scale are decreasing, then we have the case as depicted in panel (c) of the above diagram where scaling up all inputs by 100 scales up output by less than 100. One factor responsible for decreasing returns to scale is bureaucracy or the managing of large numbers of people. Obviously, watching a tailor in a shop is not really hard. But when you operate in a garment factory where several thousand work, then it is very hard for manager of the firm to monitor every employee. Controlling employees pilfering of office supplies and product inventory is almost impossible, and several thousand rupees a year per worker are lost in the Pakistan Corporate Sectors due to these problems. Similarly, coordinating activities of various departments of the firm becomes increasingly difficult as the size of firm’s operation expands, especially in more than one city. Even when authority is delegated to individual department managers (sales manager, HR manager etc.), the final decision is yet taken by the ‘top management’. The decision making and its implementation process becomes less and less efficient as scale of production grows because of the stretched long managerial hierarchy, a tendency termed diminishing returns to management. Another important area where decreasing returns to scale arises is in the case of exhaustible natural resources. For example, doubling the fishing fleet may not lead to doubling of catch of fish; or doubling the plant in an oil or gas extracting field may not double the output obtained.

10.3.3: Input Substitution Thus far we have discussed one short run and one long run property of production function: returns to input (short run) and returns to scale (long run). Besides return to scale, there is another long run feature of production technology that is directly relevant to a firm’s decision of ‘choice of technique’ and its expansion path in the long run (to be discussed in next chapter). This property is technically termed as elasticity of substitution which shows the ease with which inputs can be substituted for each other in the production process without losing output. The formal algebraic measure for elasticity of substitution will be developed in the next chapter; here we discuss the graphical intuition behind this idea. This property is related to the shape of a single iso-quant curve. To see how, note that an iso-quant projects the idea of producing a given level of output with a number of different input combinations—i.e. firm has the freedom to substitute labor for capital while still producing same output. However, the ease with which inputs can be substituted with each other in production process may vary from one industry to another. In some cases, substitution can be accomplished rather easily and quickly in response to changes in economic circumstance. But in other cases, firms may have little choice about the input combinations available to them. Here we consider one case where input substitution is impossible. Fixed Proportion Production Function Consider figure 10.16 showing a technology that allows no input substitution resulting in L-shaped iso-quant curve. The idea behind this is that labor and capital must be used in exactly fixed proportions. In other words, there is one and only one way of producing a given level of output and both inputs are perfect complements—every unit of capital has a fixed complement of workers that cannot be varied no matter how much output you produce. For example, if 1 machine is in use, 3 workers are required to produce Yo output. Combining more than 3 labors with 1 machine will not increase output. Point C shows a redundant amount of labor used. In other words, output does not increase as long as more labor is not combined with additional capital in a fixed proportion; i.e. marginal productivity of labor is zero beyond 3 units of labor. Graphically, it means that iso-quant is horizontal beyond point (3L, 1K). This can be seen by comparing upper panel of figure 10.13 with 10.16. Note that adding extra labor into production process with fixed capital puts firm on a higher iso-quant curve in figure 10.13, but firm remains on the same iso-quant in 10.16. Figure 10.16: Fixed proportion production function0LK1Yo3ABC26Y1Expansion Path slope = ⅓ Figure 10.16: Fixed proportion production function 0 L K 1 Yo 3 A B C 2 6 Y1 Expansion Path slope = ⅓ Such a production function is called fixed-proportion production function that shows no possibility of trade-off between inputs; i.e. there is no way to substitute labor for capital or vice versa. Both inputs are fully employed only if a combination of K and L that lies along 0AB is chosen. Otherwise, one input will be redundant in the sense that it could be reduced without decreasing output. Secondly, note that since more output can be produced only if more of both inputs are available in a fixed proportion, say at B where 6 of labors and 2 of capital units produce Y1 output which is exactly twice the factors at point A, thus, doubling the inputs doubles the output—hence the process shows constant returns to scale.

The question now is ‘how to write a function representing such a fixed proportion production process?’ For this, note that for each unit of output to be produced, we need at least one unit of capital. Turning this around, this means that firm can produce no more output than the number of capital units available. For example, if it has 10 machines in our figure 10.16 example, then the maximum it can produce is 10 units. However, the mere availability of capital in a certain amount does not guarantee 10 units of output as labor is also required in a particular fixed amount. So, output can be less than 10 units. This can be stated algebraically as an inequality: Since at least three units of labor are required to produce one unit of output, so output cannot be greater than one third the amount of labor available: For example, if 60 workers are available, then the maximum the firm can produce is 20 units [= 60 / 3]. The above conditions create two requirements that must be satisfied to produce a unit of output. For example, if there is enough labor to produce 20 units of output (i.e. L = 60), but there are only 10 units of capital, then maximum 10 output units can be obtained. In other words, the smaller of the two input availabilities restricts the output. Such a condition is expressed as: which says that output, Y, is the minimum of the two inputs, K and L/3. Generally speaking, if aL units of labor (aL may be 3) and aK of capital are needed to produce one unit of an output, we find that: and or (10.15) This is the general form of a fixed-proportion production function. To take an example of fixed-proportion production function, consider the input-requirements for, say, shirts in terms of its raw material: cloth (C), buttons (B), thread (T) and buckram [بکرم] (M). Let’s assume that an average shirt needs at least 3 meters cloth (ac = 3), 10 buttons (ab = 10), 10 meter thread (at = 10) and 1/10 meter buckram (am = 1/10; i.e. a shirt needs one tenth of one meter buckram, or alternatively, one meter buckram can be used in 10 shirts). Now the production function for shirts can be written as: The ease with which inputs can be substituted for each other in production process is of great relevance to capitalist firms. Read Application Box 10.3 to see why the shape of iso-quant matters to profit-maximizing firms as well as to economy as a whole in rapidly changing technological societies. A P P L I C A T I O N B O X 10.4 Why Input Substitution Matters? To illustrate an example, suppose that capital-labor ratio in manufacturing industry is two to one—it takes two machines to employ one worker, or alternatively one worker operates two machines. On the other hand, assume that capital-labor ratio in agriculture is one to one. Now if consumers’ preferences change in favor of industrial production as has happened in most capitalist societies over time, then agricultural production will decrease while that of manufacturing industry will increase. When output in agricultural industry decreases, it will release capital and labor in the ratio of one to one; i.e. every time when one machine is released, one worker is also unemployed. However, manufacturing industry can absorb capital and labor in the ratio of two to one. In other words, transferring two machines from the agricultural sector employs one more worker in manufacturing. Thus, half of the workers released by agricultural sector would be unemployed. However, the released labor could easily have been absorbed if capital-labor ratio in manufacturing could be changed. The effect of a shift in demand for a product on inputs depends upon the flexibility of production technique.

However, the above type of situations where economists study the cross-industry substitution of inputs assumes away a highly important feature of reality: specificity of capital. Almost all capital units are specific to the task for which they ware originally designed and it is almost impossible to use them for producing some other type of output. Consider, for example, the thresher machine used in agricultural production. If agricultural production decreases, some of the thresher machines would cease to operate. Now think: do these thresher machines have anything to do with manufacturing output? Is it possible to fit thresher machines anywhere in manufacturing industry? Clearly no, but economic theory assumes that capital can be instantaneously and costlessly moulded so as to be suitable for producing any type of output. This is clearly a non-sense assumption. Some of the capital must be lost forever even if we assume that we can transfer capital from one shape to another using technological innovation. Similarly, it is also difficult to absorb laborers working in agricultural industry into manufacturing simply because both industries require different types of skills: people who are trained to do one type of job can’t fit into other jobs without loss of some output in between this transition. It can only be through some sort of magic that instantaneous transformation of inputs is possible. Why Typical Iso-Quant? The typical shape of iso-quant as drawn in figures 10.13 to 15 assumes that technology allows infinite possibilities of substituting labor for capital in production process; i.e. it is always possible to substitute labor for capital for even very small changes in capital. But this is in fact not a correct description of production technologies made available to firms. Not only is it the case that technology usually does not allow such input-substitution, but also the industrial production (the dominant mode of production in capitalism) takes place more or less under the conditions of fixed-proportion production methods—very small adjustments cannot be made between inputs in industrial production. No matter how firm the economists’ belief may be in magic, it is literally impossible in this physical world to transform capital costlessly and instantaneously to be suitable for operation by any number of workers. Even if we accept all of the revolutionary characteristics of modern technology, the maximum we can get is an iso-quant as shown in figure 10.17. The point that such a shape highlights is that even if technological innovations allow firms some substitution between labor and capital, however, this substitution is never infinite to make an iso-quant look like a smooth negatively sloped curve—an iso-quant must have kinks. The smooth curve can emerge only if we assume that even very small changes in capital can be substituted with or for labor; but this is clearly an absurd idea because it is physically impossible to add some very small unit into machines or take away some very small portion from machines.

Figure 10.17: Impossibility of small changes in inputs results in kinks in iso-quants0LKYoY1 Figure 10.17: Impossibility of small changes in inputs results in kinks in iso-quants 0 L K Yo Y1 The question then is: why economists insist that an iso-quant must have a typical shape? The answer to this question does not lie in the fact that economists have somehow empirically observed the underlying production technology through some microscopic eye; rather this fictitious shape is adopted because this is the only shape of iso-quant that fits within the microeconomic theory of income distribution as discussed in part 5 of this book in detail. We show in the next chapter that if iso-quant takes even a shape of 10.17 which is much less rigid than fixed proportion production, then neoclassical economics fails to justify its theory of faster decrease in response to changing input prices. This and only this can explain why all major economics text-books use “well behaved “ shaped iso-quant curves in their modeling of capitalist production. Moreover as we have argued throughout this book a central purpose of microeconomics is to develop ideal types of the optimal behavior of capitalist individuality as consumer, producer and exchangers. The iso-quant is not smooth, and nor it can be. But it ought to be smooth according to microeconomic theory. Why? Because the ideal capitalist producer is not committed to the production of any specific good or the employment of any specific technology, rather he is committed to the maximization of the rate of capital accumulation. This alone is the end in itself and every thing else—choice of technology production of specific commodities—is an instrument for achieving this supreme end in itself. Inputs must be infinitely substitutable if they are merely instruments for maximizing capitalist accumulation. Thus in capitalist order factors of production have no intrinsic value. The value ascribed to them is solely determined by their relative contribution to capital accumulation and that is why value of all physical assets is ultimately determined in the financial markets. A central purpose of the financial markets is to reduce asset and commodity market rigidities so that factors of production can become infinitely substitutable. This is achieved for example through securitization and through the organization of merger and acquisition (M and A) transactions. The capitalist ideal is to make all factors perfectly substitutable since no factor has any intrinsic value; its value is derived solely from its relative contribution to capital accumulation. Of course the universal dominance of the financial markets that capitalism requires cannot be achieved. This illustrates the inherent incoherence and irrationality of capitalist order. Microeconomics cannot of course acknowledge the essential irrationality of capitalist order. It continues to use a false criterion for measuring performance of capitalist agents in capitalist market. Key Concepts

Average product is the ratio of output to labor Constant returns to scale means returns to scale is 1, reflecting the fact that output increases at the same percentage rate as do all inputs Decreasing returns to scale means returns to scale is less than 1, reflecting the fact that output increases at a less percentage rate than all inputs Diminishing marginal product of a factor refers to the tendency of marginal product of a factor to decrease, other factors held constant Diminishing marginal rate of technical substitution refers to the tendency of MRTS to decrease as more labor is added to production process Division of labor means allocation of task between workers such that each one of them performs fewer distinct tasks in producing output; i.e. each worker produces a very small part of total output produced Factors of production are inputs that are not embodied in output and are retained after the end of production process. They include labor, land, capital and entrepreneur Fixed factor is the input that cannot be changed in short run (also called fixed input) Fixed-proportion production function refers to the situation when there is only one technically efficient way of producing a given amount of output and, hence, shows no possibility of trade-off between inputs; i.e. there is no way to substitute labor for capital or vice versa Increasing returns to scale means returns to scale is greater than 1, reflecting the fact that output increases at a greater percentage rate than all inputs Iso-quant curve shows different combinations of inputs that yield same level of output Long-run is the time duration when all inputs can be changed Marginal product of a factor is the change in output due to change in an input Marginal rate of technical substitution (MRTS) measures the rate at which labor can be substituted for capital still producing the same level of output Production function is a relation between the amount of output a firm can produce with given inputs Return to factor / inputs refers to the behavior of change in output in response to change in a single input: what happens to output as we change single input Returns to scale measures the percentage change in output due to percentage change in all inputs: what happens to output as we change all inputs Short-run is the time duration when at least one input is fixed Variable factor is the input that can be easily varied in the short run (also called variable input) Chapter Summary The theory of production attempts to show that there is a positive relationship between price and the output supplied. This is necessary to derive “well behaved” individual and market supply curves Since it is logically (except on very stringent assumptions) and empirically impossible to justify the existence of such “well behaved” aggregate demand and market supply curves microeconomists cannot justify their view that capitalist society is merely an aggregate of the free choices of utility and profit maximizing individuals Microeconomics assumes that production—conversion of inputs into output—is merely a technical process. Thus the relationship between laborers and managers are determined purely by physical and natural forces. The production function models the presence of the conversion of inputs into output on the basis of a profit maximizing technology

Factors of production are those inputs which do not become embodied in output but retain their existence after the end of the production process Microeconomists prefer the form of the production function which relates output to factors of production (and abstracts from other inputs) because this allows them to justify capitalist property rights. All factors of production and their owners are seen as equal capitalist contractors establishing harmonious relations of production and willingly appropriating the part of the value of the net output which has been produced according to their individual contribution Microeconomists usually write the production function as Y = (L, K) and claim that all inputs can be accommodated within this general form. But as Sraffa has shown no unambiguous meaning can be attached to the microeconomists’ conception of capital K in this production function. Usually this ‘K’ is supposed to mean physical capital (i.e. the total machinery, building etc., used in the production of a specified amount of output). But it is impossible to sum up the separate constituents of “K”— how do you add machines to rooms, to electric circuits etc. You can only add up their values (price times quantity). ‘K’ cannot therefore be ‘physical capital’. Labor on the other hand can be measured in physical units as hours worked for example. Therefore L and K are logically different—and therefore not equal but asymmetrical concepts. Recognizing L and K as unequal, different, asymmetrical concepts undermines the microeconomic justification of capitalist property and its theory of income distribution as we shall see in later chapters. Since microeconomics is a justification of capitalist rights, it cannot abandon the fictitious notion that K and L can be measured in physical terms The short run is the period in which at least one factor of production remains fixed. In the long run there are no fixed factors of production Microeconomics assumes that marginal productivity is usually positive since profit maximizing firms would not hire labor whose wage is positive while its marginal productivity is negative or zero. Where negative MP exists as it does in developing countries, Lewis suggests that this is an opportunity to turn non-capitalist production units into capitalist ones by moving the laborers with negative MP from the non capitalist firm to the capitalist factory in the city where their MP will be positive Microeconomists subscribe to the Law of Diminishing Marginal Productivity and expect marginal produce to decline as the scale of production expands. This implies that the slope of the production function (the total product curve) increases for some time but ultimately starts decreasing According to microeconomic theory the marginal productivity of labor (MPL) declines because as more and more of labor is added to the fixed factor K, the capital-labor (K/L) ratio will decline. The amount of capital each laborer has to work with falls. This assumption of decreasing returns to input is of vital importance in microeconomic theory

As Sraffa pointed out that assumption leading to the law of diminishing marginal productivity cannot apply to mature capitalist order where machinery is built to operate with fixed (optimum) quantity of labor all the times. It therefore makes no sense to keep on adding labor to fixed capital. Sraffa showed that a profit maximizing firm is likely to operate at maximum productivity (optimum level of K/L). Otherwise it will not be able to maximize profit. Profit maximizing capitalist firms would leave the portion of the factor the marginal productivity of which is less than optimal. Sraffa showed that a profit maximizing capitalist firm would/should leave some of its fixed factor unutilized. This implies a constant return to scale production function. The law of diminishing marginal productivity does not apply to mature capitalist economies. When marginal product is greater than average product/cost, average product rises. When marginal product is less than average product, then average product falls. Finally, when average product equals marginal product, average product is at its maximum point. The marginal product curve intersects the average curve at its maximum height The profit maximizing capitalist firm continues to increase production as long as marginal product is positive Non capitalist producers on the other hand may stop production when marginal product is rising. A non capitalist producer may continue to expand production when marginal production is negative. This is because the non capitalist producer rejects profit maximization as the objective of production Capitalist firms choose technologies of production which allow them to maximize profits. Non capitalist firms choose technologies of production on the basis of other considerations Iso-quant identifies different technologies of productivity which produce the same level of output. Iso-quants are expected to be convex to the origin like indifference curves and roughly for the same reasons. The iso-quant curve is negatively sloped and shows input substitution to keep output constant. The marginal rate of technical substitution (MRTS) measures the rate at which one factor can be substituted for another in the capitalist / production process. This implies that information about the role of substitution between two inputs can be used to infer their marginal productivities MRTS tends to decrease as more and more of one input is substituted for another. This tendency is known as the diminishing marginal rate of technical substitution The Iso-quant like indifference curves are negatively sloped and cannot intersect. However, iso-quants can be measured cardinally reflecting the amount of production different input combinations yield at different iso-quant curves. Indifference curves can only be measured ordinally The concept of returns to scale measures the impact on output of changing all input in the same proportion. Returns to scale may be (a) constant (b) increasing or (c) diminishing. Returns to scale is a long run concept

Iso-quant sets take different shapes depending on input substitution and taste. Production function is L-shaped when there is a fixed proportion production function. Such a productive function shows constant returns to scale Microeconomics often ignores fixed factor proportions and input substitution rigidities and works with models which assume infinite substitution of inputs. Capital can be substituted for labor and one type of capital for another type of capital without cost and without any loss of time. The typical iso-quant therefore takes a shape that assumes infinite substitutability of capital for labor. In the real world the typical iso-quant must have kinks The smoothly downward sloping iso-quant must be assumed to justify the microeconomics theory of income distribution The iso quant is shown as smooth because microeconomics is a moral science. The capitalist producer is committed only to profit maximization. He is not committed to the production of any specific commodity or the employment of any specific inputs. Choice of technology and production of specific commodities is only means to the maximization of capital accumulation which is the only end in itself. Factors must be infinitely substitutable if they are merely means for maximizing accumulation. No factor of production in capitalist society has any intrinsic value. Financial markets operate to reduce factor substitution rigidities. Review Questions What is the production function? What are factors of production? Why do microeconomists prefer the form of the production function which relates output to factors of production only? Why can ‘K’ and ‘L’ in the neoclassical production function not be regarded as equal and symmetrical concepts? Define the ‘short run and the long run’ in production. What is “marginal productivity”? Why do microeconomists expect marginal productivity to be positive? State and explain the law of diminishing marginal productivity with the help of a diagram showing a typical production function. Derive a typical marginal product curve assuming some numerical numbers Illustrate Sraffa’s criticism of the theory of diminishing marginal productivity using an example of your own. Why are capitalist firms more likely to operate on a constant rather than diminishing productivity? Why must the marginal product intersect the average product curve at its minimum level? Why cannot the theory of marginal productivity explain the behavior of a non capitalist producer such as Abdullah Zhaghzai? Why would a typically Islamic society—e.g. the Zhaghzai tribe for example—prefer a non-profit maximizing technology of production? What are the characteristics of an iso-quant curve and how are they justified by microeconomic theory? Why the iso-quant curve is negatively sloped? Define and explain the concept of the marginal rate of substitution. Explain / justify the tendency of diminishing marginal rate of technical substitution. What is the meaning of the concept ‘return to scale’? Define a fixed proportion production function. State and explain its general form with a numerical example.

What do you understand by ‘factor substitution’? “Typical iso-quant assumes infinite substitution possibilities between inputs”. Explain. “In the real world the typical iso-quant must have kinks”? Explain why. “Iso-quants are assumed to be smoothly downward sloping eventually for ideological reasons.” Discuss. Chapter 11 NEOCLASSICAL THEORY OF COST The last chapter modeled production technology as conceived in microeconomics. But technology alone cannot determine what to produce and how to produce. This chapter goes on to explain the microeconomic theory of how capitalist firms make choices about input usage and output scale in response to changes in output level. The first section clarifies the specific sense in which micro economists use the term ‘cost’. The model of input-choice in section 2 is then extended to derive standard microeconomic cost curves in sections 3 and 4. 11.1: The Economic Concept of Cost The concept cost is often used in ordinary language, but it has a very specific and somewhat different meaning in economics. Cost refers to the sum of expenditures needed to produce a given level of output. First note that cost cannot be defined independent of the level of output—you can’t tell how much cost a farmer incurs on producing wheat until you specify how much output he produces. For example, cost of producing 100 bushels of wheat may be Rs 50, but cost will be different for the output level of 200 bushels. For micro economists, the cost of producing something is opportunity cost— the value of foregone consumption. Recall from chapter 1 that the assumed scarcity of resources by capitalist implies that any decision to produce more of one good means giving up some other good. For instance, when an automobile is produced, an implicit decision has been taken not to produce, say, bicycles. If it is possible to produce 50 bicycles using the same labor and capital that goes into the production of one automobile, then the opportunity cost of one automobile is 50 bicycles. In order to calculate the total opportunity cost of something, care must be given to include not only the explicit cost but also the implicit cost elements. Explicit cost refers to expenses which the entrepreneur has to pay from his own pocket for the purchase of inputs. It includes: Labor cost i.e. expenditures on salaries and wages. When considering the wage rate, micro economists assume that this rate is the amount that workers would earn in their next best alternative job. If a firm hires a worker, say, at Rs 50 per hour, micro economists say that this number represents what the worker would earn elsewhere. Borrowed capital cost: if capital is borrowed from financial markets such as banks, then the cost of capital is the interest rate paid to the lender of capital. For example, if the market interest rate is 10% and a firm borrows Rs 100 for one year, then its interest cost will be Rs 10. Implicit cost, on the other hand, measures the cost of foregone alternative actions though no physical payment is made against them. Such costs occur when an the entrepreneur uses his own capital or labor.

Owner’s own capital cost: If, instead of borrowing, a person invests his own capital into a business, then the cost of using this capital is also the forgone interest rate that he could have earned had he lent out this capital instead of using it personally. For example, if he invests his own Rs 100 in some business, then apparently it seems that he has no cost to pay for its use after one year. What if he had put this amount in some financial market, say deposited in a bank, for one year instead of using it himself? If the market interest rate is 10%, then this person could have earned Rs 10 after one year. So, by continuing to use this amount of capital, he is implicitly foregoing the interest that someone else (say a bank) would be willing to pay for its use. Alternatively, he is paying a price of Rs 10 for using his own capital. In general the cost of capital is the interest rate for the capital that a firm must pay for its use regardless of whether the firm owns the capital (in which case it is an implicit cost) or borrows the capital from someone else (in which case it is an explicit cost). Entrepreneurial cost: Legally, the owner of a capitalist firm is entitled to receive whatever is left from the firm’s revenue after all costs have been paid. This excess of revenue over cost is treated as profit by the accountant. However, micro economists ask the question: whether owners (or entrepreneurs) also incur opportunity costs of being engaged in a particular business. If so, then their services should also be treated as input to the firm and some cost should be imputed to that input. For example, suppose a highly skillful business graduate starts his own business. Again, apparently he seems to work for free. But, the wage that he might earn if he worked for someone else is the implicit cost of working at his own business. Let us consider a simple example to clarify these concepts. Suppose a capitalist (Nomi) runs a coaching centre at his home. Nomi may make a typical income statement of his business as shown here: Profit Ignoring Implicit Cost Fee collection Rs 1,000 Explicit costWage bill Explicit cost Rs 500 Utility bills Rs 200 Miscellaneous Rs 100 Profitaccountant Rs 200 However, this calculation does not impute full opportunity cost of Nomi business as it ignores the cost of using Nomi’s own house and his personal labor. A micro economist would prepare the following balance sheet taking into account not only of explicit cost, but also of implicit cost: Profit Taking Account of Implicit Cost Fee collection Rs 1000 Explicit costWage bill Explicit cost Rs 500 Utility bills Rs 200 Implicit costMiscellaneous Implicit cost Rs 100 House rent Rs 100 Personal wage Rs 50 Profiteconomic Rs 50 Note that economic profit (Rs 50) is less than accounting profit (Rs 200). In fact, economic (capitalist) profit could be negative if the opportunity cost of renting the house and personal wage exceeded the accounting profits being earned by the business. Application Box 11.1 looks at these cost ideas in relation with capitalist cost of studying at some business school.

A P P L I C A T I O N B O X 11.1 Cost of Education Suppose Nomi is an MBA student at some business school in Karachi. How would he calculate his cost of obtaining a 2-years MBA degree? If the tuition fee is Rs 150,000 and some other expenses (e.g. daily traveling and refreshment expenses etc.) amount to Rs 50,000, then Nomi would count total expenses equaling Rs 200,000. However, this calculation includes only the explicit cost of doing an MBA. Considering implicit cost would reveal that the cost of an MBA degree is much higher than this explicit cost. But what is the implicit cost of the MBA? Assume that after graduation, instead of taking admission in MBA, Nomi could have started a job that paid Rs 10,000 per month. This means that taking admission in a 2-year MBA involves a loss of Rs 240,000 (Rs.10000 × 24) because he could have earned this amount by not taking this study program. In other words, Rs 240,000 is the implicit value of the time Nomi is putting into an MBA program. The total opportunity cost of a 2-year MBA degree now equals Rs 440,000. We consider Nomi to be a capitalist student because the purpose for which he is doing his MBA is to maximize his lifetime earnings and consumption, and the money that he spends on the MBA is capitalist money i.e. investment. However, it is possible that Farooq, on the other hand, is doing his MBA to understand how capitalist business work. Farooq is a member of the Dawat-e-Islami and Maulana Muhammad Ilyas Qadri, the Sheikh of the Dawat-e-Islami, has ordered him to do an MBA so that the knowledge of how capitalist business works can be used by the Dawat-e-Islami to destroy the global capitalist system. Farooq is not doing the MBA to maximize his lifetime income/consumption, rather to contribute to the Jihad against global capitalism. Therefore no capitalist value can be ascribed to Farooq’s action and the concept of opportunity cost becomes meaningless. For analyzing Farooq’s behavior implicit cost in particular cannot be calculated because the real value of Farooq’s output is the rewards he will become entitled to as a Mujahid in heaven which, according to Hadith. is in principle infinite and therefore incalculable. The Cost Equation With this meaning of cost in mind, let’s obtain an algebraic expression for cost. Since cost in general is defined as the sum of expenditures on the purchase of inputs: Total Cost = Sum of expenditures on all inputs (11.1) With two inputs, labor and capital, the equation becomes: Total Cost = Expenditures on labor + Expenditures on capital By definition, expenditures on labor is given by the wage rate (w) multiplied by number of laborers employed while, similarly, expenditure on capital equals interest rate (r) times amount of capital; so we have: Total Cost = wage rate × labor + wage rate × capital or (11.2) Note that the cost equation for the firm is very similar to the budget equation for the consumer discussed in chapter 7. The next section will develop further similarities between consumer and cost theory.

11.2: Choice of Technique as Cost Minimization The last chapter discussed how to model production technology of the firm, but technology alone cannot tell what and how to produce—i.e. which combination of inputs would be best to use. Technology embodied in the production function shows physical trade-offs involved in the production process. For microeconomics theory of production to make proper sense, prices of all inputs, as well as output, must be given and known to the firm in advance before undertaking the production. Technically it is assumed that all inputs are hired by the firm in perfectly competitive markets (discussed in the next chapter) where all firms are price takers—no firm has any control over market prices and accepts them for making its input and output choice decisions. In other words, a firm can hire any number of laborers at given market wage rate and borrow as much capital as it wants at the given market interest rate. This is to say that wage and interest rates are fixed for a single firm. The cost equation now becomes: (11.3) where the bar over w and r indicate that they are held fixed. Stating the Problem of Cost-Minimization We know that profit (π) is given by the difference between total revenue (TR) and total cost (TC): with total cost given by expression (11.3) and TR equaling price (P) times quantity (Y): (11.4a) Substituting the production function Y = f (L, K) for Y we have: (11.4b) This equation says that with given prices of output and inputs, profits earned by a firm depend directly on the amount of labor and capital employed. We can see that profit can be increased either by increasing revenue or by reducing cost of producing some given level of output. Here we investigate the later issue of minimizing cost; i.e. which production technique (or input mix) to choose so that cost is minimum. In other words, of the many ways to produce a given level of output, how would a firm trying to minimize cost choose to produce? Obviously, the problem of cost-minimization cannot be addressed unless some specific level of output is given because the amount of labor and capital that a firm needs to hire depends upon how much output it produces. A farmer cannot decide on how much land he needs to cultivate unless he knows how much wheat is to be produced in any specific time period. The problem is formally depicted in figure 11.1 which shows an iso-quant curve for an output level say, 10 dozen-donuts daily. The curve shows that many technically efficient ways are available to the firm to produce this output as some are shown by points A, B and C. With output level fixed, the scale of production is given, so the only relevant question is the choice of technique—how to produce this output level. Moreover, with given output, revenue is also fixed, so the only way to increase the profit is to keep cost to a minimum. The desire for profits implies that the firm would try to produce this output by choosing that combination of inputs where cost of production is the lowest. So the cost-minimization problem of the firm can be stated more formally as:

Minimize By choosing optimal amounts of L and K Subject to the constraint: Minimize By choosing optimal amounts of L and K Subject to the constraint: Again this expression is a concise way of expressing the capitalist firm’s choice of technique problem. Figure 11.1: Problem of choice of technique along iso-quant0LKY10ABC Figure 11.1: Problem of choice of technique along iso-quant 0 L K Y10 A B C It tells us that : (a) First what is the objective of the firm—minimize cost; (b) Second what is the firm choosing—a combination of inputs L and K, and (c) Third what are the constraints the firm faces—the given output level. Obviously, cost will be least when it is zero; i.e. when the firm hires no labor and capital at all. But this strategy will not work because with zero labor and capital, no output can be produced and hence revenue will be zero. So, the objective of the capitalist firm is not merely the minimization of cost; rather it is to minimize cost such that the given output is also produced. More precisely, the capitalist firm wants to minimize cost by choosing quantities of L and K such that those quantities can produce the given output level, . Let us develop an answer to this problem. 11.2.1: Cost Minimizing Input Choice The first issue in the solution to this problem is how to represent the cost of various input bundles in the factor-plane (L-K) diagram 11.1. The cost-equation can be drawn in this figure by keeping cost fixed at some specific level, just as we did in the case of the budget equation by keeping income constant. For example, if total cost is Rs 100, w = Rs 1 and r = 2, then the cost equation becomes: The vertical intercept of this equation is given by 100/2 (TC/r) while the horizontal axis is 100 (TC/w) as shown in figure 11.2. This line is called the iso-cost line—the curve representing different combinations of inputs where cost is the same. Note that this line is very similar to consumer budget line as discussed in chapter 7. The slope of an iso-cost line is given by the ratio of input prices; i.e. (11.5) which is the price of the input on the horizontal axis over the price of the input on vertical axis. This ratio of input prices is called the factor-price ratio. Figure 11.2: Iso-cost lines in factor plane diagram0LK100/r100120/r120 Figure 11.2: Iso-cost lines in factor plane diagram 0 L K 100/r 100 120/r 120 The proof of this expression is very similar to the one we discussed in the case of the budget line in chapter 7. Briefly speaking, the slope of the iso-cost line while moving from its vertical intercept to its horizontal one can be calculated as: or For our iso-cost equation drawn in figure 11.2, the value of the slope is which says that in order to purchase one extra unit of labor half a unit of capital must be sacrificed, and this can be directly confirmed by the prices of the two inputs. Moreover, note that all iso-cost lines have the same slopes; they differ only in their vertical intercepts which reflects the level of cost for which they are drawn. The iso-cost curve away from the origin represents a higher cost level, as shown above. The cost minimization can now be viewed as the problem of choosing an input combination that produces the desired level of output and is on the lowest iso-cost line.

Graphical Solution The solution to this problem is shown in figure 11.3 which draws four different iso-cost lines along with iso-quant curve representing Y10 level of output. Obviously, Rs 100 is too little amount to produce Y10 output as no point on Rs 100 iso-cost line intersects the Y10 iso-quant curve. In other words, with Rs 100, no input combination can be purchased that are required to produce the desired level of output. On the other hand, Rs 120 are enough, but this amount is too large. To see this, consider combination B. Here the firm can minimize its cost by moving from combination B to A as A is on a lower iso-cost line and can also produce the desired level of output—so B is not the cost-minimizing point. Figure 11.3: Locating minimum cost point0LK100/r100120/r120Y10KaLaBCA Figure 11.3: Locating minimum cost point 0 L K 100/r 100 120/r 120 Y10 Ka La B C A The same holds for point C because this would also fall on a higher iso-cost line as compared to A. We can see that as long as the iso-quant is intersecting iso-cost line, there will always be a trading set for firm to move into and this move will enable it to reduce its cost. The cost minimizing input combination reflected in the iso-cost curves must be tangential to the iso-quant as shown in figure 11.3. Point A is the best technique to producing the desired level of output as no other point on the same iso-quant is any cheaper than this point. Thus this fourth referred the producer equilibrium. What condition applies at the cost-minimizing input combination? We have shown above the best technique is chosen when the two curves are tangent to each other. The tangency condition means that the slope of the iso-quant and the iso-cost line must be equal. Recall from the last chapter that the slope of the iso-quant is given by the negative of the MRTS, and (as discussed above) the slope of the iso-cost line is the negative of the factor price ratio. Equating them (and removing the negative signs) yields: Also remembering that MRTS equals the ratio of marginal productivities, we get: (11.6) This says that the cost minimizing input combination is the one where the marginal rate of technical substitution is equal to the factor price ratio. Equation (11.6) can be converted into another meaningful expression by rearranging it as: (11.6a) The marginal productivity of an input divided by its price is the marginal productivity of a rupee spent on that input, measured in terms of the output. For example, if MPL = 6 bushels of wheat and w = Rs 3, then the marginal productivity is 2 bushels per rupee—each the rupee spent on labor gives 2 bushels of wheat output. Now the equation (11.6a) says that cost minimizing input combination is achieved when the marginal productivity of the last rupee spent on all inputs is the same—i.e. when marginal productivity of the last rupee spent on labor is equal to the marginal productivity of the last rupee spent on capital. Clearly, if the marginal productivity of the last rupee spent on labor is less than that of capital; then the firm should not spend that last rupee on labor; rather it should spend it on capital because here it is more productive. Almost everything in this result is similar in nature to the one we have already discussed in consumer theory, so there is no point in explaining this result any further (see the discussion on equi-marginal principle in chapter 7 if you are not clear yet).

Uniqueness of Equilibrium and Convexity of Iso-quants The last sub-section of the previous chapter stated the type of shape—smooth and convex to origin—that an iso-quant must take for micro economics to make sense. We can now show why it is also necessary for the iso-quant to take this particular shape if micro economic theory is to be justified. Look at the equilibrium point A in figure 11.4 again. This point shows that if a particular wage and interest rate (say w* and r*) prevail in the market, then a firm would hire La and Ka amounts of labor at these input prices. In other words, producer equilibrium shows how many units of inputs a firm demands at given market factor-prices. If factor prices were different than w* and r*; then the firm would choose some other combination of inputs (because changing input prices would change the slope of the iso-cost line just like changing goods’ prices changes the slope of the budget line (for detailed discussion, see chapter 15). As long as iso-quant curves are strictly convex to the organ the problem of cost-minimization will have a unique-solution; i.e. there will be one and only one point of input demand for each particular factor price. This is shown in the left hand panel of figure 11.5 where the lower panel projects the information from input-space to input-wage space. Point a in the lower panel gives the information about demand for labor at wage rate w*. The upper part of the right hand panel draws a kinked iso-quant curve. Note that if tangency occurs in the flat region of the iso-quant, then more than one input combination is consistent with cost-minimization. Such a possibility of non-unique solution implies more than one level of input demand at a single wage rate as shown in the lower panel. We will see in chapter 15 that this situation has devastating implications for micro economics theory of income distribution—according to which the share of an input in national income is a function of its market wage rate which is, in turn urgently, determined by the intersection of a negatively sloped demand and a positively sloped supply curve of that input. It is for protecting their fallacious conceptual framework that economists assume iso-quant curves to be strictly convex—because it is this and only this shape which yield a unique-solution to the cost-minimization problem. Figure 11.4: Non-convex Iso-quants are not consistent with micro economic theory of firm0LKKaLaAY100Lwagew*Laa0Lwagew*LaaLbb0LKKaLaAY10LbBKb Figure 11.4: Non-convex Iso-quants are not consistent with micro economic theory of firm 0 L K Ka La A Y10 0 L wage w* La a 0 L wage w* La a Lb b 0 L K Ka La A Y10 Lb B Kb 11.2.2: Firm’s Expansion Path The tangency between a single iso-quant and an iso-cost line defines an equilibrium point only for some specific level of output. The impact on choice of technique of changes in input prices and output level can now easily be examined. In this chapter, we will analyze the effect of changes in output on the choice of technique while the effect of factor-price changes is left to later chapters (see chapter 15). The above analysis can be performed for many different output levels. For example, the bakery might get another large order or it may simply want to know its cost at various levels of output. At each possible level of output, we can find an input combination that minimizes the cost of production. With given input prices, the problem is just like the one already analyzed and results in the tangency solution, as long as the firm is able to adjust both inputs, as shown by the ray coming from the origin in the left hand panel of figure 11.5. This ray records the cost minimizing tangencies for successively higher levels of output. The set of all cost-minimizing input combinations at different output levels is termed the expansion path, because it records how input use expands as output expands. Note that this expansion path may not necessarily be a straight line as drawn here.

Figure 11.5: Short run and long run expansion paths of firm0LKExpansion pathY10KaLaBCAY15Y250LKShort run Expansion pathY10LdBCAY15Y25DELbLe Figure 11.5: Short run and long run expansion paths of firm 0 L K Expansion path Y10 Ka La B C A Y15 Y25 0 L K Short run Expansion path Y10 Ld B C A Y15 Y25 D E Lb Le The expansion path in the left hand panel assumes that the firm can adjust both of its inputs when choosing the best choice technique or input combination. However, the short run (the duration of time when one input is fixed) expansion path would look different from this long run one. Assume that the bakery has a fixed amount of capital, , to work with. What difference does it make to the expansion path of the firm? The resulting expansion path is shown in the right hand panel which effectively a horizontal line is representing the existing level of the fixed factor combined with varying amounts of the other input. This is the short-run expansion path. For example, to produce Y10 output, the bakery must use Ld units of labor, similarly Lb units of labor must be used to produce Y15 and Le units of labor to produce Y25. Note that combinations A and C are not available in the short-run because of the inflexibility of capital. A somewhat detailed comparison of short-run and long run expansion paths is carried out below in section 11.4.2. The point to note here is that to vary its output in the short-run, the firm is forced to use ‘non-optimal’ input combinations—i.e. it cannot fully minimize its cost of production because of its inability to adjust all inputs. If you have gone through this chapter with some care, you must have found clear resemblances between the theories of capitalist consumer and capitalist producer behaviors. A summary of comparison between them is given in table 11.1. You can easily construct a table listing similarities as well as dissimilarities between microeconomic consumer and microeconomic producer theories from the above table. We leave this as an exercise for you to test your understanding. With this background of cost minimization, we are in a position to relate this with cost curve analysis. We begin by deriving short run cost curves and then move on to long-run cost curves of capitalist firms. Table 11.1: Comparison between theories of consumer and producer behaviors Theory of Capitalist Consumer Behavior Theory of Capitalist Producer Behavior 1 Agent Consumer Producer 2 Objective Maximization of utility, given by utility function U(X,Y) Minimization of cost, given by Iso-cost line = C = w × L + r × K 3 Given Variables Taste represented by utility function U(X,Y) Goods Price, Px and Py Technology represented by production function f(L,K) Input Prices, w and r 4 Constraint Budget line: M = Px×X + Py×Y Given output level, 3 Choice Variable Goods X and Y Inputs L and K 4 Analytical tool Indifference curve: Negatively sloped, convex and unique Slope of IC = Iso-quant Negatively sloped, convex and unique Slope of Iso-quant = 5 Conditions to satisfy MUX > 0and MUY > 0 MPL > 0 and MPK > 0 8 Solution condition

11.3: Short Run Cost Curves Once a cost-minimizing input combination is determined, a specific cost level required to produce a given level of output is also determined. For example, in figure 11.3, the cost of producing 10 dozen donut is given by: Clearly, we can see that the cost minimizing cost level, TC(Y, w, r), is a function of the particular output level to be produced. At larger amounts of output, costs would be higher, as shown in figure 11.5. Further, the input prices also affect the cost but this relation is studied later in chapter 15. Let us explore the relationship between cost and output here. 11.3.1: Deriving Total Cost Short run total cost can be separated into two elements for analytical purposes: fixed cost and variable cost. To see this, recall that total cost is given by: Since K is held fixed in the short run, the equation turns out to be: (11.7) You can see that the cost of capital, rk, is now a fixed cost in the sense that changes in output do not cause any change in this cost element —thus it can be treated as fixed cost. Note that this fixed cost occurs in the short due to a fixed input. On the other hand, variable cost can be reduced by cutting back on hiring the variable input. Here, the variable factor is labor, so that the wage bill, wL, is the variable cost component. Thus we can write the short run cost equation (11.7) as: (11.8) Since fixed cost is not affected by changes in output, any change in total cost due to change in output is caused by the variable cost component. The question now is: how do these costs change as the capitalist firm’s output varies? Fixed and Variable Cost Curves Fixed costs are obviously fixed as they do not change as output changes. This relationship is shown in the left hand panel of figure 11.6 represented by a horizontal line. However, the shape of the variable cost curve as drawn here requires some explanation. To see what determines the shape of the variable cost curve, recall that variable cost is given by What we need to study is changes in variable cost due to change in output; i.e. what happens to variable cost as output increases? First note that producing more output requires hiring more labor inputs as shown by the right hand panel of figure 11.5. For example, if the firm needs to produce Y10 output level; it needs Ld units of labor. However, production of Y15 output requires Lb units of labor. So, we can write: (11.9) where L(Y) is not in multiplicative form, rather it says that the amount of labor input hired by the firm depends upon the amount of output to be produced—i.e. it shows the functional dependence of the input on the level of output. Now we can see the channel through which output affects cost: which can directly be seen in figure 11.4 (as we move to a higher iso-cost line while producing Y15 level of output). So, if output is increased by ΔY amount (by any positive number, say 5 units as shown in the right hand panel of figure 11.4 between iso-quants Y10 to Y15), demand for labor will change by ΔL amount (Lb - Ld), which will cause cost to increase by some amount. Let that change in cost be ΔVC (say Rs 20); then from (11.9), we have:

which says that change in cost is equal to wage rate times change in labor inputs. For example, if labor is increased from 10 to 12 units while the wage rate is Rs 10 per laborer, then change in cost is 20 [= 10 × (12 - 10]. Dividing it by ΔY we get: Figure 11.6: Fixed Cost, variable and total cost curves0YCostFCYoVC0YCostFCYoVCTC Figure 11.6: Fixed Cost, variable and total cost curves 0 Y Cost FC Yo VC 0 Y Cost FC Yo VC TC The left hand side measures the change in cost due to change in output, called marginal cost (MC)—cost of producing an extra unit of output. What about the right hand side of this expression? Obviously, w represents the wage rate which is clear enough to understand, but what is there in the bracketed term? To see its meaning, recall from the last chapter that marginal productivity of labor was defined as change in output due to change in labor: You can see that the bracketed term is just the opposite or inverse of the marginal productivity expression. Thus we can write it as: or (11.10) This is the desired result that we needed to explain the behavior of the variable cost curve. Two results can directly be obtained from this expression: Since both w (wage rate) and marginal productivity are positive, their ratio will necessarily be positive (because a ratio can be negative only if one of the two numbers is negative). Because ΔVC/ΔY is the slope of the variable cost curve, this means that the variable cost curve will be positively sloped in output-cost space as drawn above Since w is constant, the value of the slope of the variable cost curve depends upon the behavior of MPL. Because MPL appears in the denominator, there emerges inverse relationship between productivity and cost: When MPL is increasing, MC will be decreasing When MPL is decreasing, MC will be increasing When MPL is constant, MC will be constant We discussed in the last chapter that the marginal productivity of the variable factor (labor) is assumed to increase initially as more labor is added to the production process because the fixed factor (capital) is ‘underutilized’. Because MPL is increasing initially, marginal cost would be decreasing which means that variable cost rises less rapidly as output expands—in its initial section, the slope of VC decreases, or it is concave. In other words, the range where productivity of each additional input is increasing, each extra unit of output costs less as compared to the previous one. Ultimately beyond some output level, say Yo, the marginal product of labor will begin to decline due to over-utilization of the fixed factor, marginal cost of producing each extra unit of output will begin to rise. Stating alternatively, beyond Yo, the slope of the variable cost curve starts increasing or it becomes convex to the origin. Note that the tangent (or slope) of the VC curve is flattest at output level Yo which means that marginal cost is minimum at this level of output. The Total Cost Curve The (short run) total cost curve can now be simply derived by summing up the two cost curves, as shown in the right hand panel of figure 11.6. This curve has two features. First when output is zero, total costs are not zero but equal the fixed cost component. Since the capital input is held fixed, it must be paid its interest rate even if no production takes place. The firm cannot avoid these fixed costs in the short run. Therefore, the short run total cost curve does not pass through the origin. Since the firm can avoid all variable cost simply by hiring no labor, so the variable cost curve originates from the origin. Secondly, the shape of the total cost curve is solely determined by the shape of the variable cost curve. Because fixed costs are constant, they play no role in determining the shape of the total cost curve other than determining its zero-output intercept. The vertical difference between total cost and variable cost curves is fixed cost. Alternatively, total cost is the variable cost curve shifted upward by the amount of fixed cost. Therefore, the slope of the total cost curve must be the same at each output level as that of the variable cost curve, as shown at output level Yo.

or (11.11) 11.3.2: Per Unit Cost Curves These cost concepts can also be defined in terms of per-unit cost—defined as cost of producing one unit of output. This transformation of the total into the per-unit concept is useful for analyzing many important problems regarding the supply decision of the capitalist firm as discussed in the next chapter. Let’s first discuss the marginal cost concept a bit formally. Deriving the Marginal Cost Curve The marginal cost curve can be derived either from the variable or total cost curve as explained earlier. Let’s look at the broader concept of the total cost for this derivation. In general, the marginal cost curve is defined as change in total cost divided by change in output; i.e. Expressions (11.10 and 11) show that marginal cost of producing one additional unit of output is given by the ratio of the input price to the marginal product of that input. If the wage rate is fixed as is assumed to be the case, then the only factor that can affect marginal cost is the behavior of the marginal product of labor. This is formally shown in Table 11.2. Clearly you can see that if marginal product is rising, marginal cost of producing one unit of output is decreasing, and vice versa. Table 11.2: Relationship b/w marginal product and marginal cost 1 2 3 4 5 = 4 ÷ 3 Labor units Total output Marginal product of labor Wage rate per unit of labor Marginal cost 1 10 10 100 10 2 22 12 100 8.33 3 30 8 100 12.5 For example, if marginal product of the first laborer is 10 bushels of wheat per day and he is paid Rs 100 per day, then an extra bushel of wheat costs Rs 10 [= 100/10]—that is change in cost due to change in one unit of output is Rs 10. Now if the second laborer produces more output as compared to the first one; i.e. if its marginal productivity is greater say 12 units, and he also gets the same wages per day, Rs 100, then the marginal cost of output produced by this\ laborer would be Rs 8.33 [= 100/12] which is less than Rs 10 of the first laborer. This is no magic: if two inputs charge the same amount in rupees but one is more productive as compared to another, then the output produced by more productive labor would cost less than that of a less productive input. Or alternatively, if a worker works harder on Monday and produces more output than he done on Saturday; the cost of output produced on Monday would be less as compared to output produced on Saturday. The same logic applies in the reverse order as shown in the last row of the above table where the fall in marginal productivity of labor has caused marginal cost to rise. The graphical derivation of the marginal cost curve is shown in figure 11.7. First note that the slope of the total cost is given algebraically by In other words, the slope of the total cost curve equals marginal cost. As explained above that economists assume marginal productivity to increase in the early part of production, therefore marginal cost must decreases as output increases initially. This tendency is shown by the tangents at cost curve between points a to b in the upper panel of this diagram. You can see that the tangent is getting flatter as output increases from Ya to Yb—i.e. slope of total cost (or marginal cost) decreases in this range. The lower panel presents a decreasing marginal cost curve in the range of output Ya to Yb. Note that the tangent of the total cost curve is flattest at point b (to its left it is decreasing, and to the right of this point it is increasing). The same information is projected at output Yb in the lower panel where marginal cost reaches its minimum. Thereafter, the slope of the total cost starts increasing, so marginal cost continues to increase after Yb level of output. From the micro economic point of view, this rising segment of the marginal cost curve is the only relevant portion for analytical purposes. Keep in mind that the rising portion of the marginal cost curve is explained by diminishing marginal product of the variable factor in the production process. We will dispute this shape of the marginal cost curve after discussing some other per-unit cost curves first.

Figure 11.7: Derivation of marginal cost from total cost curve0MCMarginal costOutputYaYbYcTotal costabcTCcTCbTCaOutputTCYaYbYc0 Figure 11.7: Derivation of marginal cost from total cost curve 0 MC Marginal cost Output Ya Yb Yc Total cost a b c TCc TCb TCa Output TC Ya Yb Yc 0 Relationship between Marginal and Average Total Cost Curves First consider the average total cost (ATC) concept given by the ratio of total cost to output. Mathematically, (11.12) It measures the cost of producing one unit of output, a concept with which people are most familiar. For example, if a firm has total cost of Rs 100 in producing 20 units of output, then its cost per unit of output is Rs 5. The marginal cost concept has already been discussed as cost of producing one extra unit of output. Note carefully that marginal cost is a change concept while average is a total concept. Table 11.3 calculates values of average and marginal cost for a hypothetical cost structure of a capitalist firm. The values in this table are constructed such that marginal cost decreases initially and then starts increasing forever (look at column 5). Here, we are interested in the relationship between columns 5, 6 and 7. Before exploring this concept, be very clear about the meaning of marginal and average cost values. For example, for output level 2 units, marginal cost is Rs 20 which measures the cost of producing one additional unit of output (obviously the second unit costs Rs 20 to the firm as its cost increases by Rs 20, from Rs 50 to Rs 70, after producing this unit). Table 11.3: Introducing relevant cost concepts 1 2 3 4 5 6 = 4 ÷ 1 7 = 3 ÷ 1 8 = 2 ÷ 1 Y FC VC TC MC ATC AVC AFC 0 50 0 50 - - - - 1 50 20 70 20 70 20 50 2 50 30 80 10 40 15 25 3 50 35 85 5 28.33 11.67 16.67 4 50 45 95 10 23.75 11.25 12.5 5 50 65 115 20 23 13 10 6 50 95 145 30 24.16 15.84 8.25 7 50 135 185 40 26.42 19.28 7.14 On the other hand, average total cost of producing 2 units of output is Rs 40 which indicates cost of producing one unit of output when the firm is producing two units of output. The marginal-average cost relationship can be viewed in two ways. One is by comparing values in columns 5 and 6. You can easily verify the following relationship between them: If MC is less than ATC → ATC decreases (10.13a) If MC is greater than ATC → ATC increases (10.13b) If MC is equal to ATC → ATC is constant at its minimum point (10.13c). For example, in the range of output 1-5, each marginal cost value is less than the previous average total cost value, so ATC is decreasing in this range. On the other hand, each value of marginal cost after 5 units of output is greater than the previous average total cost value, so ATC starts increasing. Such a marginal-average relation has already been discussed in chapter 10 between marginal and average product curves (see section 10.2.2). We, therefore, leave its interpretation as an exercise for the students. Another general way of looking at the same relationship, instead of focusing on any specific numbers, is to recall the fact that there is an inverse relationship between productivity and cost, as explained above. Expression (11.11) shows this fact in terms of marginal cost

which says that marginal cost and marginal product are inversely related—the range where marginal product is increasing, marginal cost must be decreasing and vice versa. A similar type of relationship can also be shown between average cost and average product. To see this, note that average cost, ignoring the fixed cost element, is given by: The bracketed term is the inverse of average product (APL = Y/L), so we have: (11.14) which, again, shows an inverse relation between average cost with average productivity (this is so because average productivity appears in the denominator). These two expressions say that just inverting the marginal-average product curves drawn in the input-output space will give us marginal-average cost relationship drawn in the output-cost space as shown in figure 11.8. If you draw the values of column 5 and 6 in output-cost space, you will get similar type of curves as drawn in this diagram. Figure 11.8: Marginal-average relationship0Rs/unitMCOutputYoATCMC < ATC, so ATC fallingMC > ATC, so ATC risingMC = ATC where ATC is minimum Figure 11.8: Marginal-average relationship 0 Rs/unit MC Output Yo ATC MC < ATC, so ATC falling MC > ATC, so ATC rising MC = ATC where ATC is minimum Again, care must be taken while interpreting this marginal-average relationship. Students often tend to misread this relationship as: ‘when marginal cost is decreasing, average cost is also decreasing and when marginal cost is increasing, average cost is also increasing’. Note that the marginal-average relation is not explained by this line of reasoning. The actual statement of relationship goes like this: ‘when marginal cost is less than average cost, average cost is decreasing and when marginal cost is greater than average cost, average cost is increasing’. In other words, the marginal-average relationship is based on comparison of marginal and average magnitudes—the behavior of the average curve depends on whether the marginal is less or greater than the average. The same type of relationship also exists between marginal and average variable cost curves which can be confirmed directly by comparing columns 5 and 7 of table 11.3. Expressions (11.13a-c) can be used to describe this relationship by just using notation AVC instead of ATC. However, in order to draw AVC curve in output-cost space, we need to know its position with respect to ATC curve. Relationship between Average Total and Average Variable Cost Curves Again, this relationship can be seen either by comparing columns 6 and 7 of table 11.3, or by using general algebraic expressions. We use the later approach to keep our results generally applicable to all sorts of data sets, and compare the values in relevant columns of the above table so as to confirm those general results. Three features can be listed regarding the average-total and average-variable costs relationship: The ATC curve will always by above AVC curve as long as average fixed cost is positive. This can be shown rather easily using the relation (11.8):

Diving throughout by Y we have: or This says that average-total cost is also equal to the sum of average variable and average fixed costs. Writing it as: (11.15) The left-hand side gives the difference between average total and average variable costs. The equation expresses the fact that the difference between the two is equal to average fixed cost. Now we can see that ATC can equal AVC only if AFC = 0. Since AFC cannot be zero in the short run (since FC is not zero in the short run), therefore the difference between ATC and AVC must be positive; i.e. ATC must be greater than AVC. You can clearly see that values in column 6 are greater than those in column 7 for all output levels in table 11.3. Also see that the difference between ATC and AVC equals AFC for any level of output. The average-variable cost curve reaches its minimum point before that of average-total cost curve. Instead of giving a rather rigorous proof of this statement, we discuss the intuitive idea behind it. The fact that the minimum point of average-variable cost is always before that of average total cost follows from: AVC is always below the ATC curve. Marginal cost curve is positively sloped and intersects both ATC and AVC at their minimum points (as discussed above) Consider figure 11.9 to see this relationship. Mere visual observation of this diagram confirms that if the positively sloped marginal cost curve has to cut both the curves at their minimum, then the curve that is positioned below will have its minimum point earlier as compared to the one that is drawn above. There is no way to draw these curves other than the one shown here. Since it is the AVC curve that falls below, this proves our desired statement. To confirm this result in table 11.3, note that the minimum value of ATC is 23 against output level 5, while AVC has its minimum at output level 4 with 11.25. The difference between ATC and AVC keeps on decreasing as output increases. Expression (11.15) can be used to account for this tendency. Because, as you know, average fixed cost is given by dividing fixed cost by output, you should be able to see that AFC must fall with ever increasing output level (with numerator fixed and denominator increasing, the ratio keeps decreasing). According to (11.15), the difference between ATC and AVC equals AFC and since AFC keeps decreasing, this implies that the difference between the two curves falls as output increases. Note carefully that the two curves cannot intersect each other because as long as fixed cost is not zero; AFC cannot also be zero no matter how large the level of output (as long as the numerator is positive, the ratio cannot be zero). It is for this reason that the AFC curve is drawn like a hyperbola which is approaching zero as output expands, but never actually becoming zero. Again values in table 11.2 can be checked for confirmation. Figure 11.9: Average-total and average-variable costs relationship0Rs/unitMCOutputATCMinimum point of ATCYatcYavcAVCminATCminAVCMinimum point of AVCAFC

Figure 11.9: Average-total and average-variable costs relationship 0 Rs/unit MC Output ATC Minimum point of ATC Yatc Yavc AVCmin ATCmin AVC Minimum point of AVC AFC 11.3.3: The Sraffian Cost Curves The last part of Section 10.2.1 developed the famous and rigorous criticism advanced by Sraffa on the neoclassical theory of diminishing marginal productivity. We have seen in the previous sub-section that diminishing marginal productivity is the key to obtain ‘typical cost curves’ as drawn in almost all economic text books. In other words, once the idea of diminishing marginal productivity is questioned, then all of the above cost curves will have different shapes. Let us see what happens to cost curves if we reject this idea and begin with some alternative assumption about the production process. Recall Sraffa’s main argument against diminishing marginal productivity from chapter 10 which says that most production activities are undertaken under constant marginal productivity conditions. This is because firms always use their fixed factor in optimal quantity and leave some of this fixed factor idle when operating below their optimum scale. Hence, under or over utilization of the fixed factor is ruled out. If we agree, as every rational capitalist economist should, with Sraffa, then what type of cost curves would result on the basis of the constant marginal productivity assumption? With marginal productivity fixed, marginal cost (or the slope of total and variable cost curves) also becomes constant. This directly follows from expression (11.11): With numerator (wage rate) and denominator (MPL) fixed, marginal cost is also fixed for all levels of output. The resulting curves are shown in figure 11.10. Panel (a) draws the relevant total (measured in rupees terms) curves. Figure 11.10: Cost curves resulting from Sraffa’s production analysis(a) Sraffian total curves0OutputRsVCTCFC(b) Sraffian per unit cost curves0OutputRs/UnitATCMC = AVC50 Figure 11.10: Cost curves resulting from Sraffa’s production analysis (a) Sraffian total curves 0 Output Rs VC TC FC (b) Sraffian per unit cost curves 0 Output Rs/Unit ATC MC = AVC 50 The fixed cost curve is the same as shown previously. However, the variable and total cost curves are now straight lines representing constant slope, instead of having concave and convex regions. The right hand side depicts per-unit (measured in rupees per unit terms) cost curves. Since the slope of the total cost curve (i.e. marginal cost) is constant due to constant marginal productivity, the MC curve is drawn as a horizontal line at some fixed level. With marginal cost constant, average variable cost is also constant at the same level as marginal cost. This fact can be seen from conditions (11.13a to c) that average cost rises or falls when marginal cost is either greater or less than it. Since marginal cost is constant through out in this case, so would be average variable cost. On the other hand, the average total cost curve is decreasing and getting closer and closer to marginal cost as output increases. This is so because average total cost curve includes average fixed cost element and therefore it cannot equal average variable cost. A table like 11.3 can easily be constructed to confirm these shapes of the curves. The devastating implications of these cost curves for micro economics theory of the firm’s supply decision will be presented in the next chapter.

Moreover, apart from dismissing the diminishing marginal productivity assumption, Sraffa also exposed a rather more technical and fundamental weakness of the micro economics theory of the firm. We pointed out in chapter 10 that capital (K), one of the factors of production in the micro economics production function Y = f(L, K), cannot be treated as a quantity because of aggregation problems. Any meaningful interpretation of capital to make sense is to use it in value terms (price of capital times its quantity; Pk × K). The cost equation now becomes: Since the price of capital (Pk) itself includes interest payment (r) as its constituent part, the cost equation turns into a complex non-linear relationship, instead of a linear one, that cannot be drawn as a straight line. This non-linearity has serious negative implications for all of the micro economic generalizations regarding the behavior of the firm. This is dealt in detail in chapter 16. At this juncture, let’s move on to analyze the conventional micro economic analysis of the long run behavior of cost. 11.4 : Long Run Cost Curves When it comes to analyzing long run cost behavior, the fixed factor ceases to appear in the cost equation as the long run is defined as the decision horizon when all inputs to production are variable in nature. Therefore, the cost equation to be analyzed becomes without bar on either of the two inputs. This means that the factor ‘fixed cost’ is no more included in the long run cost as all costs are variable costs. With the disappearance of fixed cost, total and variable cost are synonymous to each other; and so is the case with ATC and AVC cost curves. This means that the numbers of curves to be analyzed in the long run are three: long run total cost (LTC), long run average total cost (LATC) and long run marginal cost (LMC). First we discuss the long run average total cost curve. 11.4.1: Long Run Average Total Cost Probably one of the most important of all cost concepts in micro economic theory of the firm is the long run average total cost curve. Recall that average total cost is given by: To analyze this equation, we need to concentrate on what happens to the numerator (total cost) and denominator (output) of this expression as all inputs are changed by certain percent, say 100%. Let us assume that the firm doubles all its inputs—i.e. 100% change in all inputs. What happens to total cost? It is clear that with given input prices, if all inputs are purchased in exactly double quantity, then total cost will also double. So the total cost or the numerator increases by 100% in this case. How much would the effect of this doubling all inputs have on output? Recall from the last chapter that long run response of output to input changes depends upon returns to scale. It depends upon whether there are increasing, decreasing or constant returns to scales. We take each of the three cases one by one. IRS: If there are increasing returns to scale (IRS), then output will increase by more than 100% after doubling all inputs. With denominator increasing by more than the numerator, the ratio must decrease. This can be seen as:

Thus, long run average total cost must be falling in the case of increasing returns to scale in production. A firm facing production opportunities that allow increasing returns to scale as output expands will experience decreasing average total cost in the long run. The intuition behind this fact is easy to understand: if, after increasing all inputs by x%, total cost increases by x% while output increases by more than x%, then cost of producing one unit of output must fall. Figure 11.11: Behaviour of a typical long run average-total cost curve0Rs/unitOutputYoptimalLATCEfficient level of plant sizeIncreasing Returns to ScaleDecreasing Returns to ScaleConstant Returns to ScaleLATCmin Figure 11.11: Behaviour of a typical long run average-total cost curve 0 Rs/unit Output Yoptimal LATC Efficient level of plant size Increasing Returns to Scale Decreasing Returns to Scale Constant Returns to Scale LATCmin DRS: One the other hand, if a firm is experiencing decreasing returns to scale (DRS) in production, then output will increase by less than 100% after doubling all inputs resulting in less than 100% increase in the denominator. This time with the denominator increasing by less than numerator, the ratio must increase. Thus, a firm undertaking production in case of decreasing returns to scale as output expands will see its average total cost rising in the long run. Again, the intuitive idea behind this is easy enough to grasp. CRS: Here output will increase by exactly 100% after doubling all inputs, so the denominator increases by 100%. The ratio remains the same because the denominator and numerator change by the same amount in this case. Thus, all production techniques characterized by constant returns to scale have constant long run average total cost curves. The verbal discussion is translated into graph i.e form in figure 11.11 that draws a typical long run average total cost curve exhibiting all of the three tendencies. You can see that the LATC curve is falling in the range of output where increasing returns to scale exist, while it is rising where decreasing returns to scale exist. The tendency of falling LATC is termed economies of scale while that of rising LATC is called diseconomies of scale—a firm is said to experience economies (diseconomies) of scale in the long run if its average total cost is decreasing (increasing). The lowest point on this average cost curve, LATCmin, shows the minimum necessary price that must prevail in the market if production is to take place at all in the long run by a capitalist producer. Above this price, the firm will not only be able to pay all its inputs but also earns some economic profit. This price level is important for analyzing long run decision making of firms in competitive markets. These capitalist firms are often willing to sustain losses and continue to produce between their minimum price even in the long run Issue of Reserve Capacity In the microeconomic theory of cost, the most efficient level of plant size is reached when the capitalist firm is producing Yoptimal output where cost of producing one unit of output is the least. Of course, if the capitalist firm is asked to choose the best plant size, it would like to operate at minimum average cost level—because this would be tantamount to using plant at the most efficient level. Such a level of output is termed efficient scale of production. Non-capitalist production units will have quite a different definition of efficiency. Note that the U-shaped neoclassical LATC curve is based on the critical assumption that there is one and only one efficient plant size available for the capitalist firm each plant is designed to produce optimally only a single level of output. Any departure from that particular level of output leads to inefficiency in the sense that average cost of production would be more than its minimum at that output. In other words, according to microeconomic theory of cost, the plant is completely inflexible and capitalist firms do not plan any reserve capacity at all in their plants. Such an unrealistic assumption about capitalist capacity policy has been questioned by many writers as early as the 1930s. The crux of their criticism is that firms build plants with some flexibility in productive capacity so that the average variable cost curve has a flat stretch over a range of output as shown in the left hand panel of figure 11. 12.

Note that planning reserve capacity means constant average variable cost of production over some range of output. This reserve capacity allows a firm to vary its output, say, in the range Ya to Yb without incurring any increase in its average variable cost. Several reasons have been advanced to explain this phenomenon. First, businessmen require such reserve capacity in order to meet seasonal and cyclical fluctuations in demand. Second, reserve capacity gives better opportunities for repair of broken-down machinery without disrupting the smooth flow of production. Third, since all capitalist businessmen look for growth, they will want to have some freedom to increase output in case demand increases. Firms do plan reserve capacity in anticipation of excess demand because they cannot afford to lose all of their new customers to their rivals as this endangers their future hold on the market. Fourth, some reserve capacity is always allowed in the land and building since, otherwise, any expansion in production would be seriously constrained if a new building has to be built. Finally, some reserve capacity will be required with regard to the organizational and administrative staff to allow some increase in the operation of the firm. In summary, capitalist firms do not choose the plant size which gives them the lowest cost today, rather they choose that plant equipment which permits them greater production flexibility for alterations of their production plans in future. Figure 11.12: Reserve and Excess capacity0OutputRs/unitAVCYaReserve capacityYb0OutputRs/unitAVCYaExcess capacityYm Figure 11.12: Reserve and Excess capacity 0 Output Rs/ unit AVC Ya Reserve capacity Yb 0 Output Rs/unit AVC Ya Excess capacity Ym Note that reserve capacity is completely different from excess capacity which emerges with U-shaped cost curves of traditional micro economics theory of cost (see right hand panel of 11.12). Traditional theory is built on the assumption that each plant is designed without any flexibility to produce only a single optimal output level (Ym). According to this theory as long as the firm is producing an output smaller than Ym, say Ya, there would be excess (unplanned) capacity equaling Ym - Ya. Obviously, excess capacity is undesirable because it leads to higher unit costs. A vast empirical literature has also been accumulated in support of the shape of the cost curve shown in Fig: 11.12. Given this it is surprising to see that almost all recently published microeconomics textbooks are still based on the traditional U-shaped cost curves. The reason for this adherence of micro economic theory to this conventional shape of the cost curve would be discussed in the next chapter. 11.4.2: Relation between Short-Run and Long run: The Envelop Curve Economists derive the long-run average cost curve from short run average cost curves in a technical way that creates a sense of a neat relationship between the two time horizons. Since the long run is defined as the duration of time when all factors can be varied, the long run average cost curve becomes a planning curve of the firm in the sense that it provides guideline to the entrepreneur in his decision to plan expansion of the output. Let us briefly develop this argument. Suppose that a capitalist firm has three methods of production each requiring different plant size: a small plant, medium plant and large plant. The respective average cost curves are shown in figure 11.13 according to which the small plant operates with cost denoted by SACs, the medium plant generates cost shown by SACm and so on for large plant. If the firm is planning to produce Y1 level of output, it will choose the small size plant as this is the most efficient size for producing Y1 output. Now assume that the demand for this firm’s product increases gradually from Y1 to Y2. The average cost of production decreases up to Y* and then starts rising beyond this level of output. However, if demand increases to Y** level, the firm can either continue to use the small size plant or install the medium sized one.

Figure 11.13: Decision making with different plant sizes0OutputRs/unitSVCsY1Y3SVCmSVCLC1Y*Y**C2YoY2 Figure 11.13: Decision making with different plant sizes 0 Output Rs/unit SVCs Y1 Y3 SVCm SVCL C1 Y* Y** C2 Yo Y2 At this point, the decision does not depend upon the cost factor. It depends on the expectations of the firm about its future demand situation: if it believes that demand will expand beyond Y**, it will install the medium size plant because any output larger than Y** can be produced at lower cost with the medium size plant as compared to the small one. This can be verified by comparing cost levels at output Y2 with small and medium size plants. Clearly, average cost at the medium size plant (C2) is smaller than that of the small plant (). The firm faces the same kind of considerations when it reaches Yo level of output where it can work either with the medium or the large size plants. But the extra investment on the large plant is justified when output is greater than Yo, say Y3, because this output can be produced at lower cost with the large plant. Now relax the assumption of only three plants and assume that the available technology allows many plant sizes (to be precise an infinite number of plants). Each plant size is suitable for a specific level of output beyond which the firm would want to install a larger plant and, in this case, the intersection points of consecutive plants would be many in numbers. Figure 11.14 shows the formal derivation of the long run average cost curve with five plant sizes. Each point of this curve shows the least cost of producing the corresponding level of output. Two points should be noted carefully regarding the shape of this curve. First, the long run average cost curve is drawn as an envelop of short run average cost curves because long run average cost is always less than that of the short run. To verify this fact, go back to figure 11.5. The right hand panel shows that due to fixed capital in the short run, the firm cannot achieve the minimum cost level (or tangency) for all levels of output. There is one and only one level of output where the solution of the cost minimization problem is the same both for the short run and the long run. Figure 11.14: Long run average cost curve as envelop of short run ones0Rs/unitOutputYoptimalLATCLATCmin = SATCmin Increasing Returns to ScaleDecreasing Returns to ScaleConstant Returns to Scale Figure 11.14: Long run average cost curve as envelop of short run ones 0 Rs/unit Output Yoptimal LATC LATCmin = SATCmin Increasing Returns to Scale Decreasing Returns to Scale Constant Returns to Scale It is exactly this level of output where the short run and the long run average costs would be the same. For all other output levels, short run average cost would be greater than long run one. Therefore, all of the short run average cost curves must be above long run average cost curve. Secondly, the shape of this curve reflects the laws of returns to scale (see figure 11.11). Note that in the range of output level where the firm is experiencing increasing returns to scale, long run average cost is tangent to short run cost curves before their minimum. On the other hand, long run average cost becomes tangent to short run ones in their rising portions where decreasing returns set in. Finally, both short run and long run cost curves are minimum where constant returns to scale are the case.

The relationship between short-run and long run marginal cost curves is a bit complex. Unfortunately, the derivation of long run marginal cost is tedious but, fortunately, not learning it causes no real harm to students as it adds very little in understanding the upcoming discussions in the next chapter. Interested students can see any good text on microeconomics (e.g. that by Koutsoyianis) to take a step ahead in this direction. We will now move on to analyze the supply decision of the firm within different market structures. Key Concepts Average fixed cost is fixed cost per unit of output, calculated by the ratio of fixed cost to output Average total cost measures total cost per-unit of output, calculated by dividing total cost by the output level Average variable cost is the ratio of variable cost to output Choice of technique is the problem of choosing optimal combination of inputs to produce a specific level of output at given factor-prices Cost refers to the sum of expenditures needed to produce a given level of output Diseconomies of scale refers to the phenomenon of increasing long run average cost as the scale of output expands Economies of scale refers to the phenomenon of decreasing long run average cost as the scale of output expands Efficient scale of production is the point on long run average cost curve where average cost of production is the least Expansion path is the set of all cost-minimizing input combinations at all output levels, given the prices of inputs and knowledge about technology Explicit cost refers to expenses which the entrepreneur has to pay from his own pocket for the purchase of inputs Factor-price ratio is the ratio of input prices—ratio of wage rate to rental rate—and measures the relative prices of factors Fixed cost is the part of cost that does not change as output changes and that can’t be avoided in the short run Implicit cost stresses the cost of foregone alternative actions though no physical payment is made against them out of pocket Iso-cost line represents different input combinations that cost the same amount Long run average total cost curve is the envelop of short-run average total cost curves Marginal cost is the change in total (or variable) cost due to change in output Opportunity cost is the value of second best alternative Producer equilibrium is the cost-minimizing input combination point where iso-quant and iso cost line are tangent to each other Reserve capacity is the fact of designing plants with some flexibility in productive capacity so that average variable cost curve has a flat stretch over a range of output Short run total cost is the total cost of production, given some level of fixed factor. It is the sum of fixed and variable cost components Short-run Expansion path is the set of all cost-minimizing input combinations at all output levels, given the prices of inputs, knowledge about technology and the level of fixed factor usage Variable cost is the part of cost that changes with output Chapter Summary Cost is the sum of expenditures required to produce a given level of output. Opportunity cost is the value of foregone consumption in producing a given level of output

Opportunity cost theory cannot be applied to an analysis of the behavior of non-capitalist individuals because capitalist value cannot be ascribed to the product / output of these individuals Algebraically total cost can be written as: TC = (w × L) + (r × K) Where TC = total cost,w = te wage rate, r = the interest rate, L and K are total labor and total capital employed by the capitalist firm The microeconomic theory of the firm assumes that every capitalist firm has to accept the (perfectly competitive) market wage and interest rate as the cost of labor and capital. The price of the output the capitalist firm produces is also assumed to be fixed and, therefore, the capitalist firm can effectively choose only the total amount of capital and labor to produce a given output—it can have no influence over the prices of inputs or output Capitalist firms are cost minimizers because they are profit maximizers (non-capitalist and anti-capitalist firms need not be profit-maximizers. From the capitalist’s point of view the rational choice of technique (combination of production inputs) is that which minimizes the (capitalist) cost of producing a given level of output The choice of technique problem may be stated as; minimize TC by choosing optimal amounts of L and K subject to the constraint that the given level of output can be produced only by using a combination of L and K The iso-cost curve shows different combinations of input factors entailing the same total cost. The slope of the iso-cost curve is given by the ratio of input prices (w/r) where w is the market wage rate and r the market rate of interest. w/r is known as the factor price ratio and shows the cost of using one unit of a factor of production (say labor) in terms of the other factor (say capital) Since we assume that w and r are fixed (by the market) and the capitalist firm is a price taker, all iso-costs have the same slopes and differ only in terms of their vertical intercepts which reflects the level of costs for which they are drawn. The cost minimization problem is therefore solved when the capitalist chooses the input combination which produces the desired output and is on the lowest cost curve The cost minimizing input combination is indicated by the tangency of the iso-quant producing a given level of output with an iso-cost line depicting that same level of cost. The point of tangency between an iso-cost line and an iso-quant representing a given level of output indicates capitalist producers’ equilibrium The best (i.e. cost minimizing) technique of production (input combination) from the capitalist point of view is indicated by the equalization of the slopes of the iso-quant and the iso-cost line. At this point the marginal rate of technical substitution—which is the ratio of the factor productivities—equals the factor price ratio. This is the cost minimizing input combination and therefore the best technology of production from the capitalist point of view. This indicates that the best technology of production for the capitalist firm—the technology which enables it to minimize costs and maximize profit—is indicated by the equalization of the ratios of marginal productivities to input prices of all inputs used in producing a predetermined level of output

For a unique equilibrium input price to be identified for each level of output, iso-quant must be assumed to be convex to the origin. Otherwise multiple input levels of usage can be identified for the same input price and this renders microeconomic theory incoherent The long run expansion path of a capitalist firm depicts the loci of tangencies between iso-quant and higher iso-cost curves. In the long run, the firm can vary the use of both inputs, whereas in the short run one factor is fixed and therefore the line showing the short run expansion path is usually drawn parallel to the x-axis because one factor of production is fixed in the short run hence the capitalist firm cannot use the cost minimizing input combination in the short run Comparison between the microeconomic theory of capitalist consumption and capitalist production are summarized in Table 11.1 In the short run we must take account of both fixed and variable costs. The short run variable cost curve is positively sloped with respect to output. Since we assume that wages are constant there is necessarily a negative relationship between marginal productivity and cost The slope of the total cost curve equals the marginal cost. Marginal cost has a negative relationship with marginal productivity. Marginal cost decreases when marginal productivity increases, is constant when marginal productivity is constant and increases when marginal productivity decreases When marginal cost is less than average cost, average cost falls and when marginal cost is greater than average cost average cost rises. Productivity is inversely related to average cost Average cost and average productivity are also inversely related The average variable cost curve reaches its minimum before the average total cost curve reaches its minimum because average variable cost is always lower than average total cost in this short run and because the marginal cost curve is assumed by microeconomic theory to be positively sloped and to cut both the average total and the average variable cost curves at their minimum points Sraffa rejected the theory of diminishing marginal productivity on the ground that most capitalist production takes place in conditions of constant marginal productivity. With marginal productivity fixed, the slopes of the total and variable cost curves also become constant. On this basis “Sraffian” marginal and average cost curves are horizontal and average total cost curve decreases and gets closer and closer to the marginal cost curve as output increases Long run average total costs will (a) decrease in the case of increasing returns of scale and (b) increase for decreasing returns to scale The optimum level of production for a capitalist firm thus is at the minimum level of average total cost. Microeconomic theory assumes that there is one and only one efficient plant size. But this implies that capitalist firms do not value production flexibility and plan no excess capacity which can allow them to react quickly to changes in market conditions. This is an unrealistic assumption

Planning reserve capacity implies constant average variable cost of production The long run average cost curve is an envelope of short run average cost curves—the long run average cost curve is always lower than short run average cost. Short run and long run average cost curves are at their minimum when constant returns to scale prevail Review Questions Discuss the microeconomic concept of cost and opportunity cost. Distinguish between explicit and implicit opportunity cost. Why cannot the theory of opportunity cost be employed in evaluating the productive activities of non-capitalist individuals and businesses? What are the assumptions underlying the microeconomic theory of the choice of techniques? What choice of technique is considered rational by microeconomic theory and why? Would non-capitalist producers consider this choice of technique to be rational? What would determine the choice of technique of non-capitalist firms? Discuss similarities between the budget line and the iso cost curve. Geometrically demonstrate the solution to the cost minimization problem using iso-quant and iso-cost curves. Why does the point of tangency between the curves represent the best technology for producing a given level of output by the capitalist firm? Show that the cost-minimizing input combination (capitalist technology of production) is the one where the marginal productivity of all factor inputs is equalized. Why does microeconomics assume that iso-quant is necessarily convex to the origin? Construct a table showing similarities and dissimilarities between the microeconomic theories of capitalist consumption and capitalist production. Using a diagram, derive the marginal cost curve from the total cost curve. Discuss the relationship between the marginal cost and the marginal productivity curves. Discuss the relationship between average, marginal and total cost curves. Discuss the relationship between the short run total cost and average variable cost curves. What are the similarities and differences between Sraffian cost curves and ‘normal’ cost curves of neoclassical theory? Explain the concept of ‘economies of scale’ and ‘diseconomies of scale’. Distinguish between the capitalist and the non-capitalist conceptions of “efficient production level”. “Even capitalist firms do not choose cost minimizing plant size in the short run.” Why? Distinguish excess capacity from reserve capacity. P A R T F O U R Firm in the Output Markets Foundations and Justification of Market Empowerment Chapter 12: Perfectly Competitive Output MarketsChapter 13: MonopolyChapter 14: Monopolistic Competition and Oligopoly Chapter 12: Perfectly Competitive Output Markets Chapter 13: Monopoly Chapter 14: Monopolistic Competition and Oligopoly Chapter 12 PERFECTLY COMPETITIVE MARKETS Economic theory abounds with normative expressions, and ‘perfect competition’ is perhaps the most value-laden of all of them. The doctrine of “pure and perfect competition” is a central element both in contemporary economic theory and in the practice of the Anti-Trust Divisions of the Department of Justice of most capitalist countries. “Pure and perfect competition” is the standard by which contemporary economic theorists and Justice Department lawyers decide whether an industry is working ‘rightly’ (competitively) or ‘wrongly’ (monopolistically). This chapter outlines the widely used model of perfect competition. We begin this chapter with a definition of perfect competition and its implications. Section 2 analyzes the profit-maximizing supply decision of the firm and the shut-down rule. In section 3 we discuss the long run equilibrium of the firm. Lastly section 4 lays the foundation for identifying weaknesses in the model of perfect competition that we will further develop in the next chapter.

12.1: Structure of Perfect Competition “Pure and perfect competition” is totally unlike anything one normally means when using the term “competition”. Normally the word “competition” has the connotation of intense rivalry; among producers in which each firm strives to match or exceed the performance of all others. But this is not what “perfect competition” means. Economists define markets as perfectly competitive if and only if they fulfill the following set of conditions: Very large numbers of buyers and sellers are interacting in the market A homogeneous product is being exchanged Perfect information is freely available to all market agents ( a particularly unrealistic assumption when information has become a commodity) There is free input mobility; i.e. no transaction costs There is absolutely free entry and exit for firms—i.e. no barriers whatsoever 12.1.1: Implications The assumptions could best be understood by reflecting upon their implications. Let us consider some of them here. Price Taking Behavior The first two of these assumptions say that the market should be composed of many small firms that produce an identical product. This means that each firm should be a small part of the market; i.e. its share in total market supply should be so small that it does not affect market supply. Consider for example the market for wheat in Punjab. There are thousands of wheat farmers, and even the largest of them produces only an infinitesimal fraction of total supply. Moreover, once wheat produced by each farmer has been collected in huge heaps, no single farmer can identify his product from that of others. In other words, all farmers produce more or less identical wheat. This market structure (where many small sellers are selling identical products of a relatively small category range) leads to price-taking behavior (discussed in chapter 7). This refers to a market situation where no individual, whether consumer or seller, has the power to affect market price of the sold commodity. This is assumed to be so because when there is a very large number of small sellers in the market, then share of each single seller will be so small in total market supply that he can produce no significant pressure on market supply by his individual decision to sell or not to sell at the given market price. Thus all individuals are forced to accept the price of their products as is given by the impersonal market. Law of One-Price The third and fourth assumptions, when combined with the first two, lead to the concept of the law of one-price—i.e. a commodity can be sold at one and only one price in a competitive market. This happens due to arbitrage—the practice of making profit by purchasing a commodity from where its price is lowest and selling where price is higher. To see why this must be the case, consider what makes it possible for capitalist firms to engage in price-discriminating policy. Suppose that a similar product, say milk, is sold at two different prices (Rs 32/liter and Rs.36/liter) in Lyari and Clifton respectively. One possible reason for this price differential to persist in Karachi markets could be the lack of information on the part of buyers; i.e. buyers may not be aware of this price differential. A profit-maximizing seller tries to make use of such a situation by charging different prices from different customers depending upon their demand intensity (price elasticity of demand) or purchasing power. Application Box 12.1 shows how jewelers do their best to benefit from imperfect information on the part of consumers. If customers are simply unaware of differences in prices, price differential will persist.

A P P L I C A T I O N B O X 12.1 Imperfect information and Jewelers at Saddar If you ever visit Sadar Karachi, you would see dozens of jewelers shop all along Zaib-un-Nisa street. Though all of them are selling almost similar gold (normally 21 and 22 caret), yet you would experience slight differences in price, ranging from Rs 50 to 100 per gram, if you happen to visit a dozen shops. Why does this price-differential exist even if there are so many sellers selling almost identical product? Simply because not all consumers have access to information about the current price prevailing through the market. Moreover, not all consumers have enough time and energy to collect price information visiting all over the market before making purchases. It is this lack of information on the part of consumers that capitalist sellers try to make profit on. However Abdullah may be a non-capitalist jeweler. He is not in the market to maximize profit but to perform his religious obligations. He may be willing to sell at the lowest price required to maintain a modest income sufficient to sustain his family which practices qana’at and fuqr. Abdullah may probably discriminate among customers selling at loss making low prices to poor widows to facilitate the marriage of their daughters. This shows that the law of one price as well as all other aspects of microeconomic supply theory applies only to the behavior of capitalist producers in capitalist markets. Another reason that may result in price differential in capitalist markets is cost of transporting goods from one place to another—transaction cost. If it costs, say, Rs 2/unit to transport milk from Lyari to Clifton, then milk may be sold at a price Rs 2/unit greater in Clifton as compared to Lyari—because it will not be profitable in this case for any capitalist to purchase milk from Lyari and sell at Clifton. Finally, prices may be different at two places because capitalist market agents do not enjoy free entry or exit in the market. For example, even if one knows that price at Clifton is higher than the price at Lyari, but Clifton Milk Association does not allow outsiders to do business freely at Clifton and sell at lower prices. So there is no way to eliminate this price differential. Now consider the hypothetical perfectly competitive capitalist market where all agents have perfect and free access to information regarding all profit maximizing aspects (e.g. price and quality levels), further there is no such thing as transportation cost and all of the agents have got perfect freedom to move in and out of the market —i.e. they face no barrier against their desire to maximize utility/profit, whether legal, social or psychological. All individuals and social organizations are fully committed to capitalist rationally. It would then be impossible to charge two different prices for the same commodity. Consider the milk example again. If capitalist firms know that there is a profit margin of Rs 4/liter sold at Clifton, they will practice arbitrage. In this case, demand for milk will increase at Lyari which will put upward pressure on price at Lyari. On the other hand, supply of milk would increase at Clifton resulting in downward pressure on price there. Obviously, the margin of profit will start shrinking. But to what extent? Since we assume that it costs nothing to move milk from Lyari to Clifton, the arbitrage will continue until prices are at par throughout the Karachi market—the possibility of making a profit of even a single paisa is not left unrealized in such a market. Thus, perfectly competitive capitalist markets ensure single market price for all capitalist agents, whether consumers or producers, and this is the reason why it is termed ‘perfect competition’. It provides ‘equal’ opportunities to all market agents. All market participants face one and only one price in the market and all of them have no power to change this one efficient (profit and utility maximizing) price.

The Fiction of the ‘Horizontal-Demand-Curve’ The most important consequence of the above two implications is the notational fiction of the ‘horizontal demand curve’ assumed to be faced by each single firm in a competitive market. Its diagrammatic representation is shown in figure 12.1 where the left hand side indicates the market position whereas the right hand panel shows a single representative firm operating in this market. The diagram shows that the market price (say, Pc) is determined by the interaction of market demand and market supply curves; which is the outcome of utility and profit maximization decisions of all capitalist consumers and firms in this market. Since no single firm can change this market determined price by its behavior, hence price is fixed for each single firm in this market. In other words, a firm cannot change market price by adjusting its quantity offered for sale in the market—it can sell whatever amount it wants at the given market price. This implies that a firm will be facing a horizontal demand curve which means it has the possibility of selling very large (or infinite) amount of goods in the market. Note two important things: first the possibility of selling infinite output does not mean that a firm will actually sell this much amount, the exact level of output offered for sale by a firm will be determined by its cost structure (discussed below). Second; no matter how large a level of output a firm produces, its share in total market output must remain relatively very small because we have assumed a very large number of firms operate in the market. It is highly important that the market share of no single firm should be significant because the moment its share becomes large enough to control market price, the market seizes to be perfectly competitive as it violates the ‘price-taking behavior’ assumption. Figure 12.1: Situation of a typical firm operating in a competitive capitalist market0YPriceDM(sum of all consumers’ demandYcPcSM(sum of all firms’ supply0YRs/unitPcD(demand curve facing a single firm)MarketFirm Figure 12.1: Situation of a typical firm operating in a competitive capitalist market 0 Y Price DM (sum of all consumers’ demand Yc Pc SM (sum of all firms’ supply 0 Y Rs/unit Pc D (demand curve facing a single firm) Market Firm FC FC If you are thinking of ‘real world’ markets that are characterized by such an environment; then you will soon learn that there is no market in this world which is (or has ever been) perfectly competitive! Markets such as these of wheat and milk may seem come close to this standard; however no real market can ever be classified as perfectly competitive. For example, consider the market for wheat. Though it might be true that thousands of farmers produce almost identical wheat in Punjab, yet the market is not free from transaction costs and entry barriers. If this is the case, then why do microeconomists study perfectly competitive markets at all; especially when it is known that such extreme conditions simply cannot hold in reality? FYI Box 12.1 sets out the reasons for this.

F Y I B O X 12.1 Why Perfect Competition? Remember that the reason to model such a market is not based on its empirical existence, but on its capacity to serve as bench mark so as to evaluate real world market structures—the model of perfect competition is the standard to judge all other market structures in terms of their capitalist efficiency and quality. Recall from chapter one that the capitalist problem is to allocate scarce resources efficiently. But the question is: ‘in which sort of environment maximum efficiency can be achieved?’ Economists hope to show (as we discuss below) that perfectly competitive markets provide an environment that guarantees efficient allocation of resources; i.e. if we can somehow turn all markets into competitive ones, then efficiency will be maximum. Economists believe that any departure from the five conditions underlying the perfectly competitive model means inefficiency; and the larger the extent to which a market deviates from these conditions, the greater will be efficiency-loss imposed on society. Remember ‘efficiency’ means maximization of profit/utility and nothing else. You might ask: ‘why should we have any standard or ideals at all?’ It is important for economists to develop a standard or ideal because economics is necessarily a normative i.e. moral science; and not positive as claimed, as have been shown at several places in this book. The ideal of perfect competition serves three basic purposes, as far as capitalist efficiency is concerned: provides the bench-mark to evaluate real world markets (you may think of it as the criterion of ‘good and bad’ to economists) shows the direction in which markets must be geared justifies appropriate policy tools and regulations required to move markets in that particular direction Economists believe that if a society is committed to the achievement of efficiency (accumulation), it should, and must, strive hard to maximize on perfectly competitive markets. To them, changes suggested by their theories in the existing social set-up will make this world a better place because these changes will take the real world closer to their hypothetical ideal world—a world order based on Enlightenment ideals with endless possibilities of accumulation. This shows that the dictum of perfect-competition is not a positive-fact discovered through some inductive observations, but a normative prescription based on dogmatic belief in freedom and progress. Economics is by no means committed to a description of the world that we live in. It is a prescription to which the actual world should be molded into. The conviction to subjugate the fate of our world in the hands of economics is not because of the fact that economists have won some public election; rather it is based on the belief that economic theory is sound. More on the importance of this idealized market structure is said later in this chapter (see section 12.4). It should be remembered that capitalism is a system—a complete and comprehensive way of life. Every such system defines efficiency on the basis of its own perception of the good. The capitalist conception of good is the maximization of freedom. The capitalist conception of efficiency is derived from this conception of the good. In capitalist order the most efficient pattern of resource distribution is that pattern which maximizes freedom of capital accumulation.

In Islam (and Christianity), on the other hand, the good is defined as achieving Allah’s approval in paradise. Abdullah Zhaghzai regards that pattern of resource allocation as efficient which makes it easier to earn Allah’s approval. This pattern of resource allocation universalizes Ibadat and explicitly rejects the maximization of freedom as a value. Therefore, the capitalist efficient pattern of resource allocation is the most inefficient form Abdullah Zhaghazai’s point of view for it maximizes freedom/capital accumulation and the way of life this pattern of resource allocation promotes makes it more and more difficult for Abdullah to take account of the impact of his economic transactions on his quest for reaching Paradise. Historically the growth of the capitalist market has been a fundamental cause of reducing religious consciousness and in delegitimating the religious essence of production, consumption and exchange. 12.1.2: Revenue Structure of the Competitive Firm Working out revenue structure of a competitive firm, is a straight forward matter. We need revenue structure of the firm before analyzing its profit maximizing supply decision because profit is the difference between revenue and cost; i.e. Profit (π) = Total Revenue (TR) - Total Cost (TC) Behavior of cost has been discussed in the last chapter in detail; let’s deal with the second part on the right hand side of this equation. Recall that total revenue equals price times output: Total Revenue = Price × Output = P × Y Since the competitive firm is a price taker; so price is fixed which gives: (12.1) This means that total revenue is a linear function of output—i.e. the total revenue curve must be a straight line. To see how, consider table 12.1. You can see that total revenue in the third column is increasing by a constant amount, five, every time output increases by one unit. This translates into a straight line total revenue curve as shown in the left hand panel of figure 12.2. Table 12.1: Relation between MR, AR and Price 1 2 3 = 1 × 2 4 5 = 3 ÷ 2 Price Output Total Revenue Marginal Revenue Average Revenue 5 0 0 - - 5 1 5 5 5 5 2 10 5 5 5 3 15 5 5 5 4 20 5 5 Such a straight-line revenue curve bears an important relation between price, marginal revenue (MR) and average revenue (AR). Marginal revenue is the change in total revenue due to one unit change in out put: (12.2) Figure 12.2: Revenue structure of a competitive firm0YRs/unit5 = D = AR = MRY0Rs15TR105123 Figure 12.2: Revenue structure of a competitive firm 0 Y Rs/unit 5 = D = AR = MR Y 0 Rs 15 TR 10 5 1 2 3 For example, marginal revenue from selling the first unit of output is Rs 5, from the second it is again Rs.5/-, and so on (see column 4). The last column measures average revenue which is given by the ratio of total revenue to output: (12.3) Again, for example, average revenue of selling two units of output is Rs 5 [= 10 / 2], of three units it is Rs 5 [= 15 / 3]. Note very carefully the difference between marginal and average revenues: the former measures revenue earned on selling an additional unit of output while the letter measures revenue per unit of output.

The important thing to note from this table is that price, marginal revenue and average revenue are always equal for all levels of output (look at columns 1, 4 and 5]. So, we can say that for a competitive firm; P = AR = MR. The intuitive as well as algebraic derivation of this result is straight forward. First consider price and average revenue. We can show that by definition average revenue is equal to price-- price measures average revenue because price itself is revenue per unit of output. Using expressions (12.1) and (12.3) we have: (12.4) This means that average revenue and price must always equal each other. Now consider price and marginal revenue relationship. If price is fixed for all units of output, then each extra unit of output will earn an amount of revenue equal to price—if price is Rs 5/unit, then each extra unit sold will bring extra revenue of Rs 5 for the firm, thus establishing equality between price and marginal revenue. To see this algebraically, use (12.1): (12.1) With price being fixed, if output changes by some amount, say ΔY, total revenue also changes by some amount ΔTR. So we have: Dividing throughout by ΔY we get the desired result: (12.5) With price equaling both average and marginal revenues, we have P = AR =MR—exactly what we wanted to show. The relevant curves are depicted in the right hand panel of figure 12.2 where a single horizontal line represents demand, average revenue and marginal revenue of a competitive capitalist firm all equal to market price. 12.2: Profit-Maximization and Firm Supply 12.2.1: Choice of the Scale of Output A capitalist firm exists in order to maximize profit by undertaking production and exchange. As far as production is concerned the firm faces two problems; the first is the choice of production technique (how to produce output), and the second is the choice of output-scale (how much output to produce). The solution to the problem of choice of technique was discussed in the previous chapter where we outlined how a profit-maximizing firm makes choice about the combination of inputs to produce some given level of output. Here we will discuss the second part of the question, i.e. the choice of the scale of output. The formal way to express this problem is: or From our discussion of the input demand decision (L and K) in the previous chapter, we get: (12.6) So the only choice variable remaining is with respect to output (Y). Expression (12.6) says that the firm tries to ‘make the difference between total revenue and total cost as big as possible’. What is the firm choosing? It is ‘level of output’. Alternatively, the firm wishes to choose that level of output where profit is maximum (i.e. difference between cost and revenue is the greatest). The ‘Total-Condition’ The graphical solution to this problem is shown in the three layered diagram 12.3. Note that all three panels plot different variables against output: the upper one plots total revenue and cost, the middle one shows profit while the lowest panel depicts marginal revenue and cost against output. Consider the upper panel first. Here the total revenue curve is plotted as a straight line as shown above while the total cost curve takes its standard shape from chapter 11. The vertical difference between the two curves at any output level measures profit. Only points a-to-e on this diagram have analytical importance to understand the issue at hand. Let’s take them one by one.

Consider output level zero [Y = 0] first. At output equaling zero, total revenue is also zero. But total cost is not zero at Y = 0 due to the fixed cost element; it is positive at point a [distance 0a]. Therefore profit must be negative at Y = 0 [π = TR – TC < 0]. This gives us point a in the negative quadrant of the middle panel which indicates negative profit (or loss). Note that profit is negative exactly by the amount -a. Now consider point c where output is Yc [Y = Yc]. It is clear that total revenue and cost both are equal at this output level, so profit must be zero here. The same is the case at point e with Y = Ye. So we get points b and e in the middle panel along the horizontal axis indicating zero profit at outputs Yc and Ye We are now left with segments 0c and ce. Consider first the segment 0c where the total cost curve is above total revenue [TC > TR] which again means negative profit in this whole range of output. Further you can see that difference between the two curves is increasing initially and after reaching a maximum it then starts decreasing How should one locate the maximum-difference point between these two curves? The rule says that their difference will be maximum where their tangents are parallel. Since the tangent of the total revenue curve gives the slope of total revenue whereas the tangent of the total cost curve measures its slope, so we have the condition that negative profit (or loss) is largest at point b where slopes of total revenue and cost are equal. To the left of b (from output 0 to Yb) loss is getting larger therefore the profit curve is falling at point b we have maximum loss so the profit curve is flat at this point. Finally between point b and c the difference between revenue and cost starts decreasing, therefore the profit curve becomes positively sloped in the negative axis indicating that loss is now decreasing (or profit is increasing) Figure: 12.3: Solution to the profit maximisation problemaMaximum ProfitbceTRTC0YbYYdYcYeTR, TC0YbYYdYcYebcdeProfit-aMR = ARMCP0YbYYdbdMR, MCd Figure: 12.3: Solution to the profit maximisation problem a Maximum Profit b c e TR TC 0 Yb Y Yd Yc Ye TR, TC 0 Yb Y Yd Yc Ye b c d e Profit -a MR = AR MC P 0 Yb Y Yd b d MR, MC d The case for segment ce is exactly the same, with the only difference that profit will be positive in this whole range because total revenue is greater than total cost. Again we can divide segment ce into segments cd and de. Between points c and d, the difference between revenue and cost is increasing, therefore the profit curve is rising. But between d and e profit starts decreasing; therefore the profit curve becomes negatively sloped to become zero at point e. obviously, profit is maximum at d where slopes of the two curves are equal. You can now easily answer the question at ‘which output level will a profit maximizing firm produce. Clearly, if a firm is committed in producing output level associated with the maximum profit, then it must produce at Yd level of output. We thus have the general rule that the profit-maximizing firm produces output at the point where the vertical difference between total revenue and cost is largest. Alternatively, it is the point where the slopes of total revenue and costs are equal. But one small ambiguity is still left. The rule that ‘profit is maximum where slopes of revenue and costs curves are equal’ does not seem to be complete because the slopes are equal at two points; i.e. b and d with profit being minimum at point b and maximum at d. Now how to make this rule a comprehensive one? The complete statement goes as follows: ‘profit is largest where the slopes of total revenue and costs are equal and total revenue is greater than total cost.

Total Condition for profit maximization where Slope of TR = Slope of TC and TR > TC (12.7) Marginalism: the Per-Unit-Condition for Profit Maximization The same result can also be explained in per-unit terms using marginal analysis indicated by the bottom panel of this diagram. Recall that marginal revenue is the slope of the total revenue curve ; i.e. . Since the slope of the revenue curve is fixed as it is a straight line, therefore MR-curve is constant. The marginal revenue (the slope of total revenue) curve is therefore drawn as a straight horizontal line in the lowest panel, just like the one in figure 12.2.curve. The standard, initially decreasing and then increasing, marginal cost curve from chapter 11 is also drawn in the lowest panel. Where would the two curves intersect? Since marginal revenue is the tangent of the total revenue curve and marginal cost is the tangent of the total cost curves. Therefore the two marginal curves will intersect at points where the tangents of the two total curves are parallel and, hence, equal in the upper panel—at points b and d. This implies that profit will be maximum (or minimum) where MR and MC curves interest each other. Thus, the condition (12.7) for the profit maximizing level of output can be restated as: profit is maximum at output where MR = MC. However the equality of marginal revenue and marginal cost does not guarantee the maximization of profit. Why? It is simple to see that the above condition holds at two points, b and d, and profit is minimum at point b. To complete the profit-maximization rule in terms of marginal analysis, we define it as: Marginal Condition for profit maximization: where MR = MC and MC-curve cuts MR from below (12.8) Economists normally prefer to use the marginal-condition to express the profit-maximization rule as it has intuitive meaning. Let’s explain the two-intersection points of the marginal revenue and cost curves. At point b, with output Yb, consider a small increase in output from Yb. Increasing output increases both total revenue as well as total cost as can be seen in the top panel. But since MC is now below MR, total revenue increases by more than total cost. For each unit past Yb, total revenue goes up by amount P (price per unit) while total cost goes up by MC which is less than P. This means that the increasing output from Yb increases profit of the firm. So point b is not a profit maximization point; rather it is the point where profit is minimum. On the other hand, if you consider increase in output at the point d, increase in revenue is given by P while increase in total cost is measured by MC which is more than P. So profit decreases beyond output Yd, showing that d is the point where profit is maximum. Thus we find that as long as: MR > MC, increasing output will increase profit as total revenue will be rising by more than total cost MR < MC, increasing output will decrease profit as total revenue will rise by less than total cost Only when MR = MC profit will be maximum because both total revenue and cost will rise by the same amount

12.2.2: Firm Equilibrium and Derivation of the Supply-Curve We now ask a question regarded as very important as critical by macro economic theory; what quantity of output would a competitive capitalist firm be willing to supply at any specific price? The firm is assumed to produce that level of output which maximizes its profit i.e., where marginal revenue is equal to marginal cost. Since, as noted above, marginal revenue also equals price for a competitive firm, thus implies that profit-maximization occurs at the point of equality between price and marginal cost: Short run equilibrium condition for the capitalist firm: P = MC (12.9) This says that at any specific price, a competitive capitalist firm will produce at the point where its price is equal to marginal cost of production. This is shown in the left hand panel of figure 12.4 where at price P, the firm supplies output level Yd. Figure 12.4: increase in price leading to rise in quantity supplied by the firmMR = ARMCP0YddMR, MCYMR = ARMC = SP0YddfMR, MCMR1=AR1P1Yf Figure 12.4: increase in price leading to rise in quantity supplied by the firm MR = AR MC P 0 Yd d MR, MC Y MR = AR MC = S P 0 Yd d f MR, MC MR1=AR1 P1 Yf If it tries to produce more, the marginal revenue (equaling price P) would be less than marginal cost, so profit will decrease. On the other hand, a reduction in output below Yd reduces revenue more than reduction in cost, and thus profit must also decline. Point d is therefore the short run equilibrium of the capitalist firm. It is called as equilibrium point because the capitalist firm will not want to change its supply-decision from this point unless some outside variables undergo some change. For example, if the market price increases to, say, P1 as in the right hand panel, the capitalist firm will then increase output supplied to Yf where marginal cost equals price P1. Thus, we obtain two important results: (a) the supply decision of a competitive capitalist firm always occurs at points on the MC curve, (b) increase in market price leads to an increase in quantity supplied. This means that the positively sloped marginal cost curve is itself the supply curve of the capitalist firm. But a small modification is required in this statement. In order to explore that restatement, let’s analyze the situation in which a firm is making losses in the short run.Y Y Profit-and-Loss The amount of profit/loss earned by a firm can easily be calculated by measuring the vertical difference between total revenue and total cost in the total-diagram (the top panel of figure 12.3). However, the case of the per-unit diagram (bottom-panel) requires some more information for the calculation of profit at any specific output level. Note carefully that the MR = MC equality tells us only about the profit-maximum level of output, it does not tell us anything about how much profit the firm is making at that output level. In order to determine profit/loss associated with the profit-maximizing level of output in this diagram, we need to look at the average total cost curve as well. To see this, recall that profit is given by:

π = P×Y - TC To obtain profit in per-unit terms on the right hand side, note that total cost also equals average total cost times output [TC = ATC × Y], so we have: π = P×Y - ATC×Y or (12.10) The bracketed term, price minus per-unit cost, gives profit per-unit of output produced. This multiplied by the number of output units (Y) produced gives total profit (π). For example, if price of a commodity is Rs 10 and ATC is Rs 5/unit, then profit per-unit of output will be Rs 5 (= Rs 10 – Rs 5). Now if a firm decides to produce 50 units of the output, profit will be Rs 250 (= Rs 5 × 50). Thus we find that in the per-unit diagram, we need the ATC curve in order to calculate profit. This is drawn in figure 12.5. The left hand side shows the case when price is greater than per-unit cost of producing Yd output and, therefore, the firm is making a profit equal to the amount of the area AbdP (the white shaded area). To see how, note that the height of the ATC curve at any level of output, say Yd, gives per-unit cost of production, which is here amount 0A (say Rs 5). The difference between price P (say Rs 10) and A measures profit earned per-unit of output. Finally profit-per unit multiplied by the units of output Yd gives total profit. The right hand of Figure 12.5 side shows the case of a firm making loss in the short run because average total cost is greater than price per unit here. The loss equals amount PdcA (the white shaded area). Now the question is: what should the capitalist firm do if it is making losses? Should it continue operation or stop production; i.e. shut down? Figure 12.5: Profit and loss in the short runLossMR = ARMCP0YddRs/unitYAATCbProfitMR = ARMCP0YddRs/unitYAATCc Figure 12.5: Profit and loss in the short run Loss MR = AR MC P 0 Yd d Rs/unit Y A ATC b Profit MR = AR MC P 0 Yd d Rs/unit Y A ATC c The Shut-Down Rule and the Supply Curve One might be tempted to say that the capitalist firm should shut down its business the moment losses begin to occur. However, a capitalist firm will normally not do this. The logic for shut-down is straight forward: if a capitalist firm is making loss, then profit maximization requires it to minimize its loss. The shut-down rule can be expressed in three equivalent ways: Comparing fixed cost and operating loss: when a firm is losing money in the short run, it should compare its fixed cost and operating-loss (OL)—loss incurring in operation. To see why, note that the firm loses all its fixed cost in case it shuts down operation completely because fixed cost cannot be avoided anyhow. So a profit maximizing firm will compare losses that occur in the two scenarios, loss in case of continuing operation (i.e. OL) and loss in case of shutting down (i.e. FC). Therefore, the rule as: If OL > FC → Shut down If OL < FC → Continue operation The above rule can also be expressed alternatively by comparing variable cost and total revenue. Note that variable cost measures costs that can be avoided by shutting down the business as these costs include only those components of costs that are required to keep business in operation. The rule therefore is :

If VC > TR → Shut down If VC < TR → Continue operation As long as firm is able to cover its running cost completely and some part of fixed cost as well, it should continue its business because shutting down will involve losing all of the fixed cost. On the other hand, if revenue is not enough to cover even the variable cost, then it should shut down the business because that will minimize loss—the capitalist firm will only lose its fixed cost by shutting down, while with continuing operation it will not only be losing its fixed cost but also its variable cost. Figure 12.6: Expressing shut-down ruleMR = ARLossMCP0YddRs/unitYAATCcAVCVgLossMR = ARMCP0YddRs/unitYAATCcAVCVg Figure 12.6: Expressing shut-down rule MR = AR Loss MC P 0 Yd d Rs/unit Y A ATC c AVC V g Loss MR = AR MC P 0 Yd d Rs/unit Y A ATC c AVC V g A third way of expressing the capitalist shut down rule can be obtained by dividing the second one by Y: If → Shut down → Continue operation This simply says that when price is less than average variable cost—when price does not cover AVC— a capitalist firm should shut-down its business. This third expression is the easiest one is illustrated in figure 12.6. In the left hand panel, price is greater than AVC, so capitalist firm should continue operation. The right hand panel shows the case of shut down with price being less than AVC. Note that in this case the operating loss (PdcA) is greater than fixed cost (VgcA)—the difference between average total and variable costs time output [FC = AFC × Y = (ATC - AVC) × Y]. Application Box 12.2 shows how capitalist firms put this decisions rule into application even during Ramdan. A P P L I C A T I O N B O X 12.2 Capitalist Restaurants During Ramadan Have you ever visited a restaurant during day time in Ramadan in Karachi or Lahore? Surely, you would find it almost empty. Clearly, the revenue made from the few customers could not possibly cover the total cost of running the restaurant. Then why don’t restaurant owners shut down their business during day time? While deciding whether to open for lunch, capitalist restaurant owner must keep in mind the distinction between variable and fixed costs. Many restaurant costs; e.g. rent, kitchen equipments, tables, crockery and so on, are fixed, so shutting down the restaurant would not reduce these costs. Therefore, in order to decide whether to serve lunch, capitalist owners should only consider variable costs; e.g. the price of the additional food, the wages of the extra staff and electricity bill. The shut-down rule says that the capitalist owner should shut-down the restaurant at lunch-time only if the revenue from the few lunchtime customers fails to cover the restaurant’s variable costs. However, such reasons will only attract a profit-maximizing capitalist businessman such as Bill Gate. Abdullah Zhaghazai would, of course, dismiss the idea of opening up restaurant during day time in Ramadan because he would not like to participate in the sin by offering lunch facility to those who do not fast in Ramadan. Even the very idea of creating new opportunities of making profit by employing marketing tactics—say by giving price offers—would be considered sinful by him. On the other hand, he would see the day time as an opportunity to raise his status in the sight of Allah by obtaining moral purification while spending time in prayer and seeking repentance. Economic theory fails to explain the behavior of society if capitalist rationality of utility and profit maximization is rejected by the majority of the individuals within society. The behavior of non-profit maximizing non-capitalist firms cannot be analyzed on the basis of microeconomic theory of supply. This again illustrates that microeconomics is a normative and not a positive discipline.

This analysis shows that when price is less than average variable cost the capitalist firm will shut its business down in the short run and will not supply anything in the market. As long as price is above average variable cost the capitalist, firm will continue its production along its marginal cost curve—i.e. where marginal cost is equal to price. Thus we find that: MC-curve above AVC is the supply curve of a competitive capitalist firm Figure 12.7 draws the supply curve of such the firm as the segment of MC above AVC curve (the cut-marked segment of MC-curve). Figure 12.7: The capitalist firms Supply curveMC = S0Rs/unitYAVCV Figure 12.7: The capitalist firms Supply curve MC = S 0 Rs/unit Y AVC V Market Supply Curve We learnt in chapter 3 about how to derive the market demand curve from individual demand curves. Economists believe that the market supply curve can also be obtained in a similar manner, i.e. by aggregating individual firm’s supply curves horizontally. The idea is that if each of , say 50, firms supply, say 10 units, of output at the going market price, then market supply is 500 units [= 50 × 10]. Thus we add up quantity supplied by all firms at each price to arrive at the market supply function as: (12.11) where Sj (P, w, r) is the supply function of each of the firms labeled j, and Σj means we add up quantities of all j firms. The terms in brackets (P, w, r) show functional dependence of quantity supplied— output supply depends on its own price and input prices. The formal procedure of this derivation has already been discussed in chapter 3 [figure 3.11], so it will merely be a repetition to reproduce it here. Some economists have raised objections to such a deviation (discussed below). 12.3: Transition to Long Run Equilibrium The preceding section shows that it is quite possible for firms to make positive or negative profit at some going market price (see figure 12.5). But the question is: can such a position continue for long in a competitive market with no barriers to entry or exit? To answer this question, let’s take this issue step by step. Since the only real world case where the neoclassical model of competition may be applied with some degree of practicality is for agricultural products, market we consider the market for vegetables in Mandi Bahauddin as an example. Market Period Supply Usually in Mandi Bahauddin, trucks arrive at night with new supplies from nearby farms and the produce is sold during the day. If the vegetables can’t be stored, even over night, during summer—then must either be sold or disposed of somehow. Let’s consider the market for tomatoes (which quickly go bad) where sellers are trying to sell off their produce by the end of the day. The market period for fresh tomatoes is the single selling day. More generally, the market period refers to the time duration when the supply quantity available for immediate sale cannot be increased. Before additional tomatoes reach the market next night, the amount available for sale during the market period is fixed. This fact is represented by a vertical supply curve, as in figure 12.8 at quantity To which shows the quantity of homogenous tomatoes available for sale during the market period at whatever price they can bring. Assume that it is a normal day and demand is Do. Now if the supply-demand model is appropriate for this market, then the equilibrium price would be Po where all tomatoes are sold out during one day. See Application Box 12.3 on how price adjustment takes place according to economists / theory.

Figure 12.8: Market period equilibriumSo0PriceTomatoesDoPoToD1P1 Figure 12.8: Market period equilibrium So 0 Price Tomatoes Do Po To D1 P1 A P P L I C A T I O N B O X 12.3 A Story of Price Adjustment in Mandi Bahauddin Fruit Market If you ask your economics teacher how would the price Po actually reached in reality, he would offer you a competitive process as its description: if one vendor’s price is too high compared to others, then capitalist buyers are not likely to buy from that stall. Charging higher price does not pay if a seller is unable to sell much, he will gradually adjust price down. If all vendors have set too high a price, then all would notice that their sales are too low, compared to normal, and they will begin to adjust prices. Further each would see that other vendors are also selling slowly, which would reinforce the assessment that the price was set too high. Price setting goes on until ultimately equilibrium price is arrived at and competition thus removes the power of a vendor to set price arbitrarily in capitalist market: But this applies only to capitalist markets. Suppose the price of tomatoes is Rs. 50 per kilo and suddenly a large number of new buyers arrive at the market. If the tomato sellers at Mandi Bahaudin are capitalists they will see this as an opportunity to increase profit and as microeconomics theory says price will rise to a new level. If, however, sellers are like Abdullah Zhaghazai they will not raise prices but will be glad to sell all their tomatoes as soon as possible. The Market will close in time for Asr Prayer instead of at Maghrib. Once again we see that microeconomics theory is unable to explain the behavior of Abdullah Zhaghazai and all non-capitalist buyers and sellers. The description of price determination in the above box seems persuasive, but it ignores an important element of competitive capitalist markets and that is the law of single price for all market agents at all times—the explanation pays no attention to the buyers who arrive early on the day when vendors start with a high price and adjust later in the day due to slow sale! These early capitalist buyers face only the non-equilibrium price and buy less than what they would have bought later in the day at a lower price. This means that if price is set by the above kind of trial-and-error competitive mechanism, then not all buyers face the same price in the market and, hence, everything does not happen in equilibrium. It is in fact to avoid this problem that economists assume that all market exchanges take place after the equilibrium price has been set. Why can’t the economic model afford to allow exchange of goods at out-of equilibrium prices? One reason is that this disturbs distribution of income—above equilibrium, sellers gain income while below equilibrium they lose in favor of buyers—which as a result will change the position of market demand curve (as discussed in chapter 8 that changes in income distribution affects the position of the market demand curve). Since there is a possibility that non-equilibrium prices might never converge to equilibrium, economists have invented a fiction to avoid this problem which allows no trades in any market until all markets are in equilibrium. According to this fiction, price is set by an impartial and costless ‘auctioneer’, a hypothetical individual who coordinates market exchange. He announces to all decision takers a single market price which they take as a parameter in making their choices of demand and supplies. All of them record their choices with the a ‘market umpire’ who aggregates them to find excess demand or supply at the announced price. He then revises the announced price, and the process continues and no trading takes place until and unless equilibrium price is reached where sellers deliver exactly what demanders want to buy. This mechanism is termed the tatonnement process by economists. Remember that the so called price-determination story, just as the one in Box 12.3, given in economics textbooks and often by your teacher to relate the theory of perfect competition to real market process is fallacious because the theory of perfect competition works on the assumption that everything happens in equilibrium which in fact is never the case in reality.

Capitalist markets can never be in equilibrium for as a famous twentieth century economist Joseph Schumpeter has shown that this negates progress, which is a central capitalist value. Why then this insistence on analyzing equilibrium situations? It is simply because economics is a moral and not a positive science. Equilibrium outcomes are produced when buyers and producer display complete capitalist rationality (absolute commitment to aggregate profit/utility maximization as the sole legitimate end in itself). Equilibrium outcomes are the optimum in the sense that actual behavior of decision takers must be judged on their basis, policy must force all buyers and sellers, traders and consumers to behave on the basis of capitalist rationality. Hence the microeconomics emphasizes on equilibrium as the supreme value determining criteria in all capitalist markets. We leave the nonsensical price-determination process at this stage and move on to see how, according to economists, market adjusts from market period equilibrium to the short run one. Suppose that T.V. programs broadcast that tomato is an important diet element to preserve health. Figure 12.8 shows its effect as increase in demand from Do to D1 during the market period. Since the trucks have already delivered tomatoes before new health advertisements, supply has not adjusted at all in the market period while the price has been increased to P1. However, during the next few days and weeks, capitalist tomato growers can adjust production somewhat in response to the increased price. The short run is defined as the time period when firms have some inputs fixed but can change output by adjusting variable factors. Thus the short run supply curve is upward sloping as shown in the left hand panel of figure 12.9 with new equilibrium price at P2. This price is below the market period price P1 due to increased supply while quantity sold is also increased to T2. The right hand panel shows the decision of a typical capitalist competitive firm producing t2 quantity in the short run. Market supply T2 is the sum of t2 quantities produced by each firm in the market; i.e. T2 = Σj t2 of all j firms operating in the market. By what channels did quantity increase in the short run? Response to market period change in price may come from several sources. First, consumers in the vegetable market may compete against other uses of the same tomatoes. Tomatoes can be frozen, can be sold at other vegetable market, can be sold to companies making ketchups etc. If price of tomatoes is increased at the Mandi Bahauddin market, tomatoes are bid out of its other uses. Some tomatoes may have been stored for the short period of time and increase in price would bid them out of inventory. Increases in price may even cause capitalist producers to increase their variable factors and, hence, increase the quantity of tomatoes offered for sale. Note that the price is still high enough to create long run disequilibrium in the sense that firms are making super normal profit at price P2. Point e is not a position of long run equilibrium because this profit creates incentives for new firms to enter in the market, and hence quantity will further adjust to some other level. Recall that equilibrium is defined as a state where no agent, whether a potential entrant or an existing market participant, would want to change his/her decision. So far we have discussed up to the point we reached in figure 12.5. What happens when new firms enter into the market?

Figure 12.9: Short-run EquilibriumSMP0PriceTomatoDoPoToD1P1SSRP2T2TomatoProfitMR=ARMC = SFP20t2eRs/unitATCAbP1 Figure 12.9: Short-run Equilibrium SMP 0 Price Tomato Do Po To D1 P1 SSR P2 T2 Tomato Profit MR=AR MC = SF P2 0 t2 e Rs/unit ATC A b P1 12.3.1: Moving to Long Run Equilibrium New entrants in the market mean that the market supply curve shifts outwards leading to a fall in price. As price falls, the demand curve for the individual firm falls downward. Not only does that profit attract new entrants, existing capitalist firms also adjust their plants so as to achieve minimum point of their long run average total cost curve. Obviously, as new and existing firms tend to expand their output, demand for some inputs will increase which means there will be changes in the cost structure of the firms. Clearly, as market price falls, profit margin will decrease for all firms in the market. For how long will new firms continue to enter? Simple, if it is profit that attracts new entries, firms will continue to enter as long as all profit opportunities have not been fully exploited; i.e. entry stops when super normal profit is zero. Figure 12.10 shows adjustment to the long run equilibrium position. Since the firm was making profit at price P2 in figure 12.9, therefore it has the incentive to build new capacity while new firms are also entering the market. As quantity supplied increases in the market, the market supply curve shifts to the right and price falls until it reaches the level P3 where all profits are eliminated from the market. This means that all firms are making zero super normal profit in the long run. Thus the long run equilibrium for firm is defined where marginal cost, average cost and price are all equal: Long run equilibrium condition for firm P = MC = ATC (12.12) Note that at long run equilibrium, the firm has adjusted its plant size so as to produce that level of output where average total cost is the minimum possible; i.e. it uses its plant at its most efficient level. Figure 12.10: Long-run EquilibriumSMP0PriceTomatoDoPoToD1P1SSRP2T2P3SSR1TeTomatoZero economic profit Long run equilibriumMR=ARMC = SFP20teeRs/unitATCP1P3 Figure 12.10: Long-run Equilibrium SMP 0 Price Tomato Do Po To D1 P1 SSR P2 T2 P3 SSR1 Te Tomato Zero economic profit Long run equilibrium MR=AR MC = SF P2 0 te e Rs/unit ATC P1 P3 The Meaning of Normal Profit The idea of firms earning zero-profit in the long-run often seems surprising to the students: after all why do capitalist firms enter business if they earn nothing at the end of the day? Note that zero economic (normal) profit does not mean zero accounting profit. To see this, recall that economists define cost differently from accountants. To economists, cost includes both explicit as well as implicit costs. Given this, economic and accounting profits can be defined as: Accounting Profit = Revenue – Explicit Cost Economics Profit = Revenue – Explicit Cost – Implicit Cost You can see that a part of what accountants include in profit is treated as cost (reward of the firm owner) by economists, so even when economic profit is zero accounting profit may not be. Let us go back to our tuition fee example of chapter 11 (see table 12.2).

Table 12.2: Tuition fee example revisited Fee collection Rs 1000 Explicit costWage bill Explicit cost Rs 500 Utility bills Rs 200 Miscellaneous Rs 100 Profitaccounting Rs 200 Implicit costHouse rent Implicit cost Rs 100 Personal wage Rs 50 Profiteconomic Rs 50 The accounting profit of this firm is Rs 200 which does not include implicit costs; i.e. rewards of personal labor and house rent of the owner of the business. If market value of these two inputs is, say, exactly Rs 200, then economic profit will be zero while accounting profit will still be Rs 200. In this case, what accountants count as profit will be termed as reward for personal labor and house in this particular business by the economists. How does competition force economic profit to become zero? To understand this, think what if, instead of running the coaching center, the house was rented and the tutor sold his labor at the market wage rate. Suppose that market house rent is Rs 50 (per month), while market wage rate is Rs 100 (per month), then the market value (MV) of the owners personal inputs will be Rs 150 (per month). Since accounting profit, Rs 200, shows what these inputs earn in this particular business, thus we find that market value of these inputs is less than what they fetch in this particular business. In other words, the reward for these inputs in this particular use is greater than their second best use in the market. This excess earning will attract other capitalists to enter the coaching center market by starting their own coaching centers and renting out their houses for tuition centers instead of for housing. The entry will continue until all super-normal earnings on these factors in this particular use are driven down to their market value. This will be the level where economic profit turns out to be zero; i.e. where accounting profit exactly equals market value of personal inputs. As long as economic profit is positive in any particular business, some input must be getting more than its normal market reward. It is for this reason that positive economic profit is considered super-normal profit while zero economic profit is termed normal profit. Remember that when firms are earning zero economic profit, they are earning normal accounting profit—all inputs are getting their normal market rewards. The case of the firm making a loss—negative economic profit—is now straight forward. For example, if market value of personal inputs is Rs 250 while accounting profit in this business is Rs 200, then the capitalist would be better off by renting out his house and working in the market instead of doing this business. In other words, firms will transfer resources from this use to another until economic profit is again zero for all existing firms. Thus, normal profit is one which is necessary to keep any input in its current use, and that is its market value in the second best alternative. Alleged Efficiency of Competitive Markets Recall from chapter one the basic question that economics is supposed to address: This is to identify where resources could be allocated most ‘efficiently’ i.e. so allocated that profit is maximized. Theory claims that this happens in competitive markets. In other words, competitive markets provide the basis for achieving maximum efficiency. To see why economists make this claim, note that long run competitive equilibrium is said to be efficient in two senses:

The competitive process leads to long-run equilibrium where average total cost is at its minimum possible for all firms as shown in figure 12.10. This means that in the long run, all firms use their plant size such that average total cost of production is the lowest. Alternatively speaking, production takes place at efficient scale of production in competitive capitalist markets. This is called cost efficiency The competitive process also leads to allocative efficiency which refers to the market situation where resources have been allocated in a way that maximizes total utility. A firm is said to be allocative efficient when it produces output where price is equal to marginal cost of production. This is so because price of a product, according to neoclassical theory, measures the value that society as a whole places on its consumption while marginal cost measures the effort and resources required to produce that particular product. Only when price and marginal cost are equal that total utility will be maximum—society is sacrificing for the last unit produced exactly what it is receiving from its consumption (detailed and graphical representation of allocative efficiency is given in the next chapter). The above discussion reveals that perfectly competitive firms produce output in the long run where marginal cost equals price; i.e. they are allocative efficient in the sense that they generate maximum total utility. 12.3.2: The Real Politics behind Competitive Markets The previous section has given the conventional proof of why economists believe capitalist markets to be the most efficient (i.e. profit and utility maximizing) way of allocating resources. The model of perfect competition was developed explicitly for legitimizing particular capitalist practices. From the above analysis, three strong policy implications are derived by economists. A Night Watchman State Competitive markets based on free exchange achieve efficiency in resource allocation (i.e. an allocation of resources which maximizes profit and utility) without the presence of any benevolent social planner. The message is that no central planning by some non-market agent, e.g. government, is needed to attain efficient outcomes (profit/utility maximization) because the sum total of individuals’ tastes and talents guided by their own self-interests are sufficient to achieve this objective. Greed of one man is considered to be the adequate check on that of another and universal greed is assumed to work out the highest attainable utility. If it is the case that markets automatically attain efficient, equitable and stable equilibrium (i.e. maximization of profit) neither the state nor the church have any rights to interfere in the process of resource allocation. Economists regard any interference by the state in price determination as necessarily evil. Every individual has an inalienable right to determine his own preferences—the state and the church has no rights to tell him what he is ought to prefer and value is determined in the market by the voluntary interaction of such autonomous individuals. The state has no role in value determination.

Cut Throat Markets We saw that it was quite possible for firms to make super-normal profit in the short-run which is regarded by some economists unfair in the sense that some factor is receiving more than its opportunity cost. If, however, entry is free, then the long run competitive equilibrium is characterized by zero-economic (normal) profit for all firms in the industry. This means that the possibility of making super-normal profit using entrepreneurial talent is constrained by the threat of new entry. The power of influencing market price by firms is removed from them by the existence of a very large number of small firms and free-flow of information. Therefore, perfect competition makes entrepreneurship a struggle for survival rather than the exercise of power and it is the struggle for survival that Adam Smith identified as the control of unfettered self-interest before it threatens social order—to Smith, ‘competition was absolutely essential if the “beast” in man was to be harnessed productively’. The social function of competition is to solve the problem of misuse of economic power by denying anyone power of monopolists. Thus, the entrepreneurs’ ability to erode consumer sovereignty is eliminated by assuming quantity supplied as a function of entry and exit and not as a function of the expansion and contraction of existing firms. This analysis legitimizes specific type of support, protection and regulation of capitalist property by the state. It creates something of a moral paradox for economists. On the one hand their theory says that the capitalist state should be “night watchman” and not interfere in value determination process of market, but capitalist markets if left unregulated necessarily lead to concentration and centralization of property and shrinking of small firms. This creates the danger that competition will die out (as it did in soviet and East European state capitalism) and if agents are not competitive—i.e. jealous—they will not be subjects to capital. Policy must therefore regulate capitalist market to ensure that the death of the small firms does not lead to an elimination of competition and the markets they operate in must mimic competitive markets. How this is sought to be achieved is explained on the chapter on imperfect competition. If this is what the competitive market is—that individuals face no transaction costs and barriers whatsoever—then the question is: what is it that actually motivates individuals’ decisions in capitalist society? The answer is ‘lure for profit’—the model of perfect-competition says that an ideal society is where the only motivational force behind individuals’ decisions is profit-making and utility (i.e. consumption) maximization. Everyone keeps on freely switching from one segment of the market to another in order to exploit opportunity for profiting whenever and wherever possible and, thus, adding to his capital. Perfect competition is regarded ideal by economists because it allows maximum opportunities for accumulating capital to all individuals on equal terms. The model of competitive markets provides the framework for realizing capitalist-justice prioritizing the unending endeavor for accumulating.

Freedom and Market-Justice Economists regard perfect competition as the most just and idealized social order because it: provides all market agents equal opportunities to participate in the market since they all face the same structures of prices allocates resources such that profit/utility is maximized allows no input to make reward more than its contribution to actual accumulation The perfectly competitive market outlines conditions for the achievement of capitalist justice. Every system—every complete way of life—has its own conception of justice and capitalism is also a complete way life. Capitalist justice sanctions and nurtures those values and relations which: Facilitate the maximization of aggregate profit and utility Reward/punish each contributor to the capital accumulation process strictly in accordance with contribution he is making to this process Ensure the dominance of the capital accumulation motive over all other motivations influencing individual behavior The perfectly competitive market fulfils these conditions and is therefore regarded as the ideal form of capitalist society; i.e. civil society, since the time of Fredric Hegel (1770-1831) who idealized it in his famous lectures published as Reason in History as early as in the nineteenth century. The competitive market colonizes the whole of society (as a contemporary American philosopher has shown in his book Spheres of Justice. The individual is free to enter or exit a specific competitive market. He is not free to enter or exit the capitalist system—the total set of capitalist markets within civil society. John Locke, one of the founding fathers of modern political economy, called this unjust rebellion “for rejecting participation in capitalist markets is denying the universality of capitalist justice” and capitalism has throughout history resisted such rejection through the use of brutal state force. Michel Man in his famous book The Dark Side of Democracy shows why this must happen in his analysis of the continuing slaughter of 80 million Red Indians during the 17th, 18th and 19th centauries in America. Capitalist justice is in reality injustice because it rejects all religious values. No religion—neither Islam nor Christianity nor Hinduism—has ever sanctioned maximization of profit or utility as a morally valued objective of life. All religions have regarded the quest for maximization of profit and utility as evil, that is why capitalism is described as a “celebration of sin and evil!” Capitalist justice promotes sin and vice, an example will make this point clear. Suppose Abdullah is offered a job at Los Vegas casino with a wage fifty times greater than what he is earning as a Quranic teacher in Aleemiyah Madrassah, Karachi. Abdullah will of course immediately reject this offer because: America is dar–ul–harb, a country at war with the Muslim Ummah The casino business is filthy and sinful Abdullah wants to earn Allah’s pleasure by containing to teach the Quran to little children He does not want to leave Karachi because here he can easily serve his old father and sick mother

Capitalist rationality—as expressed in economics—regards these tendencies as psychological barriers to Abdullah’s participation in the market. Capitalist rationality requires that Abdullah should: Betray the Ummah and overlook America’s mass slaughtering of Muslims in Iraq, Afghanistan, Somalia and Pakistan Agree to become a sinful gambler Reject the Sawab (reward) he is getting as a Quran teacher Abandon his old father and sick mother All of this is necessary if Abdullah has to maximize his utility—i.e. the present value of his life time consumption opportunities. The capitalist market however cannot force Abdullah to submit to capitalist rationality; but the capitalist state can. It can peruse a set of policies—indeed it must pursue some of such policies if it is to remain a capitalist state—which forces and pursues Abdullah to accept the dominance of capitalist rationality. The capitalist state can follow some or all of the followings: shut down Aleemiyah Madrassah accusing it of terrorism impose direct and indirect taxes on the Madrassah revenues force the Madrassah to teach social and physical sciences which can serve as transmitters of capitalist values to Madrassah teachers and students refuse to recognize Madrassah qualification in determining social hierarchy motivate, and also force, the parents of Madrassah students to send their children to secular schools All these evil and exploitative policies are regarded as just within capitalist order. The capitalist state must pursue such polices so that barriers to market entry are removed and the market is enabled to allocate resources efficiently for maximizing total utility and aggregate profit. 12.4: Perfect Competition Is Not Perfect This model of competitive markets based on self-centered individuals leading to efficient (profit utility maximizing) resource allocation is presented as one of the most powerful results of economic reasoning in support of legitimizing liberal state policies. However, as we show below, the model of perfect competition faces several theoretical problems. These problems belong to two general categories: one of the model being based on either unrealistic or incorrect assumptions, and second of having internally contradictory assumptions. Here, we take on two of these problems to show that the results economists hope to derive from this model are unwarranted because the model is internally inconsistent. The next chapter will take up more problems inherent to this model. 12.4.1: Sraffa on Perfect Competition We have been spelling out Sraffa’s critique on neoclassical theory of production and cost, it is now time to apply his critique to expose another fundamental flaw in neoclassical theory of the firm and the market. We proceed in steps with his criticism. Competitive Market with Constant Marginal Product Recall from chapter 10 that Sraffa’s criticism involved refutation of the law of diminishing marginal product. His argument can’t be taken lightly as it constitutes a fundamental criticism of economic theory. This is so because diminishing marginal product determines everything in the economic theory of production. The following list of statements would make this point easy to understand:

Figure: 12.11: Perfect competition with Sraffa’s production analysisBreakeven pointeTRTC0YYBERsVC0YYBEMRRs/UnitMCATC Figure: 12.11: Perfect competition with Sraffa’s production analysis Breakeven point e TR TC 0 Y YBE Rs VC 0 Y YBE MR Rs/Unit MC ATC Output function determines marginal product, which in turn determines marginal cost With diminishing marginal product, the marginal cost of production eventually rises to equal marginal revenue This equality of rising marginal cost to marginal revenue gives maximum profit and hence determines the level of output If it is shown that constant, instead of diminishing, marginal product actually prevails in capitalist markets, then the production function would turn out to be a straight line through the origin and lead to straight line total cost curve (see figures 10.6 and 11.10), just like the total revenue curve. Now if the slope of total revenue curve is greater than that of the total cost curve, then the marginal revenue curve would be above marginal cost one as shown in figure 12.11. This means that for each output unit produced after output level YBE, profit will keep on increasing, hence more output means more profit never reaching any maximum level. So we find that in terms of economic theory of profit maximizing production, there would be no limit to the amount a competitive firm would wish to produce. The conventional economic model of the competitive market cannot explain how capitalist firms choose to do what they do; i.e. it can’t explain the decision of how much to produce. Ironically, if Sraffa is correct, then economic theory predicts that firms would produce infinite amounts of output. This rather awkward implication of Sraffian production analysis hits right at the foundation of neoclassical theory of the firm. Diminishing Marginal Product and Independence of Demand-Supply Not only did Sraffa dismiss the assumption of diminishing marginal product by establishing forth the fact that a rational capitalist firm having a fixed resource would leave some of it idle when operating below its optimum scale, he went a step further by exposing two contradictory assumptions working behind the neoclassical theory of the firm. Those are the assumptions that there are factors of production which are fixed in the short run, and that supply and demand are independent of each other; i.e. the decisions of consumption and production are taken independently by separate rational capitalist agents. He argued that the two assumptions cannot hold simultaneously. Briefly speaking, circumstances when it is valid to assume some factor of production as fixed in the short run, supply and demand would not be independent, which means that every point on the supply curve would be associated with a different demand curve. Conversely, in conditions where supply and demand can be treated as independent, then in general it would be impossible for any factor of production to be fixed, which means that marginal product and hence marginal cost of production would be constant. Let’s see how Sraffa’s reasoning works to devastate the economic theory of the firm.

To begin with, recall that marginal product falls in neoclassical theory because the ratio of ‘variable factor’ to ‘fixed factor’ exceeds some optimal level. The question then is: when is it legitimate to regard a given factor, say land in wheat production, as fixed. To Sraffa, this is a valid assumption only when industries are defined very broadly, but this contradicts another assumption of the model that demand and supply are independent. Let’s consider a very large definition of industry, say agriculture. In this case, it is valid to treat factors it uses heavily, e.g. land, as fixed because additional land can only be obtained by converting land from other uses such as manufacturing or tourism. So, when agricultural output is increased at fixed agriculture land by employing more variable factors, the agricultural industry will suffer from diminishing returns as predicted by economic theory. But what happens to other industries as agricultural industry output increases? Clearly, such a broad definition of industry means changes in its output must affect other industries. Particularly, increasing agricultural output will affect the price of its chief variable input, say labor, as it is driven from other industries. This feed back affect might seem to strengthen the case for diminishing marginal product because input price is increasing while its productivity is decreasing. However, it also undermines two other equally important parts of the neoclassical model: firstly the assumption that demand for and supply of a commodity are independent, and secondly the proposition that one market can be studied in isolation from all other markets. This is so because if increase in the supply of agricultural output changes the relative price of land and labor, then it will also change the distribution of income. We have already seen in chapter 8 that any change in the distribution of income changes the position of the demand curve—change in income distribution changes the position of the consumers’ budget line and hence their demand point). There will therefore be a different demand curve for every different position along the supply curve for agriculture output, depicted in figure 12.12. Figure 12.12: Multiple demand curves with broad industry definitionSagr0PriceWheatDoPw = ?W1D1W2WoD2 Figure 12.12: Multiple demand curves with broad industry definition Sagr 0 Price Wheat Do Pw = ? W1 D1 W2 Wo D2 The essence of the argument is that it is impossible to draw independent demand and supply curves that intersect just at one point in price-commodity space because factors that alter supply will also alter demand. Demand curve for agriculture will shift with every movement along its supply curve; hence they will intersect at multiple points and it is impossible to tell which price or quantity will prevail in the market. So we find that while diminishing marginal product does exist with the broad definition of industry, but then no industry can be considered isolated from all others and demand-supply become interdependent.

Can this problem be overcome by taking a narrow definition of industry, say wheat instead of agriculture? Off course, but this gives birth to another equally important problem of non-diminishing marginal product. Sraffa argued that though the assumption of independent demand-supply would work under this case, but now it would be invalid to treat some factor as fixed. With such a narrow definition of industry, firms will normally be able to draw all factors of production rather easily either from other industries or from stocks of under-utilized resources. Fro example, if demand for wheat increases, then instead of farming a given quantity of land more intensively, farmers would convert some land from another crop to wheat, or they might convert some of their own lands currently laying fallow, or farmers who currently grow some other crop will convert to wheat. In all circumstances, the ratio of one factor to another will remain fairly constant while total amount of resources devoted to wheat production will increase. This means that marginal product remains constant which results in a straight-line production function as discussed in chapter 10. As we have seen that the shapes of total, variable, marginal and average total cost curves determined by the shape of the production function, so a straight line output function results in constant marginal and falling average total cost curve as shown in the bottom part of figure 12.11. With this picture of a firm, every additional sale after YBE brings forth more profit. This implies that sales are not constrained by rising cost as claimed by economic theory. Given the economic assumption that a competitive firm faces a horizontal demand curve, then according to economic theory the firm would be seeking to produce an infinite amount of output. Thus, if marginal cost is constant rather than falling, the neoclassical explanation of everything collapses—it can neither explains neither the output decision of the firm nor the determination of wage and interest rate (to be discussed in chapter 15 and 16). Though taking the narrow definition of industry helps avoid the problem of interdependence in demand and supply, it takes away all of the explanatory power of economic theory. Sraffa’s argument is therefore fundamental in the sense that if his argument is accepted, then the entire structure of economic theory Crum. Despite such a fundamental weakness, economic theory has continued as if Sraffa’s paper was never published. Capitalists may hope that this might be because there is some fundamental flaw in Sraffa’s argument, or because economists have discovered some deeper truth to justify the old model with a new explanation. But, neither is the case and Sraffa’s “deconstructions” of economic theory is as valid as it was in 1926. What about the Real World? Ironically, although economists always boost of themselves being the practitioners of an empirical science, yet the fundamental postulates embedded in their model of perfect competition are never reformulated on the base of empirical investigation—they are accepted as tautological postulates that are necessarily true by definition. When tested empirically, several researches supported Sraffa in that the vast majority of firms operate with constant or even falling marginal costs, and set prices without reference to the economic concepts of marginal cost or marginal revenue. For example, Table 12.2 summarizes the result of a survey conducted among factory managers about different ways in which their costs change with output.

Table 12.2: Empirical support for firm setting price where MC=MR By Firm By Product Supports MC = MR 18 62 Contradicts MC = MR 316 1020 Percentage Supporting MC = MR 5.4 5.7 Percentage Supporting MC = MR 94.6 94.3 Source: Eiteman and Guthrie, 1952 Surprisingly, almost 95% report non-increasing marginal cost up to a very high level of output. Similarly, in a more recent survey Blinder showed in 1998 that “over 89 per cent of respondents indicated that ‘marginal’ costs either declined or stayed constant with changes in output (sometimes involving discrete jumps). Only four out of 200 enterprises had both elastic demand curves and increasing marginal costs.” Eiteman explains these results as follows: Engineers design factories “so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, a fact that makes it physically impossible for enterprises to determine a scale of operations by equating marginal cost and marginal revenues”. The best assessment of neoclassical idea that the factor that constraints firms’ output is built into their own cost structure was given by Sraffa himself in 1926: “Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend when they want gradually to increase their production does not lie in the cost of production—which, indeed, generally favours them in that direction—but in the difficulty of selling the larger quantity of goods without reducing the price, or without having to face increased marketing expenses.” If economics is a positive and an empirical science, why do then neoclassical economists ignore these researches which have been appearing during the last 90 years. As we have maintained throughout this book, economic theory was never meant to describe how a capitalist society actually works, It’s chief concern was to give prescriptions regarding how ideal capitalist society ought to operate; i.e. it is necessarily a normative science as discussed in FYI Box 12.1 (you are recommended to read that box again). We hope that by the time you have reached this far in the book you will immediately ask: “Efficiently for what?”—of course the answer is “allocate resources efficiently for the maximization of profit/utility/capital accumulation as an end in itself”. This capitalistically efficient pattern of resource allocation is the most inefficient if the purpose of economic objective is seen as the promotion of virtue or the winning of God’s approval. Economics argues that it is irrational to seek God’s approval or promote religious virtues as an objective of economic activity. Economics presents a capitalist conception of rationality and assumes that every one possesses this rationality i.e. unreserved, unqualified commitment to maximization of total utility and profit as an end in itself. Its models of price and output determination based on capitalistically rational individual and firm assumes that only ‘one person’ exists—everyone is equally capitalistically rational, hence market demand is the aggregation of individual demand and market supply is the aggregation of the supply function of individual firms. The interaction of such market demand-supply curves are shown to yield equilibrium / harmony by yielding unique (profit / utility maximizing) structures of price and output in the market.

But Sraffa has shown that such a derivation of unique output/price configuration is not generated by actually existing capitalist markets where conditions of conflict and exploitation prevail. Economic theory cannot explain how prices and output decisions are made in actually existing capitalist markets because when everyone behaves rationally—everyone seeks utility/profit maximization—the result is irrationality (i.e. non-maximization of total utility / profit. When everyone seeks his own profit / utility, maximization of total utility/profit cannot maximized because everyone is preying upon everyone else. Everyone is intensely selfish, demonic, greedy, jealous, lustful and evil. How can harmony exist in such circumstances? There is endless, limitless conflict, exploitation and domination in capitalist markets and as Sraffa has shown prices, output levels and distribution of income are all determined by antagonistic forces. Economic theory thus fails to provide moral justification for the existence of capitalist order which is inherently and essentially evil. We will return to these themes in detail in the chapters on income distribution. Key Concepts Allocative efficiency refers to the market situation where resources are allocated to activities that earn higher rates of return. Firm is allocative efficient when it produces output where marginal cost equals price Arbitrage is the practice of making profit by purchasing a commodity from where its price is lower and reselling where price is higher Average revenue is given by the ratio of total revenue to output Cost efficiency in production takes place at efficient scale of production in competitive markets; i.e. production should take place where average total cost is minimum possible Firm equilibrium means firm doing its best to maximize profit. This is characterized by the condition when marginal revenue equals marginal revenue Law of one-price means a commodity can be sold at one and only one price in a competitive market. This happens due to arbitrage Long run equilibrium of a competitive firm and market is achieved when marginal cost, average total cost and price are all equal; i.e. P = MC = ATC. In the long run equilibrium, no firm has incentive to exit or enter the market Marginal condition for profit maximization implies that maximum profit output is one where marginal revenue equals marginal cost and marginal cost curve cuts marginal revenue from below Marginal revenue is the change in total revenue due to one unit change in out Market period refers to the time duration when the supply quantity available for immediate sale cannot be increased Normal profit means all firms are earning zero economic profit in the market Price-taking behavior is a competitive behavior when all agents in the market lack any control to determine market prices and take them as given information by the market for making their choice decisions Short run equilibrium of a competitive firm is achieved when it produces where its price is equal to marginal cost of production, i.e. P = MC

Shut down rule says that under circumstances of loss, firm should try to minimize its loss. Firm should shut down its business only when operating loss is greater than its fixed cost. Alternatively, it should shut down when revenue is less than variable cost of operation Super normal profit refers to positive economic profit earned by firms in the market Tatonnement process refers to a hypothetical perfect market setting where an impartial and costless auctioneer coordinates market exchange Total condition for profit maximization says that profit is maximum where slopes of total revenue and cost curves are equal and revenue curve is above cost curve Transaction cost is the cost of executing exchange; e.g. transportation and brokerage costs Zero economic profit means amount of profit which is necessary to keep an input in its existing use. It is attained when all inputs are receiving their market reward; i.e. their opportunity costs Chapter Summary Perfect competition is the moral ideal of capitalist economic theory. All capitalist markets are judged on this basis both by capitalist economic theory (ideology) and by the Departments of Justice of capitalist states Perfectly competitive markets are those in which (a) there are an infinite number of buyers and sellers none of whom can individually influence price (b) a homogeneous product is being provided (c) transaction costs are zero (d) information is perfect and costless (e) there are no barriers to entry or exit Arbitrage is the practice of making profit by buying a commodity where it’s price is lower and selling where its price is higher The Law of one price states that a uniquely determined efficient price will prevail throughout the capitalist market. This law will not apply to non-capitalist markets where producers do not seek profit maximization Theoretical commitment to the law of single price leads to the assumption of the horizontal demand curve faced by the firm. The individual capitalist firm cannot influence price and its supply is determined by its cost structure Perfectly competitive markets have never existed nor can they ever exist in the real world Economists’ analysis is focused on perfect competition as it illustrates the full implications of universal capitalist rationality and therefore provides a vital benchmark for both evaluating existing capitalist markets and for formulating system wide capitalist policies In a perfectly competitive market the total revenue curve for a firm is a straight line dependent only on level of output as price is assumed to be fixed. This also implies that in perfectly competitive markets price, marginal and average revenues are equal to each other The capitalist firm chooses to provide that level of output where it maximizes profit. Profit is maximized at the output level where the positive distance between the total revenue and total cost curves is greatest and their tangents are parallel to each other. This is also the case where the MR and MC curves intersect, with the MC curve cutting the MR curve from below

Profit is minimum when the MC curve intersects the MR curve from above In the short run a capitalist firm will produce at the level where MC equals price in perfectly competitive markets The “shut down rule” may be stated in three ways. The profit maximizing firm should shut down if: Operating loss exceeds fixed cost OR Variable costs exceeds total revenue OR Average variable cost exceeds price The positively sloped MC curve above the average variable curve is the supply curve of the profit maximizing firm in competitive markets since supply decisions always take place on the MC curve of a competitive capitalist firm The market supply curve is obtained by aggregating individual firms’ supply curves according to the microeconomic theory of supply Economic theory insists that exchange takes place only at equilibrium price which is set by a neutral auctioneer through a trial and error process. This assumption is made to avoid considering the impact on income distribution and hence a change in market demand as price changes Capitalist markets are never in equilibrium, indeed Schumpeter has shown they cannot be in equilibrium. Since economics is a moral science the concept of equilibrium is indispensable. It allows economists to claim that when capitalist rationality is universalized; all outcomes are freely chosen and reflect a pattern of value allocation bared on the simple aggregation of the free choices of all capitalist individuals In the short-run some factors are considered variable. Supply is therefore not fixed. Price is expected to be lower than in the market period. The short run supply curve slopes upward to the right, and above normal profits can be made In the long run the supply curve shifts upwards. Firms produce output level at the lowest point on their average total cost curves and abnormal profits are eliminated Economic profit is the rate of return that is required to keep a factor in its present businesses because that is its market value Economics defines efficiency as that pattern of factor use which maximizes profit. Long run competitive equilibrium is said to be “efficient” because average total cost is the lowest and total utility is maximized Competitive markets allocate resources “efficiently” from a capitalist prospective—i.e. they allocate resources in a manner which maximizes both total utility and total profit This implies that the state should not interfere in the process of price determination. Competitive markets spontaneously generate just and efficient prices which fully reflect the freely chosen desires of autonomous individuals Perfectly competitive markets are regarded just in capitalist order because all capitalist agents face the same prices and because factor rewards are strictly equal to their contributions to the capital accumulation process. These markets establish the social dominance of capital accumulation as an end is itself Capitalist justice is injustice because capital accumulation is another name for the flourishing of the vices of greed (hirs) and jealousy (hasad). The capitalist states promote the flourishing of these vices

Perfect competition cannot exist in capitalist order. This means that even in its own-terms capitalism is an unjust order. The assumptions on which economists premise their justification of perfect competition are mutually inconsistent One such inconsistency is exposed by Sraffa who shows that since constant (and not diminishing) marginal productivity characterizes capitalist markets, the output decision of firms cannot be explained by microeconomic theory. Assuming constant marginal productivity in the standard model implies firms would produce an infinite level of output in competitive markets Sraffa also showed that supply and demand decisions cannot be viewed as independent when (as in the short run) some factor of production is taken as fixed. When it is realistic to assume the independence of supply and demand, no factor of production can be taken as fixed and this implies the constancy of marginal product (and marginal cost) If demand and supply are seen as interdependent then the determination of unique equilibrium prices become impossible Empirical evidence has shown that in developed countries the over-whelming majority of firms does not experience diminishing marginal productivity and does not take account of marginal cost in setting their prices Economic theory can afford to ignore such market realities because it is not a positive, but a normative and a moral science. It describes how the capitalist system and all capitalist agents ought to work, not how they actually work Capitalist markets are a sphere of conflict and chaos not a sphere of equilibrium and harmony. Economic theory seeks to, but cannot, hide this evil essence of capitalist order and as Sraffa has shown all market decision—regarding prices, output and income distribution—are determined by the relative forces of conflicting antagonistic agents, each committed to his own utility / profit maximization by exploiting everyone else Review Questions Why is perfect competition a normative concept? What are its characteristics? State and evaluate the doctrine of the law of one price? Illustrate with the help of an example how the process of arbitrage works in capitalist markets. Why is the price generated by perfectly competitive markets regarded as the just price of capitalist order? Derive the horizontal demand curve of the firm from the assumptions underlying the theory of perfect competition. Although perfectly competitive markets cannot exist in the real world microeconomic theory focuses upon them. Why? Using some numerical date redraw Fig 12.3 to show what level of output will be chosen by a profit maximizing firm. Explain why profit may not be maximized at a point where MR = MC. State and justify the short run equilibrium condition of a capitalist firm in a perfect competitive market. Why is the MC curve the supply curve of the profit maximizing firm in a competitive market? Why does it slope upwards to the right? State and explain different versions of the shut down rules. Describe the tatonnement process through which equilibrium prices are supposed to be generated in capitalist markets

Why do economists insert on using equilibrium analysis when capitalist markets can never be in equilibrium in the real world? Define the short run period and distinguish it from the “market period”. Distinguish between short and long run equilibriums with the use of diagrams. Distinguish between economic and accounting concepts of profit with the use of an example. Define “economic profit”. Why is it regarded as norma? Define and evaluate the economic conception of efficiency. Why is perfect competition a model of capitalist justice? Why is capitalist justice regarded as injustice (zulm) by all of the world’s religions? “Capitalist justice cannot exist even in capitalist society”, comment. Why does the microeconomic theory of output determination in competitive markets break down if we accept Sraffa’s view that constant and not diminishing marginal productivity characterizes capitalist markets? Why is it not realistic to assume both that (a) some factor of productions is constant and (b) that supply and demand are independent? What are the implications of rejecting? Why does microeconomics theory continue to pretend that Sraffa never wrote anything? Why does microeconomic theory continue to ignore how prices are determined by firms in actually existing capitalist markets? Appendix Chapter 12 Consumer and Producer Surpluses Economists measure the efficiency of a market in terms of consumer surplus and producer surplus. This appendix will briefly outline how economists measure these two important concepts. Consumer Surplus Consumer surplus (CS) refers to the extra value a capitalist consumer receives over and above what he pays for a commodity. Alternatively, it is the difference between what a consumer is willing to pay for a specific quantity of a commodity and what he actually pays for it in the market. Formally, it is: CS = Amount consumer is willing to pay – Amount he actually pays To make sense of what the above expression says, consider the demand curve in figure 12.1A. You can see that the height of the demand curve at any quantity measures the amount a consumer is willing to pay for that quantity. For example, initially he is willing to pay Rs 10, for the second unit he is willing to pay Rs 8 and so on. Alternatively, we can interpret the consumer’s willingness to pay as a monetary measure of value a capitalist consumer receives from a particular unit. Viewing this way, we can say that the value of the first unit is Rs 10 while that of the second is Rs 8 for this consumer. Adding his willingness to pay for all the units (here 1 to 3) gives the amount he is willing to pay for all the units. Therefore, the area below the demand curve 0ABQb gives his willingness to pay for the three units. In other words, 0ABQb measures the value of three units to this consumer. Next we have to determine the amount he actually pays. Note that if the market price is Rs 6 per unit, then the consumer can purchase all the units, from 1 to 3, at this market price: he buys the first unit at Rs 6, second also at Rs 6 and so on for the third. This means that he receives a surplus value of Rs 4 on the first unit because he was willing to pay Rs 10 for it but he actually pays only Rs 6. Similarly, the second unit brings him unpaid value of Rs 2. The consumer is indifferent about the last unit because he is paying what he is willing to pay for it. Adding up the price paid for each unit we get the amount which the consumer pays in the market, area 0PBQb. If we add up the surplus value received by him on all the units, we get the consumer surplus. Graphically speaking, consumer surplus is the area below the demand curve and above the price level; the area PAB. This area measures the extra value a consumer receives over and above what he pays for. Given this description, we can also define consumer surplus as:

CS = Value of output to consumers – Amount paid by them (12.1A) Figure 12.1A: Calculating consumer surplusPx106 = PDxABQ3 = Qb10Consumer Surplus = ABP82 Figure 12.1A: Calculating consumer surplus Px 10 6 = P Dx A B Q 3 = Qb 1 0 Consumer Surplus = ABP 8 2 Producer Surplus This concept is similar to that of consumer surplus. Here the idea is to subtract the amount firms need to produce a given unit of output from the amount that they actually receive in the market. PS = Amount firms actually receive for output – Amount they need to produce this output Consider figure 12.2A where the standard upward sloping supply (or MC) curve is drawn. The height of this supply curve against any output level measures the marginal cost of production—amount needed to produce a given unit of output. For example, the MC of producing the first unit of output is Rs 2 while that of the second is Rs 4 and so on. Summing up the marginal costs of producing all units (here from 1 to 3) gives total cost (or amount needed to produce this level of output). Therefore, the area 0CBQb below the supply measures total cost of producing 0Qb output. Since each item is offered at a given market price in a competitive market, the firm receives Rs 6 per unit sold; i.e. all units from first to third earn it Rs 6. Alternatively, the revenue received from selling 3 units is equal to the rectangle 0PBQb. This area measures the amount received by the firm for a given level of output. If you subtract the amount needed to produce the output from the amount received by selling a given level of output, you will end up with producer surplus equal to the triangular area CPB. Graphically speaking, producer surplus is the area below the price line and above the supply curve. We can now define producer surplus as: PS = Amount received by the firms – Cost of producing output (12.2A) Figure 12.2A: Calculating producer surplusPx26 = PMC = SxCBQ3 = Qb10Producer Surplus = CPB42 Figure 12.2A: Calculating producer surplus Px 2 6 = P MC = Sx C B Q 3 = Qb 1 0 Producer Surplus = CPB 4 2 Social Welfare or Total Surplus If you add up consumer and producer surpluses in a capitalist society, you will obtain total surplus as shown in figure 12.3A. Algebraically, Social Welfare = Consumer Surplus + Producer Surplus Substituting in this the expressions of consumer and producer surpluses we get: Social Welfare = [Value to the consumers – Amount paid by them] + [Amount received by the firms – Cost of producing output] Since the amount paid by the consumers equals the amount received by the firms (0PBQb), the second and third entries cancel out in this expression and we end up with: Social Welfare = Value of output to consumers – Cost of producing output (12.3A) This says that total surplus in a capitalist market and economy is the value of output to consumers measured in terms of their willingness to pay minus the seller’s cost of producing that output. An allocation of resources is said to be capitalistically efficient by economists if it maximizes total surplus. Economists maintain that when markets are free (i.e. prices and output levels are determined by individual’s self-interest), then total surplus is automatically maximized and no all-knowing benevolent social planner is required to maximize social welfare—i.e. the consumption possibilities. No can increase social welfare by altering this market outcome. The socially desired level of outcome is achieved naturally by the pursuit of self-interestedness. Smith called this pursuit of self-interestedness the operation of ‘invisible hand’ that guides people to promote social welfare without intending to do so.

Figure 12.3A: Social welfare or total surplusPx6 = PMC = SxCBQ3 = Qb0Total Surplus = CS + PSDxA Figure 12.3A: Social welfare or total surplus Px 6 = P MC = Sx C B Q 3 = Qb 0 Total Surplus = CS + PS Dx A It should be noted that only capitalist societies seek social welfare maximization for they alone measure welfare in terms of net utility yielded by an economic process. Non-capitalist societies reject this conception and typically they seek to promote virtue, not social welfare (maximization of total surplus). In non-capitalist society economic practices are valued in terms of their ability to enhance virtuous behavior among individuals (this is the predominant discourse with regard to economic transactions in Islamic fiqh for example) and not in terms of the net utility these practices generate. Chapter 13 MONOPOLY The last chapter outlined the idealized fiction of the perfectly competitive market. However, real world markets are by no means characterized by perfect competition. When you shift in an apartment, it is not difficult for you to choose the company producing electrical power as there is only one in the country. The same holds for natural gas and water supply services. This chapter begins the analysis of what the economist’s term as imperfect competition or markets. Markets are said to be imperfect when any of the conditions of the competitive markets are missing or lacking to any degree. Broadly speaking, market structures are differentiated by economists on the basis of three important features as listed in table 13.1. Table 13.1: Differentiating Market Structures Market Structure No of Firms in Market Nature of Good Sold Entry / Exit Conditions Perfectly competitive Infinite or very large Homogenous Free Entry & Exit / No Barriers Monopolistic competition Large Heterogeneous / Differentiated Easy Entry Oligopolistic competition Few Homogenous / Differentiated Significant Barriers Monopoly One No Close Substitute No Entry To make more intuitive sense, we can place these capitalist market structures along a spectrum measuring the intensity of competition as shown in figure 13.1. The spectrum runs from left to right and shows that the extent of competition is decreasing with movement from left to right. Monopoly is placed at the right hand corner of this spectrum Bwssweazaqzaaaaaaazazazaqqqqqqqqqqqqqqqqqqqqqqqqqqq1ssssssssdddecause it is the least competitive market structure. On the other hand, perfect competition is on the left hand corner because this involves large number of firms competing with each other. The other two structures are placed in between the two polar extremes. Note that monopolistic competition is closer to perfect competition while oligopoly is farther away. It should be clear that, according to economic theory, the two key factors that determine the extent of competition in any market structure are the number of firms operating in the industry and entry-exit conditions; i.e. market barriers. Figure 13.1: Competitive Structures Figure 13.1: Competitive Structures

Perfect CompetitionMonopolyMonopolistic CompetitionOligopolistic CompetitionMost CompetitiveLeast Competitive Perfect Competition Monopoly Monopolistic Competition Oligopolistic Competition Most Competitive Least Competitive The chapter begins with the description of the monopoly structure and examines its The chapter begins with the description of the monopoly structure and examines its implications for firm behavior in markets characterized by monopoly. We then go on to analyze the supply decision of the monopolist. Section three describes the meaning of monopoly power while section four takes up the question of what makes monopoly possible. Section five explains the standard justification offered for policy preference for competitive market structures and then explicates the regulatory tools available for correcting monopoly behavior. The last section will outline a detailed critique of the standard neoclassical theory of firm. 13.1: Structure of Monopoly Monopoly is placed at the polar extreme of perfect competition. The word monopoly itself says all about its nature: mono means single while poly stands for producer. Thus monopoly is a market structure characterized by a single-firm supplying an entire market. Formally speaking, monopoly is defined by three features: Single seller in the market No close substitute of the product No entry in the market due to significant barriers Clearly, the assumptions suggest that this market structure is exactly the opposite of what we call perfect competition because there is no competition at all. Strictly speaking, there is hardly any firm in Pakistan that can be described as monopoly in the literal sense of sole-producer. Take for example the case of Pakistan Railways. Thought it carries most of the middle class passengers, yet substitutes are available, e.g. bus services. The only businesses in Pakistan that come close to monopoly in its strict sense are WAPDA, Sui-Southern-and-Northern Gas Supply Corporations and perhaps KESC. And the reason why they are monopolies is because of the state imposed legal restrictions for potential entrants. Once state imposed restrictions are removed, entry begins to occur which is obvious from the case of the telecommunication industry in Pakistan where once PTCL was the only operating firm. Thus, we can say that there is no private sector business in Pakistan that may be called a monopoly in its strict sense. But for practical purposes, monopoly is defined in a looser way. According to this view, if the market-share of a single firm exceeds fifty percent of total market sales, then such an industry is said to be a monopoly. This is so because one firm is leading or dominating the rest of the firms in the market—the dominating firm sets the price while the rest are forced to follow it if they want to survive in the industry. The model describing this market structure is technically called the dominant firm model. Think of Microsoft in Pakistan software industry and Railways in Pakistani travel. Though there are some competitors of Microsoft, yet their market share is too small to affect Microsoft business strategy in Pakistan. This can be contrasted with the case of Pepsi and Coca Cola where both the firms ruthlessly compete with each other none enjoying a dominant share in the market. This is the case of oligopoly which we will study in the next chapter.

13.1.1: Implications How a profit-maximizing capitalist firm behaves in the market largely depends upon the structure of the market. The above examples show that the model of competitive markets with very many firms operating with free entry and exit cannot describe the reality of a market with a single seller—the analysis on the supply side of the monopoly firm has to be changed. There are significant differences in the behavior of a monopolist as compared to a competitive firm. To begin the modeling of these differences, let’s start with identifying the behavioral implications of the monopoly structure of market. Price Setting Behavior When discussing monopoly behavior, economists are often interested in how much monopoly power any firm (not necessarily a sole producer) has. Monopoly power refers to the extent to which a firm can raise prices without losing all its customers. Since a monopoly producer supplies the entire market demand, it is unlikely that it will take the market price as given. It would recognize its influence over the market price because it is the only firm in the market. This implies that a monopoly faces a downward sloping demand curve for its product and it ignores other firms’ reactions to its own pricing decisions. This situation is shown in figure 13.2 which can be compared with that of competitive market where the firm’s demand curve was horizontal and not downward sloping. This negatively sloped demand curve shows that the monopolist can change market price by adjusting its quantity decision—this is what is meant by monopoly power. Figure 13.2: Demand curve faced by a monopolist0Rs/unitYDP1Y1P2Y2 Figure 13.2: Demand curve faced by a monopolist 0 Rs/unit Y D P1 Y1 P2 Y2 It should be clear that only when a firm faces downward sloping demand curve does it have the opportunity for price strategies and does not have to accept market determined prices. Thus we find that a monopoly is a price setter or price maker and not price taker. Obviously, the fact that the monopolist can set price independent of other firms’ decision does not mean it can charge whatever price it wants—no monopolist can ever have infinite monopoly power. For any given price, it will be able to sell only what the consumers are willing to buy. If it chooses a very high price, such as P1, it will be able to sell only a small quantity. True that WAPDA has monopoly over electricity supply, but it does not mean that it can charge Rs 1,000 per unit and yet be able to sell its desired level of output. Demand behavior will obviously work as a constraint on the monopolist’s choice of price. In other words, monopoly power depends upon the price elasticity of demand for its product—the lower the price elasticity of demand, the larger the price increase a firm can make without losing too many customers, and vice versa. Only in the highly unlikely case of perfectly inelastic demand can the monopolist charge whatever it wants. Remember that a monopolist firm operates to maximize its profit and, thus, it will charge that price level which maximizes its profit.

Revenue Behavior The revenue structure of a monopolist is different from that of a competitive firm due to the fact that price changes as quantity sold changes. To see this, recall that total revenue for a competitive firm was a linear function of quantity sold which resulted in a constant marginal revenue curve. The Marginal revenue was fixed because price of the product was assumed to be constant for a firm as it was a price taker. As discussed above, the assumption of price taking is not valid for the monopolist because he has the power to control market price. This changes the shape of the marginal revenue curve. Table 13.2: Revenue behavior of the monopolist 1 2 3 = 1 × 2 4 5 = 3 ÷ 2 Price (P) Quantity (Y) Total Revenue (TR = P × Y) Marginal Revenue Average Revenue 5 1 5 - 5 4 2 8 3 4 3 3 9 1 3 2 4 8 -1 2 1 5 5 -3 1 Figures 5.6 and 5.7 in chapter 5 show the formal derivation of the total revenue curve when the demand curve is negatively sloped (refresh your understanding from chapter 5). You can see that with a falling demand curve, total revenue curve takes an inverse U-shape. Table 13.2 shows the logic behind this phenomenon. The same definitions of average and marginal revenues are used as in chapter 12. First note that the average revenue and price are equal for all levels of output (compare columns 1 and 5). This is the same result as given by expression (12.4) which says that price and average revenue are two names for the same thing. Intuitively, average revenue is the price per unit charged on quantity. Similarly, the demand curve shows the price that can be charged per unit, so both are the same. The demand curve and AR functions are always the same—nothing new in this case. However, the behavior of marginal revenue is different in the monopoly case, as it is not constant. Clearly, you can observe that marginal revenue is always less than price (or average revenue) for all levels of output (see columns 1 and 4). For example, for price level Rs 4/unit, MR is 3 and so on. This slightly complicated behavior of MR arises because output moves in the opposite direction as price varies. When price is reduced, the monopolist not only earns extra revenue on the additional unit of output sold, but it also loses revenue on all the previous units (called infra-marginal units) that are now sold at this lower price. For example, after reduction in price, say, from Rs 5 to Rs 4, the monopolist is able to sell one extra unit which brings him extra revenue of Rs 4. Let us call this Radd. But the reduced price is applied on all the units sold. This means that the first unit which was previously sold at Rs 5 is also offered at Rs 4 after reduction in price. The monopolist loses Rs 1 on this infra-marginal unit. Denote this change in revenue by Rlost. Thus the change in revenue for the monopolist is given by revenue earned on extra units minus the revenue lost on all previous units: Similarly, the monopolist makes extra Rs 3 (Radd = Rs 3) when he reduces price from Rs 4 to Rs 3 as he is able to sell one extra unit (sales increase from 2 to 3 units). But he also loses one rupee on each of the previous two units as they were previously sold at Rs 4/unit; i.e. Rlost = Rs 2. Therefore, MR is Rs 1 (). The same logic applies to all other units. This shows why MR of monopolist is always less than the price or AR for all levels of output—lowering revenue on infra-marginal units means the MR from selling another unit through a price decrease does not equal price or average revenue.

The formal derivation of the MR-curve is given in figure 13.3. The top two panels of this figure are redrawn from figure 5.7 in chapter 5—the upper panel draws the demand curve facing the monopoly and the middle panel shows the corresponding total revenue curve. How is the marginal revenue curve derived as drawn in the bottom panel? Remember that the tangent of a total curve is the marginal curve. Consider the situation at point B. At this price, the price that can be charged is Pb as shown in the top and bottom panels. Total revenue is TRb in the middle panel. The tangent at point b measures marginal revenue while the slope of the ray coming from the origin to point b gives average revenue (equaling TRb over Yb). You can see that the ray is steeper than the tangent at point b, so we have shown that MR < AR at point b. Pick up any point on this total revenue curve and you can confirm the result that the ray is steeper than the tangent of the total revenue curve. Algebraic Treatment of Marginal Revenue Let us work out the expression for the marginal revenue function. Note that a small decrease in price from, say, Po to P1 allows the firm to increase its sales from Yo to Y1. So, change in total revenue is given by: Figure 13.3: Total, average and marginal revenue curves of monopolistABPbYYbC0PriceDemand curveeaTRc0YoYYbbaPbYYb0Rs/unitD-curveMR-curveMRbbYoTRb Figure 13.3: Total, average and marginal revenue curves of monopolist A B Pb Y Yb C 0 Price Demand curve e a TR c 0 Yo Y Yb b a Pb Y Yb 0 Rs/unit D-curve MR-curve MRb b Yo TRb Further, the new price P1 can be defined as P1 = Po + ΔP. Similarly, Y1 also equals Y1 = Yo + ΔY. Substituting them in the above function gives: or or (13.1) The last term in this expression will be equal to zero for a small change in price and quantity, hence ignoring this term gives us: (13.2) This says that when a monopolist decides to increase its output by Y, there are two effects on revenue. First, it sells more output and receives additional revenue on the sale of additional output which equals PY. However second, the monopolist pushes the price down by P to sell additional units and gets this lower price on all the output it has been selling previously at higher price. The loss in revenue due to reduction in price will be YP. Thus, the total effect on revenue of changing output by Y is given by (13.2). For calculating marginal revenue; i.e. the change in revenue divided by the change in output, divide both sides of (13.2) by Y Taking P common we get: (13.3) Note that the second term in brackets is the reciprocal of the price elasticity of demand: Thus, the expression for MR becomes (13.4) Since price elasticity is always negative, we can also write this expression as (13.5) Expression (13.5) has shifted the minus sign of the price-elasticity and considers only the absolute values of elasticity (irrespective of its sign). This is the desired expression to consider the relation between price and marginal revenue. A number of results can be derived from this expression:

The first immediate result is that as long as elasticity is not zero or infinite, marginal revenue must be greater than price. For any number of price elasticity, the fraction is less than one which means that the bracketed term is also less than one and hence we have: for This simply says that as long as price-elasticity is positive (in terms of its absolute value), MR will be less than the price of a commodity. This is exactly what we learnt graphically in the previous discussion. Secondly, if the price elasticity of the demand curve that a firm is facing in the market is infinite (as is the case for competitive firms), then MR will be equal to price as for exactly the case we had in competitive markets. FYP Box 13.1 works out the mathematics behind this relation for a linear demand function. F Y I B O X 13.1 MR for a Linear Demand Curve Understanding this box requires a bit of mathematics, so if you are not good at it leave this box and move to the main text. Let us consider the specific case of linear demand curve [as that of figure in our previous discussion] and plot marginal revenue curve. The equation of linear or straight line demand curve is given by P = a – bY (13.1.1) Here a is the vertical intercept (measured at zero value of Y showing the level of price at which quantity demanded will be zero), while b is the slope of the demand curve (preceded by the negative sign because demand curves are negatively sloped) (13.1.2) which shows the change in price per unit change in quantity (this is the slope of the inverse demand curve). Recall from expression (13.3) that marginal revenue is (13.3) Substitute the slope term (13.1.2) for in this expression as: MR = P - bY And now substituting P from (13.1.1) MR = a - bY - bY or MR = a - 2bY (13.1.3) It can be seen from this expression that MR curve has the same vertical intercept a as does the demand curve [this can be confirmed from figure 13.3]. However, the slope of the MR curve is twice as steep as the slope of the demand curve, as claimed earlier. The output level where marginal revenue is zero can be calculated by setting (13.1.3) equal to zero and solving for Y as: MR = a - 2bY = 0 Moreover, marginal revenue is negative when Y > a/2b. Further, the quantity a/2b is the quantity at which the elasticity is equal to 1 (in absolute term). This can be seen by recalling the discussion of elasticity of the linear demand curve, from the chapter of elasticity, that its elasticity of a straight line demand curve is given by: The value of P at which elasticity is equal to one is: So, marginal revenue is zero when Y = a/2b which is exactly the half way of the demand curve. At any larger value of Y, the demand will be inelastic which implies that the marginal revenue is negative. 13.2: Profit-Maximizing Output And The Monopolist’s Price The supply decision of the monopolist can now easily be expressed using the standard revenue-cost curves apparatus. Figure 13.4 draws marginal and average revenue (or demand) curves of the monopolist as well as marginal and average cost curves. The question is: at what point will the monopolist be able to maximize his profit? Mathematically expressed, the monopolist would like to solve the profit-maximization problem subject to cost constraint:

(13.6) Note that unlike a competitive firm, the monopolist can not only choose output (Y) but also price (P) to maximize profits because it is price-setter—i.e. has control over market price. For the monopoly firms, price is not a given social parameter emerging out of an impersonal market mechanism. The implication of this market power in the hands of monopolist firm will be discussed later in the chapter when we raise policy issues related to curbing monopoly power. Let’s solve the above mentioned problem that the monopolist is facing. The Marginal Condition The general marginal solution for any maximization problem says that an activity should continue up to the level at which marginal benefits equal marginal costs. This occurs for the monopolist at the level where marginal benefits (MR) equal marginal cost (MC)—exactly the rule we derived in the last chapter. So, point E shows the equilibrium condition for a profit-maximizing monopolist in figure 13.4 where MR and MC curves are intersecting and the monopolist produces Ym output. The price Pm that it would charge for this output level is given along the demand curve corresponding to the output level Ym (at point M)—this is the maximum price that consumers would be willing to pay for Ym level of output, hence Pm is the profit-maximizing price. Note that the monopolist charges a price greater than MC—unlike a competitive firm—because it equates MC with MR and its MR is less than price at all levels of output. Therefore, the equilibrium condition for the monopolist can be stated as: MR = MC < P (13.7) Figure 13.4: Profit-maximizing by the monopolistPmYYm0Rs/unitD-curveMR-curveMRbMMCATCEAB Figure 13.4: Profit-maximizing by the monopolist Pm Y Ym 0 Rs/unit D-curve MR-curve MRb M MC ATC E A B The reason why E is the equilibrium or profit-maximizing point was explained in detail in the last chapter, so you should go through the relevant section in order to consolidate your understanding. To summarize, if the firm raises quantity beyond Ym, profit would fall because MR is below MC (addition to revenue will be less than addition in cost by increased output). On the other hand, if price is increased, this will reduce quantity sold cutting down revenue by MR. The forgone cost would MC which is less than the revenue loss. This means that the result of raising price would be to lower cost by less than revenue is reduced, so the profit would decrease. Only the intersection point of MR and MC curves is the best output level if the firm is to maximize profits. How much profit the monopolist is making at point E? Profit is given by the difference between total revenue and total cost, so we have also drawn the ATC curve to calculate total cost in figure 13.4. The revenue is given by the area 0PmMYm (= Pm × Ym) whereas area 0ABYm shows the total cost of producing Ym output. Therefore area BAPmM shows the profit of monopolist which is clearly positive in this case. Since the monopolist is the only seller in the market and no entry is allowed for a new firm, therefore it will continue to make this supernormal profit both in the short run as well as in the long run. But it is not guaranteed that the monopolist will always make positive economic profit, it may lose money depending upon its cost situation. Pakistan Railways is probably the best example of a monopoly losing money. What should a monopolist firm do if it is making losses?

Total Condition and Shut Down Rule We said in the last chapter that the marginal condition can be combined with the corresponding total condition for equilibrium. The total condition is especially helpful in identifying the shut-down point for firms. Figure 13.5 shows the case of a monopolist making lose (may be because demand for its product has decreased alarmingly—say for WAPDA the electricity demand has decreased drastically because many people have reverted back to doing without electricity). Of course the best operating point is E where MR and MC curves intersect. However, at that point price Po is below average total cost A, since the demand curve lies below ATC curve. Figure 13.5: Monopoly incurring lossesPoYYm0Rs/unitD-curveMR-curveMMC ATCEACLoss Figure 13.5: Monopoly incurring losses Po Y Ym 0 Rs/unit D-curve MR-curve M MC ATC E A C Loss Here, the demand curve is always below ATC curve which means that no matter what the level of output, consumers value the firm’s output less than the cost of resources needed to produce it. Thus even a monopolist cannot make profit in these circumstances. The monopolist, say WAPDA, will ultimately shut-down if this tendency of incurring losses continues for a long period of time because capitalist firms—whether competitive or monopolist—are necessarily profit-maximizing entities. The shut-down rule for a monopolist is exactly the same as the for competitive firm; i.e. Shut down in the short run if TR < VC Shut down in the long run if TR < TC You should go through section 12.2.2 if you are not yet sure why this is the shut-rule for monopolist. 13.2.1: Monopoly Supply Curve It is important to note here that ‘marginal cost curve is the firm’s supply curve’ holds true only for the competitive firm which is, according to economic theory, a price taker. On the other hand, marginal cost is not the supply curve for a monopolist. In fact, the monopoly has no specific supply curve as shown in figure 13.6. A competitive firm always produces on its marginal cost curve no matter what the level of demand. This is so because price is assumed to be equal to marginal revenue for a competitive firm, therefore the amount it produces corresponds in every case to its marginal cost curve. On the other hand, the output a monopolist produces depends both on the firm’s marginal cost function and the market demand curve. Since both are needed to determine supply, and many different demand curves can be drawn through the same point each having a different slope and therefore a different MR curve, it is impossible to derive a curve which shows how much a monopolist will supply at each price level. Figure 13.6: No supply curve can be derived for monopolistPoYYo0Rs/unitD1MR1eoMCP1D2MR2S2S1PoYYo0Rs/unitD1MR1eoMCY2P2e1D2MR1S1S2a Figure 13.6: No supply curve can be derived for monopolist Po Y Yo 0 Rs/unit D1 MR1 eo MC P1 D2 MR2 S2 S1 Po Y Yo 0 Rs/unit D1 MR1 eo MC Y2 P2 e1 D2 MR1 S1 S2 a The left hand panel of figure 13.6 shows the possibility of monopolist producing the same output level with two different price levels. This happens when two marginal revenue curves having different slopes pass through a MC-curve at the same point (eo). The right hand panel shows the situation when the monopolist is supplying more output at a lower price. Even if the two demand curves are passing through the same point (a), the amount produced for the two demand curves differ because their marginal revenue curves differ. Supply curves thus can’t be drawn for monopolist independent of demand curve—there is no unique combination of price and output supplied for a monopolist. This is result becomes very important when we compare competitive markets with monopoly later in this chapter.

13.3: Monopoly Power We have seen that the monopolist enjoys market power; i.e. the ability to change market price. This ability of a monopoly business is reflected by the fact that it charges a price greater than marginal cost of production. Let us develop a quantitative measure of this monopoly power. 13.3.1: Measuring Monopoly Power Before doing this, it would be useful to have a practical rule of pricing for monopolist firms. The above analysis says that the monopolist should choose his price and output such that MR and MC are equal, but how can a monopolist manager find his correct price in practice? The question is important because managers have only limited knowledge of the average and marginal revenue curves of their firm. Similarly, they might know the firm’s marginal cost over a limited output range. Fortunately, the MR-MC rule can be translated into a rule of thumb that can be applied easily in practice. A Rule of Thumb for Monopoly Pricing To accomplish this task, begin with the expression of marginal revenue in (13.4): (13.4) or Since the firm wants to charge profit-maximizing price, setting marginal revenue equal to marginal cost we have: This can be arranged to have: or (13.8) which is the desired result. The left-hand side is the mark-up over marginal cost as a percentage of price. For example, if price is Rs 10/unit while marginal cost is Rs 8/unit, then price mark-up is 20% . The relationship says that this mark-up equals the negative of the inverse of price elasticity of demand (of course, this will be a positive number because price elasticity of demand is a negative number). Equation (13.8) can be used by a monopolist as a rough guide to determine price mark-up level once the value of price-elasticity of demand is known—however the estimation of elasticities remain problematic. For example, for a value of price elasticity -2, the market up would be 50%. Clearly, the smaller the value of price elasticity, the larger will be monopoly mark-up over marginal cost and vice versa. The expression (13.8) can be rewritten to express price directly as a mark-up over marginal cost as: or or (13.9) For example, if elasticity of demand is -4 and MC equals Rs 9/unit, the price should be: The expression (13.9) can also be used to compare the price charged by a monopolist to that of a competitive firm. We learnt in the last chapter that the competitive firm charges price equal to marginal cost whereas, as explained above, the monopolist charges price that exceeds marginal cost. Expression (13.8) shows that the amount by which the monopolist charges the surplus price over marginal cost depends inversely on the price elasticity of demand. Figure 13.7: Price Mark-up and elasticity of demandPoYYm0Rs/unitDMRMMCEMCP - MCEPoYYm0Rs/unitDMRMMCMCP - MC Figure 13.7: Price Mark-up and elasticity of demand Po Y Ym 0 Rs/unit D MR M MC E MC P - MC E Po Y Ym 0 Rs/unit D MR M MC MC P - MC This means that if demand is highly price-elasticity; i.e. ηyp is a very large (negative) number, then price will be very close to marginal cost and monopolized markets will function very much like competitive ones. In fact with very high demand elasticity, there is little benefit in being a monopolist. As an extreme case, if price elasticity of demand is infinite (as is the case for competitive firm), monopoly market becomes a perfect competition in practice. The situation is depicted in figure 13.7.

Lerner Monopoly Power Index What does the above analysis have to do with the measurement of monopoly power—the problem we started with? A vigilant student can sense that that the expression (13.8) directly gives a measure of monopoly power. The concept of monopoly power was first introduced by Abba Lerner in 1934, and therefore it is called the Lerner index of monopoly power. The formal expression of his index is: (13.10) which simply says that monopoly power is reflected by percentage surplus of price over marginal cost; so that the larger the value of L, the greater the monopoly power. We have seen that the value of this index can be expressed in terms of price-elasticity of demand as given by: (13.11) As noted above, the value of the Lerner monopoly power index depends inversely upon the price-elasticity of demand. One thing should be noted at this stage rather clearly: considerable monopoly power does not necessarily imply high profits. Remember that profit depends upon average cost relative to price. It is possible that a firm might have monopoly power but may end up as losing money as was shown in figure 13.5. Exploring the sources of market power is equally important as is its measurement. But this issue will be tackled in the chapter on monopolistic and oligopolistic competition because it requires some additional concepts for grasping it properly. Here we move to the factors that make monopoly possible at the first place. 13.4: Creating and Sustaining Monopoly Power: Entry Barriers Monopoly is of course a desirable state for a profit-maximizing firm, but it is not easy to create and maintain it. Application Box 13.1 gives an example of an attempt of creating a monopoly in Brazil. A p p l i c a t i o n B O X 13.1 Brazilian Rubber Monopoly The Brazilian rubber monopoly yielded enormous profits for Brazilian land-owners in the 19th century and the government tried its best to protect its monopoly. However, a British citizen managed to get some rubber trees out of Brazil and transplanted them in British held Malaya. After a decade when a large numbers of the rubber trees in Malaya came into production, there was a crash of rubber prices in 1910 and Brazil lost its monopoly power. The question we ask in this section is ‘how does someone create a monopoly?’ We will highlight the strategies firms employ to maintain their monopoly position. The problem of creating and maintaining monopoly could be seen in terms of barriers to entry—factors that either make entry by a new firm impossible or difficult. Let’s discuss these barriers in the following sub-sections now. 13.4.1: Franchise Rights Probably the easiest way of creating a monopoly is to have the government to create one for you. An obvious example is WAPDA which has sole legal rights on the distribution of power and water in Pakistan. The same was the case for PTCL until the late 1990’s. PTV also enjoyed these legal rights for a long period of time until private channels were allowed in the business. A monopoly created by the government is often termed as franchise monopoly. The government granted rights restrict others’ entry into an industry in an area. Most franchise monopolies are in the transport and public sectors of the economy. Some of the conventional forms of these franchise rights are the following.

Patens One common form of franchise rights offered for protecting intellectual property rights are patents, usually advanced for new products or processes. These rights are normally limited to 50 years in Pakistan and include disclosure of the invention in the application documents. A patent holder can exploit the patent on its own (e.g. by selling the specific designs of product), sell it to another firm or license anyone else who pays royalty to the patent holder. Patents are important to many industries because they are means to recover costs involved in researching and developing new products and processes. Copyrights Copyrights are means of protecting intellectual property. Copyrights normally last for the life of the author plus some (usually 50) years. For anonymous works and those written under pen names or by corporate authors (such as newspapers), the copyright lasts for 75 years. A copyright protects a particular expression of idea, not the idea itself. For example, if someone writes a book on microeconomics (such as the one in your hands), then copy rights will protect only the specific themes and coverage of the theory of microeconomics covered in that particular book, they will not disallow anyone writing another book on microeconomics. This is why we have hundreds of books on microeconomics all with some variations in their central themes. Copyrights protections are normally offered to musical works and recordings, lyrics, book authors, broadcasting and TV channels. These rights have also been extended to computer programs. Trademarks Trademarks are yet another type of intellectual property rights; especially in computer industry. Trademarks usually take the form of a distinctive mark or logo by which a person can distinguish one firm’s goods from those of others; e.g. KFC, Sony etc. Unlike copyrights and patents, trademarks protections never expire—an obvious advantage to the firm that has been in the market for a long period of time and wants to continue to use the protection. The functions of trademarks are to stop foreign clones from being sold in the domestic market and to subject consumers to a particular brand. Allowing one’s trademarked name to become the common term for the whole class of similar products makes it almost impossible to stop infringers through the courts. That is why ‘Coca-Cola’ and ‘Pepsi’ try their level best to maintain their brand names—to ensure that when one orders a ‘Coke’ or ‘Pepsi’ in a restaurant, a substitute cola drink is not automatically sold. Why Franchise Rights? How could one justify the above franchise rights within the framework of economics which puts great emphasis on the moral/ethical value of the model of perfectly competitive markets—markets where it is absolutely impossible for firms to differentiate their products from one another and no barriers (including legal) are available to firms to hide information from others? Two arguments are given to justify franchise rights. First, if large initial investments are required to set and serve a market at all, then the firm making this investment should be protected from entry, at least for some period of time. To understand the logic behind this argument, think of a firm planning to make large fixed investments to serve a new market in a country. Of course, it would be worried about its investment being overtaken by new technology. The firm may be investing not only in plant and equipment but also in creating a market for its product. Once investment is made and demand has been created, a new firm might enter with a slightly better or cheaper version of the commodities and take away the revenue needed to cover the large initial investment. If easy entry by new firms is allowed in the market, then possibly no firm would ever start the business by making large fixed investment. Without some form of protection from entry, the outcome could be inefficient compared to that which franchise monopoly could create. The electricity and telecom companies have been historically granted monopoly rights on this basis—their investments were very large and market for their product initially very small and uncertain. Note that the underlying rationale behind this argument is ‘to increase the accumulation of capital’. Economists hope that in general competitive markets provide maximum opportunities and impetus for growth—accumulation of capital. However, in some cases competitive markets fail to achieve this end and whenever this happens, capitalist government should look to achieve this end using strategies that may apparently go against the spirit of competitive markets but do advance the ultimate end that is actually desired from competitive markets—i.e. accelerated accumulation. Thus, deviations from competitive market policy are allowed if such deviations are aimed at exploiting the opportunities for capital-accumulation which are otherwise not possible to avail. You will see more examples on these forms of legitimate policy deviations in this chapter.

Another important argument for justifying franchise rights emerges from natural monopoly case. But before explaining this argument, we need to discuss natural monopoly and some other related issues. 13.4.2: Natural Monopoly Natural monopoly, often also termed technical monopoly, is a business with increasing returns to scale at the level of the whole market. The obvious outcome of such a business structure is that the average total cost (ATC) curve keeps declining as firm expands its operation, a phenomenon termed as economies of scale in chapter 11. Let us look more closely at the conditions that make natural monopolies possible. A new profit-maximizing capitalist is thinking of building a water treatment and supply plant for the city of Karachi—say because it is the largest city in the country and hence the market size is very large. Of course this venture will involve purifying the water from its existing source and providing it to the customers at a price they are willing to pay. It is expected that this business would be capital-intensive and involve extensive fixed capital expenditures for the treatment of plants and for equipments such as pipes, filters, storage tanks etc—in other words fixed costs would be very high for this business. However, the variable cost component is not going to be significant because a small work-force can monitor a well-designed water treatment plant. This means that the firm’s cost will compose mostly of fixed costs. Because average fixed cost [AFC (= FC / Y)] decreases as more output is produced, the more water the firm supplies the more it can spread its heavy fixed cost. Therefore, average total costs would decline over a large amount of output. Figure 13.8 depicts this type of cost behavior where average total cost is decreasing up to q2 units, say 70 thousand gallons of water per day. The average cost function in figure 13.8 gives rise to natural monopoly where technically the cheapest way to produce any given level of output in the market is to have one firm—i.e. the cost of production by a single firm is less than that of more than one firm. For example, consider output q2 which costs Rs 12 per gallon. So the total cost of producing 70,000 gallons of water is calculated as: TC (q2) = TC of Monopoly Firm TC (q2) = ATC × Y TC (q2) = 12 × 70,000 = Rs 840,000 (= ATC × Y) But what if the total of 70,000 gallons water is processed and supplied by two firms? If both firms serve half of the market, then each firm will supply 35,000 gallons with per unit cost of Rs 16. The total cost of producing 70,000 gallons in this case would be: TC (q2) = TC of Firm 1 + TC of firm 2 TC (q2) = 16 × 35,000 + 16 × 35,000 TC (q2) = 560,000 + 560,000 = Rs 1,120,000 Clearly, total cost is less for monopoly firm as compared to the two firms serving the market. Technically, it is desirable to have only one firm operating in the market than two or more because with a falling ATC-curve, the monopolist is able to produce output in the least cost way at all levels of output up to q2. If total demand for water per day is 70,000 gallons in Karachi, people will benefit if the water monopoly is granted to our capitalist and he is charging a price Rs 12/gallon of water, instead of two firms operating and charging a price Rs 16/gallon (of course no capitalist firm would like to charge a price below its average total cost because that would simply mean losing money). Thus one of the conditions for natural monopoly to develop is to have a falling ATC-curve over a large scale of production—i.e. production technology to exhibit increasing returns to scale. This condition is satisfied for the water-supply monopolist for all quantities below q2 = 70 thousand gallons of water per day. It is due to these technical reasons that we see public utilities like electricity, gas, water and telephone services, being supplied by public sector firms in many societies. Competitive markets are not desired in this case because inclusion of more firms in the market disallows firms to benefit from economies of scale.

Figure 13.8: Cost behavior that makes monopoly possibleRs/unitbY0a ATC40301612q1 = 35cd10q2 = 70q3 =105 Figure 13.8: Cost behavior that makes monopoly possible Rs/unit b Y 0 a ATC 40 30 16 12 q1 = 35 c d 10 q2 = 70 q3 =105 However, two points should be noted here. First, development of natural monopoly does not require falling average total cost every where. We can have technical monopoly even in the case of non-decreasing segment of ATC-curve. In our monopoly case, this would be possible if per day water requirements are slightly more than 70,000 gallons, say 75,000 gallons. In this case we will have a point on ATC-curve near by the right of point c for the monopoly and by repeating the above type of analysis for more than one firm with different combinations of output that add up to 75,000 gallons per day we can confirm the above result. Secondly, firm experiencing technology producing cost function as drawn in figure 13.8 is not a natural monopoly at every level of output. For example, consider output level q3, say 105,000 gallons per day. If this amount is produced by one firm, the total cost would be Rs 3,150,000 [= 30 × 105,000]. However, the same output can be produced more cheaply by three firms each producing 35,000 gallons costing Rs 1,680,000 [= 16 × 35,000 × 3], or by two firms one producing 70,000 while other 35,000 gallons and costing only Rs 1,400,000 [= 12 × 70,000 + 16 × 35,000]. Hence, there could be a level of output beyond which a firm with the cost function depicted in figure 13.8 is no longer a technical monopoly. This fact gives rise to the issue of sustainability of natural monopoly; i.e. under what circumstances a natural monopoly could be sustainable. Sustainable Monopoly The mere fact that the water-supply firm is a natural monopoly does not protect it from entry by rival firms. Consider panel (a) of figure 13.9 which draws the same average total cost curve as in 13.8 except that market demand curve has been superimposed. If the total water requirement for Karachi city is yb gallons, then Rs 15 a gallon is the lowest price that will allow our monopolist to cover cost of producing this output level. We can see that for all output levels below yb, any producer is a natural monopolist. Is there any possibility for a new capitalist firm to make entry in this market, take customers away from the existing monopolist and make a profit? The answer is yes. To understand how, think of a firm that enters the market and produces ya output at an average total cost of Rs 12/gallon. Such an entrant can set a price between Rs 12 and Rs 15 (the existing monopolist’s lowest price), sell ya gallons of water and make a profit. This new firm will be successful because it needs not supply the entire market when it enters; rather it can provide only ya gallons and enjoy low costs associated with producing this output. Figure 13.9: Sustainability of natural monopolyYyb0Rs/unitDoATCa15bya12(a) Natural Monopoly with possible entry Yyd yc0Rs/unitDoATCaPcc(b) Natural Monopoly with no entry possibilityPddPe

Figure 13.9: Sustainability of natural monopoly Y yb 0 Rs/unit Do ATC a 15 b ya 12 (a) Natural Monopoly with possible entry Y yd yc 0 Rs/unit Do ATC a Pc c (b) Natural Monopoly with no entry possibility Pd d Pe Such a strategy of market entry will force the existing monopolist to produce less than total market demand and accept the new entrant. As this happens, two firms will start serving the entire market and price will rise in the longer run as average total cost starts increasing due to the fact that both firms are unable to exploit full benefits from falling average total cost. A natural monopoly that can prevent entry and keep others out of the market is called sustainable monopoly. This monopoly is characterized by the situation where average total cost is decreasing every where up to the level of the whole market. This is shown in panel (b) of figure 13.9 where market demand of water is yc gallons. This quantity can be sold at price Pc where demand curve is intersecting the ATC-curve at point c. Because average total cost is decreasing up to that point, the firm has sustainable natural monopoly for that quantity. What if another firm tries to make entry in this case by selling quantity less than yc? In order to avoid loss, the entrant must set price equal to or above pc. Suppose it sets price pd and hopes to sell yd amount. Since this price of pd is higher than that existing monopolist charges, consumers will not buy from the new entrant. The only way to take customers away from the monopolist is to set price below pc. If the entrant does so, and chooses a price pe, its price will have to be lower than its average cost of production which means it loses money and hence does not enter. Therefore, output of yc is sustainable for the monopolist, as is any quantity at which the demand curve intersects the average cost curve to the left of point a. Note that the sustainable price-output combination must be a point where the demand curve intersects ATC-curve. Alternatively, the capitalist can have sustainable monopoly if he sets a price and quantity with demand equaling average total cost (the marginal cost pricing rule is not consistent with natural monopoly, this point will be discussed below). To summarize the above discussion in rather technical language, we can define a sustainable natural monopoly as one that meets the following three conditions: y = D (p)—output of the firm (y) satisfies all market demand (D) at any price P × y = TC (y)—the firm covers its cost by producing that output (y) P’ × y’ < TC (y’) for all p’ < p and y’ < D (p)—and sets a price p such that any competing firm that tries to enter by selling a smaller quantity (y’) at a lower price (p’) incurs loss The above conditions confirm that a market characterized by always decreasing average total cost must be a sustainable natural monopoly. Thus if a market structure is characterized by the above conditions, it becomes an effective barrier to entry for new firms. Such market structures allow the existing firms to engage in pricing strategies that prevent entry by new firms as discussed below.

13.4.3: Active Pricing Strategy Having considered the conditions under which natural monopoly would be successful, the capitalist decides to establish his water supply firm. Figure 13.10 shows the decision making process of the capitalist. Since this is a profit-maximizing firm, given the demand situation the profit-maximizing price is Pm and Ym is profit-maximizing quantity. You can see that Ym quantity is determined at the point where marginal revenue equals marginal cost and the price is set above the marginal cost depending upon the elasticity of the demand curve in expression (13.9). The monopolist makes super-normal profit equal to the area AbcPm. Obviously, this profit will attract a new entrant. Is the monopolist ready to tackle this event? If a competitor tries to enter the market, he can immediately reduce the price to Ps which is the sustainable price for the market (price Ps is comparable to Pc in figure 13.9). Inertia Shopping Rule Note that the monopolist does not need to charge Ps price all the time to prevent the entry. In fact, the pay offs associated with each move in this market make it possible for the monopolist to continue charging Pm price and yet no entry would take place. Figure 13.10: Using Limit pricing to prevent entryYYm0Rs/unitDoATCcePmbMRMCAPsdYs Figure 13.10: Using Limit pricing to prevent entry Y Ym 0 Rs/unit Do ATC c e Pm b MR MC A Ps d Ys To understand how, suppose the capitalist is currently charging price Pm. Of course this price will attract new competitors because it promises super-normal profits. Will it not be possible for the competitor to make successful entry by charging price Ps which is lower than Pm—the price the existing monopoly is charging—and take away the market from the monopolist? The answer is ‘no’ as long as customers suffer from inertia—the tendency of customers not to shift their demand to the entrant immediately. In these circumstances, the monopolist assumes that customers will behave according to the inertia shopping rule when deciding which firm to buy from. The rule is simple: buy from the firm that charges the lowest price, but if you are already buying from a firm and another firm enters the market with a lower price, give your current firm a chance to meet the entrant’s price before shifting your demand. This behavior on the part of customers gives enough time to the monopolist to decrease its price and prevent the entrant from taking away its customers, despite the fact that the entrant starts with a lower price than the existing monopolist. The strategy of the new entrant can be summarized as follows: If the existing monopolist is currently charging price Ps, there is no point in entering the market If the monopolist initially sets monopoly price Pm and, after the entry occurs, he lowers it to the sustainable price, the entrant will gain no customers (this would be true as long as the inertia shopping rule holds). The entrant will lose whatever amount he invested in the plant It should be clear to any potential capitalist entrant that if it enters the market after the monopolist has set the monopoly price, the monopolist will subsequently lower its price, force the entrant out of the market and cause it to lose its investment. Hence, even the monopoly price will deter the entry of any potential competitor. Because no entry will take place whether the price is Pm or Ps, the monopolist will set the monopoly price. Thus, pricing strategies used by existing firms are also barriers to entry. The above is an example of limit pricing where the existing firm sets a price so that an entrant can’t make profits at that price. More on such pricing strategies will be said in our discussion about oligopoly in the next chapter.

13.4.4: Investment Requirements and Capital Market Imperfections Entry barriers can be distinguished on the basis of the degree of space they leave for new entry. Barriers discussed above are called absolute barriers—barriers that rule out new entry whatsoever over some time horizon. Such barriers arise out of legal impediments, such as franchise rights, or out of specific market conditions, such as characterized by natural monopoly, or out of active pricing strategies. Unlike them there are some relative barriers which place a new entrant at a disadvantage, but they are not insurmountable ones. Relative barriers may also arise due to a number of factors: capital market imperfections, specific competitive advantages etc. Here we discuss some of them; first take large investment requirements and capital market imperfections. We learnt in the last chapter that super-normal profits lure new firms to enter the market. What do you understand by new firm? Normally, economic theory gives an impression that such a new firm is launched by a person who was initially not a supplier; i.e. an ordinary person becomes a capitalist by starting his own business. The model of perfect competition presents a simplistic picture of entrepreneurship—something realized merely by the possibility of making ‘super-normal profit’. In fact, such a conception of ‘spontaneous new entrepreneur’ is the requirement of the ‘large number of firms’ assumption to make a market perfectly competitive—markets can be perfect only when all people consider themselves as potential capitalists and actually keep transforming themselves into ones whenever profits exist. However, this conception of the entrepreneur is largely heroic and superficial since, in capitalist order, it is not the entry by new firms that increases production in response to profit-margins; rather it is due to the expansion of scope of business by the existing firms. Indeed, a great deal of the new entry in capitalist markets takes place in the form of diversification and integration by already established firms. To look for the examples to confirm this statement, ask yourself: ‘who bought KESC or PTCL in Pakistan?’ Ordinary household agents? Of course not, rather they were purchased by already established large capitalist firms such as Siemens. One reason behind this phenomenon has been the large initial investments required to set up a business. As capitalist markets grow and production becomes capital and technology intensive, the fixed cost of entering the market keeps mounting sky high. Suppose you are thinking of starting a new mobile subscription company today. Clearly, you can’t begin this business by incorporating an out-dated technology hoping for gradual updation later as your business succeeds. Instead, you need to start in this business using the current state of mobile technology to have any hope for success whatsoever. Since this ‘starting point’ of entering the market tends to become higher and higher with improved technological production, entry by genuinely new firms becomes more and more difficult as capitalism matures. A reflection of this fact can be seen in the job market for MBAs as discussed in Application Box 13.2.

A p p l i c a t i o n B O X 13.2 MBAs: Entrepreneurs or Wage Laborers? Universities regularly offer courses on entrepreneurship in their MBA programs giving students the illusion that freely available possibilities of ‘entrepreneurship’ is what make market economies more efficient and dynamic as compared to planned economies. Students are often fascinated after going through these subjects as if the only barrier they need to overcome in order to become an entrepreneur is to get an MBA. However, in reality fewer and fewer people can afford to become entrepreneurs as markets mature. This tendency is reflected in the fact that only a negligible proportion of graduates of business administration go for the entrepreneurship option while the vast majority opts for wage-labor. It can safely be stated that almost 95% of MBAs from all universities of Pakistan become wage laborers. Thus as far as most students are concerned, becoming an entrepreneur is simply not a realistic option. The competitive market model assumes away the entry problems arising out of investment requirements because it assumes that capital markets work competitively which implies that: all market agents have borrowing access to whatever amount they need the real cost of borrowing remains constant irrespective of the amount borrowed and there are constant returns to scale in the market But these assumptions are never true in reality as different borrowers pay different interest rates and this interest rate also increases with the amount borrowed. This means that a new entrant will have to pay a higher interest rate than the well-established monopolist. This tendency is further strengthened if the lender regards the entrant as risk—interest rates tend to rise as investment becomes more and more risky. The above tendencies are further enforced when increasing returns to scale (or economies of scale) exist in the production of the monopolized good. In this case, if the entrant sets up production on a scale smaller than at which average costs are at a minimum, then it will incur average costs which exceed those of the monopolist. On the other hand, if it enters on a scale large enough to achieve minimum average costs, then the required capital expenditures will be very large, and may again involve the payment of higher interest costs than those incurred by the existing monopolist. The entrant may not even be able to obtain the required amount of funds to set up an optimal production scale if there is capital rationing in the capital markets. Thus, ever improving production technology leading to large fixed costs and capital market imperfections pose significant market barriers. More on the difficulties of market entry due to these reasons will be presented in the next section. 13.4.5: Competitive Advantages Another category of barriers arise because of competitive advantages enjoyed by existing firms due to product differentiation—when markets are characterized by product differentiation, firms may have advantages over new entrants because of a number of factors. Competitive advantages exist when a firm is able to deliver the same benefits as do its competitors but at a lower cost, called cost advantage, or deliver greater service for the same price to its competitors, called differentiation advantage. Thus, a competitive advantage enables the firm to create superior value for its customers and, hence, superior profits for itself. Firm develops competitive advantages by having unique resources or by excelling in certain capabilities as compared to its competitors and the competitors are unable to replicate what the firm is doing. Examples of resources that create such advantages to firms, for example, are:

Patents and trademarks: exclusive control of superior product design or formula through patent protection Trade or business secrets: contractual right created between a pair of firms doing business or between an employer and employees. Application Box 13.3 gives an example of trade secret Consumer preferences or installed customer base: brand loyalty on the part of customers An example of a firm’s capability is efficient supply and distributional chain—ability to bring a product to the market faster than its competitors. Such capabilities are embedded in the routines of the organization and are not easily documented as procedures and thus are difficult for competitors to replicate. A p p l i c a t i o n B O X 13.3 Coca-Cola’s Formula as Trade Secret Coca-Cola’s formula for its syrup has never been patented or had any other form of legal protection. The Coca-Cola firm has kept the formula secret, revealing it only to people and firms that have signed contracts explicitly requiring them not to reveal its composition. In 1987, when the government of India attempted to force Coca-Cola to turn over the formula without such trade secret provisions, Coca-Cola backed out of the negotiations and went out of India’s market. The firm’s competitive basis is the composition of its syrup. Imitators might take much of its market away if it were to reveal this trade secret. This is also true for KFC and Mc-Donald’s. Since new firms need to make additional expenditures to acquire these advantages, existing firms therefore have absolute cost advantage over the new entrant and they can hence charge a lower price to discourage entry. However, these disadvantages will be only of limited duration as new entrants establish their products in the market during an initial ‘break in’ period. But keep in mind that the new entrants are not new firms; they are new product and service lines established by existing large firms. Capitalist Dynamics and the Emergence of Monopolies This section tells us something about capitalist order. As capitalism matures, organized units controlling capitalist property become fewer and fewer. The perfectly competitive model becomes less and less relevant as a description of capitalist market reality. It retains its usefulness as an ideological benchmark for evaluating the behavior of capitalist individuals (consumers, producers, financers, regulators etc.). At the end of the 1980s there was much talk of “unorganized capitalism” and the emergence of dynamic small producers and distributors in countries like Italy and Spain was widely celebrated. A Pakistani economist working at the Institute of Development Studies Sussex U.K also found such dynamic firms in Sialkot! Schumpeter, Schmidt and many other capitalist economists proclaimed the end of large scale capitalism. But this euphoria soon evaporated. The “dynamic new firms” were soon integrated into global supply chains managed and controlled by a handful of capitalist conglomerates. Capitalist organization has shown that this is quite compatible with the concentration and centralization of capitalist property in fewer and fewer hands. This centralization and concentration of capitalist property is an essential aspect of globalization.

Centralization and concentration of control is necessary for the survival and reproduction of capitalist order. Capitalism, just like socialism, also abolishes private property. All wealth in capitalist order is controlled by a small group committed to using it for the sole purpose of accelerating the rate of capital accumulation and for ensuring that all economic activities are valued and assessed solely on the basis of their relative contribution to the acceleration of the rate of capital accumulation. Private property allows its owner to use wealth for purposes other than capital accumulation–––Abdullah Zhaghazai uses his wealth to repair the mazar of Pirbaba and Abdul Basit uses it to support the Chechen Jihad. Capitalist order must therefore restrict the opportunities of Abdullah and Abdul Basit to acquire wealth for they take wealth out of the circuit of capital where wealth becomes solely an instrument for the self-expansion of capital. Hence capitalist property––in the form of banks, corporations and state owned firms—: destroys private property, turns Abdullah and Abdul Basit into capitalism’s wage-laborers and concentrates the control of all wealth in the hands of those fewer and fewer entrepreneurs who are committed to and have the necessary skill for using wealth for the sole purpose of accelerated capital accumulation Capitalism concentrates the control of wealth (all wealth becomes capital). But it does so in a manner which allows competition to flourish in capitalist order. Competition is the central mechanism for sustaining capitalism’s foundational virtues––avarice and covetousness. If the scope of competition is constrained, scope for the practice of these capitalist virtues; avarice and covetousness is also constrained and capitalist morality tends to ‘wither away’. That is why “State Capitalism” usually succumbs to market capitalism. Scope for competition––the practice of avarice and covetousness––is smaller in state capitalist (socialist) order than it is in market capitalist (liberal) order. Therefore, competitiveness has to be sustained for ensuring capitalist survival. Competition intensifies in market capitalist order in two main ways. First there is intensified competition among individuals as capitalist property replaces private property. The category of wage-labor is universalized. Every man owns nothing except his labor power. And be he operative or manager, he must be an employee and must compete against all other employees to maximize the rate of capital accumulation. Structuring the reward / incentive system to ensure that competition is intensified within each firm is a primary means for universalizing competition. Secondly capitalist order is necessarily unstable, crisis prone and vulnerable to systemic shocks. Most prices––especially prices of financial products and services––are determined by speculation. There are always a large number of losers and some winners in every capitalist order which is never in a state of system wide equilibrium (‘general equilibrium’) or in a state of steady-state growth. Capitalist markets necessarily become imperfect and remain imperfect forever. Oligopoly, not perfect competition or monopoly, is the normal market structures of liberal capitalist order. Competition in oligopolistic markets is intense––characteristics of oligopolistic market structure will be discussed in the next Chapter.

13.5: Need for Regulating Monopoly and State Policy Most of the capitalist governments try to restraint and regulate monopolies so that more competition could flourish. We first examine the justification offered by standard economic theory for such state regulation of monopoly and then move on to the instruments of these regulations. Suppose that a monopolist establishes a water supply firm and charges a monopoly price. With the passage of time he finds things going the way he planed as no entry takes place and he continues to make super-normal profits. Is this state of affairs a satisfactory one for capitalist (or civil) society? Economists would say no. If you think that the reason for this answer is the super-normal profit made by the monopolist, then you are wrong because economists have another criterion to evaluate the efficiency of market structures. The following sub-section explains the logic behind this criterion, but you must go through the appendix to chapter 12 that outlines the necessary tools—i.e. consumer and producer surpluses—to understand this section fully. 13.5.1: Social Cost of Monopoly: The Standard Story The trick (used in almost all standard microeconomics textbooks) is to compare the equilibrium output of the competitive firm with that of the monopolist. We have seen that in a competitive market, price equals marginal cost while monopoly implies that price exceeds marginal cost. The monopolist charges a higher price and produces a lower quantity as compared to the competitive firm. This can be seen by comparing points em and ec in figure 13.11. Point em is the monopoly equilibrium point with MR equaling MC associated with Pm price and Ym output. On the other hand, ec is the competitive market equilibrium point because competitive firm produces where MC equals price (or average revenue, AR). Figure 13.11: Deadweight loss from monopoly powerMCDeadweight lossEFYYm0Rs/unitAR = DoPmMRPcYcemecGABCD Figure 13.11: Deadweight loss from monopoly power MC Deadweight loss E F Y Ym 0 Rs/unit AR = Do Pm MR Pc Yc em ec G A B C D e e This means that competitive equilibrium is achieved in this diagram where MC curve intersects demand (or average revenue) curve. The competitive and monopoly output-price combinations can now easily be compared. Monopoly and Deadweight Loss How should we compare the two equilibrium points; i.e. which of them is the better from a capitalist point of view? The capitalist benchmark for evaluating two economic states is the sum of consumer and producer surpluses: market structure resulting in larger consumer and producer surpluses is treated as welfare superior. Let us compare the corresponding surpluses under monopoly and competitive situations. Consider competitive equilibrium first. Recall from the appendix in chapter 12 that consumer surplus (CS) is given by the area under the demand curve and above the price level while producer surplus (PS) is the area below the price level and above the supply curves. Given these definitions, consumer and producer surpluses in figure 13.11 are represented by the following areas:

CScom = A + B + C + D +E PScom = F + G TScom = A + B + C + D +E + F + G Similarly, surpluses under monopoly case are given by the areas: CSmon = A + B PSmon = C + D + G TSmon = A + B + C + D +G We can now easily examine how surpluses change if we move from competitive to monopoly equilibrium. Algebraically, the change in total surplus is given by subtracting competitive surplus from monopoly surpluses; i.e. ∆TS = TSmon – TScom Therefore, TSmon = A + B + C + D +G – TScom = – A – B – C – D –E – F – G ∆TS = –E – F The result shows that civil society has lost the welfare (consumption possibilities) equivalent to the area E-F as indicated by the shaded area in the diagram. But what is the intuitive meaning of this calculation? Consider what happens to consumer and producer surpluses when we move from point ec to em. It can be seen that consumer surplus falls by the areas C, D and E because price has increased. Algebraically, it can be calculated by subtracting consumer surplus under competitive equilibrium (A + B + C + D + E) from that under monopoly: CSmon = A + B – CScom = – A – B – C – D –E ∆CS = – C – D –E Unlike this changes in producer surplus are a little more complex. Areas C and D have been added to producer surplus after rise in price from Pc to Pm while area F is lost by the producer because it is now producing lower quantity, Pm. These changes are given as: PSmon = C + D + G – PScom = – G – F ∆PS = C + D –F Adding the two changes we get the change in total surplus: ∆TS = ∆CS + ∆PS = (– C – D –E) + (C + D –F) = –E – F which is exactly what we had above. You can see that out of the total changes, areas C-D have been transferred from consumers’ to producers’ surplus, so this merely represents a redistribution of income. If society places the same value to the gains of producers as that of to the loss of consumers, then the reduction in consumers’ welfare by C-D is compensated by the gains in producer welfare by the same amount. The two areas thus cancel each other out. But what about the loss in consumer surplus shown by area E and that in the producer surplus by area F? This is the net loss in social welfare resulting from monopoly power—called deadweight loss. You can see that the deadweight loss is independent of monopoly profit; i.e. it exists whether or not the monopolist makes a super-normal profit. Even if the monopolist’s profit is completely taxed away and redistributed to the consumers of its products; there would be inefficiency because output would be lower than that under competition. The deadweight loss shows the social cost of this productive inefficiency. Remember, as explained in the last chapter, that firms achieve production efficiency when they follow marginal-cost-pricing. Table 13.3 summarizes the differences between the monopoly and the competitive firm model. Table 13.3: Differences between monopoly and competitive model S. No Competitive Firm Monopoly Firm 1 Price taker Price setter 2 Faces horizontal demand curve Faces downward sloping demand curve

3 Marginal revenue equals price Marginal revenue is less than price 4 Charges price equal to marginal cost Charges higher price than marginal cost 5 Results in efficiency Imposes deadweight loss on society Since according to economic theory, monopoly business is associated with deadweight loss and inefficiency (i.e. loss of consumption), this sets the grounds for preventing firms from exercising monopoly power. Putting the argument in the context of our water-supply monopolist, people see no reason why a monopolist should make profits and yet not provide water to all the customers who want it. 13.5.2: State Instruments for Regulating Monopoly Given the above situation, economists would quickly ask government officials to do something about this situation in order to increase civil society welfare—i.e. consumption. Economists suggest a number of policy options available to the state for regulating monopolies. We discuss them one by one. Price Regulation One of the objectives of price-ceiling is to eliminate deadweight loss. Figure 13.12 illustrates how this policy works. Here, Pm and Ym are the price-quantity combinations that result without price regulation. Now assume that the government regulates price to be no higher than P1—sets a maximum price limit. How would the demand and marginal revenue curves change after this price regulation? Because the firm cannot charge anything more than P1 for output levels up to Y1, its new demand (or the average revenue) curve is a horizontal line at price P1 (look at the dark thick horizontal line at P1). The dashed part above P1 is no longer effective after the imposition of price ceiling. This is very similar to the competitive firm’s horizontal demand curve when price is fixed. Figure 13.12: Monopoly with price-ceilingMCMR-curve when price is regulated to be no higher than P1YYm0Rs/unitAR = DoPmMRP2 = PcYcemecATCP1P3P4YoY3Y1e3e3’e1AB Figure 13.12: Monopoly with price-ceiling MC MR-curve when price is regulated to be no higher than P1 Y Ym 0 Rs/unit AR = Do Pm MR P2 = Pc Yc em ec ATC P1 P3 P4 Yo Y3 Y1 e3 e3’ e1 A B But for output greater than Y1, the new demand curve is identical to the old one because at these output levels the firms will charge less than P1, and so would be unaffected by the regulation. Since the marginal revenue curve is derived from the demand curve, the new marginal revenue curve will also change as it will correspond to the new demand curve now. For output levels Y1, marginal revenue equals the demand (or average revenue) curve. On the other hand, for output greater than Y1, the new MR curve is identical to the original one. Note that the MR curve is vertical from price P1 up to the level where it corresponds to the old MR curve. Thus, the effective MR curve after price regulation is the dark line. With price ceiling, the monopolist will produce Y1 output because that is where its MR curve intersects MC curve (point e1). It can now easily be seen that the deadweight loss has been reduced from area emAec to e1Bec due to this price-regulation. As price is further reduced, quantity produced continues to increase and deadweight loss decreases. At price Pc, where the demand curve is interesting the MC curve, quantity supply has increased to the competitive level, Yc, and the deadweight loss has disappeared. What if price is further reduced to, say, P3 level? Note that this will result in reduction in quantity to Y3 because in that case the firms’ demand and MR curves will be horizontal at price P3 up to the quantity level Yo. This means that MR curve will intersect MC at point e3 and the monopolist will produce Y3 output. This reduction will also create a shortage equivalent to (Yo – Y3) because demand is greater than quantity supplied at this price. As the price is lowered further, the quantity produced continues to fall and the shortage grows. Finally, if the price is set below P4, the minimum average total cost level, the monopolist loses money and will opt out of business.

Price Regulation and Natural Monopoly Price regulation is often practiced for natural monopoly. The above analysis shows that the best way to regulate monopoly price is to set it equal to marginal cost of production. What if the price regulatory authority tries to implement the marginal-cost pricing rule to natural monopolies, such as our water supply monopolist? Unfortunately, the policy will not work as it will force the monopolist out of the business. To understand why, consider figure 13.13 which shows the case of natural monopoly. Note that average total cost is falling everywhere due to increasing returns to scale (the ultimately rising segment of ATC curve is not shown because that is irrelevant in the natural monopoly case). Since average total cost is decreasing everywhere, therefore MC curve is always below ATC curve. Unregulated, the firm would produce Ym and charge Pm price. If the regulatory authority pursues the ideal pricing policy of pushing price down to the competitive level Pc where the MC curve cuts the demand curve, then the firm will not be able to meet its cost as this price is below its average total cost by distance Bec. Here, the regulatory authority has two options. First, force the monopolist to use welfare optimal price Pc, but in that case government must pay him subsidy to cover his losses so that he can stay in business. Second, set the monopolist’s price where it can break-even. This price is achieved where the demand curve intersects the average total cost at point er with price Pr. With this price, the monopolist earns no monopoly profit and output is as large as it could be without driving the firm out of business. This pricing rule is called average-cost-pricing. True that this plan will not produce welfare (consumption) optimal result for society, but it will achieve the second best result from civil society point of view. Though average-cost pricing seems to have solved the problem of monopoly power, but it is not an easy option to use in reality because of informational requirements about cost and demand structure of monopoly business. Firm’s demand and cost curves keep shifting as market conditions evolve. Figure 13.13: Regulating natural monopolyDoYYm0Rs/unitATCemPmAMRMCBPcYcPrYrecer Figure 13.13: Regulating natural monopoly Do Y Ym 0 Rs/unit ATC em Pm A MR MC B Pc Yc Pr Yr ec er Rate of Return Regulation Another option for regulating monopoly business is the use of the rate of return regulation which is not only simple to administer but requires less information that the price regulatory scheme. The underlying idea behind this regulation option goes as follows: when capitalist agents invest money in an enterprise, they expect to receive at least a rate of return they could have earned by investing their money elsewhere, most probably in a bank saving account. If they do not expect this rate of return, they will conclude that the investment is not worthwhile and should be dismissed or ended. So the regulatory authority must allow any firm under its jurisdiction to make a rate of return sufficient to keep its capital in the given business. This means that the monopolist would not be allowed to earn more than a fair or competitive rate of return. If profits are large enough to create excessive rate of return, the firm will be directed to reduce the price of its product.

How could such a price be calculated? Let K stand for the amount of capital invested by our water-supply monopolist and rr for rate of return (say x%) permitted by the regulatory authority. After the firm has paid its variable costs, it must earn enough money to pay its shareholders rK amount. The key is to make sure that rr is large enough to satisfy the investor. Since the amount of capital K is something observable, so the regulatory authority should find it relatively easy to measure that amount. If we assume that labor and capital are the two inputs in operation; and w is the wage rate for labor, Y be the output and P the price of output, then the formula for rate of return regulation is: (13.12) This expression says that after the firm has subtracted its labor (or variable) cost from revenues, the amount left over must not be greater than what is necessary to pay the rate of return rr on capital K. This can now be solved for the price P that guarantees the desired rate of return as: (13.12) Since the rate of return regulation is based on the amount of capital stock, one difficulty arising in case of this regulation is the information on true valuation of the monopolist’s capital stock. The difficulty of agreeing on a set of cost numbers to be used in the rate of regulation calculation often leads to delays in regulatory response to changes in cost and other market conditions, as well as long and expensive court hearings. The major beneficiaries of this situation are lawyers, accountants and sometimes economic consultants. The net result is regulatory lag—the delay of months usually required to change the regulated price. These lags benefit the regulated firms if average long run average total costs are falling over time (due to the realization of economies of scale as firms grow). The regulatory lags allow these firms to enjoy actual rate of return higher than those regarded fair at the end of regulatory proceedings. Application Box 13.4 shows how the rate of return regulated firm can become very lucrative for capitalist regulators. It also explains how regulatory authorities are jeopardized by capitalist firms via promoting formal corruption—one of the glaring hallmarks of capitalist societies. A p p l i c a t i o n B O X 13.4 Rate of Return Regulation and Job Career as Regulators The politicizing of pricing decision and the investment decisions of a rate-of-return regulated firm can become very lucrative for regulators. One of the common career paths for staff members of a regulatory commission is to take such a job immediately after graduating from law school. After spending a few years with the law commission, learning its procedures and developing relations with personals, the staff members can work for one of the regulated firms. The insider knowledge and contacts obtained can then help the regulated firm. Many economists have argued that regulatory bodies become ‘captured’ by the firms they regulate. Only the regulated firms have a large sustained interest in the regulatory process and devote substantial resources to influence regulatory authorities. The outcome is the regulation works in the interest of those regulated firms. This means that getting the benefits of natural monopoly through regulation reflects a trade-off for the costs regulatory system creates.

However, sometimes regulatory lags go against the monopoly. For example, when oil prices rise sharply, electric utilities and railways need to raise their prices. Regulatory lags cause them to accept rate of return well below the fair rates they have been earning earlier. Price-Cap Regulation The above regulation schemes are problematic because they provide monopolists an incentive to maximize costs—the greater a firm’s costs are, the greater the price it will be allowed to charge. For example, under average-cost-pricing, the amount the monopolist is allowed to charge for a product is based on the average cost of producing that product. This means that a higher cost leads to a higher price. Moreover, this policy enables the monopolist to survive without paying close attention to new cost-reducing opportunities. Similarly, rate of return regulation provides an incentive to use more capital than is necessary or efficient to produce in order to increase the firm’s rate base. An alternative tool of regulating a monopoly firm is to use price-cap regulation which is a regulatory method designed to encourage efficient production by allowing firms to share in any cost savings that they have achieved in the production process. The idea behind this scheme is simple. It is expected that as firms continually produce the same product, they should improve on its production and average costs should decrease. Price-regulation tries to give exactly this incentive to monopolist by permitting them to keep at least a portion of the cost savings they achieve. Suppose that the productivity of our water-supply monopolist increases, say, by 2% each year so that average cost falls every year by this amount. For implementing price-cap policy, the regulatory authority announces that it will adjust the price of purified water each year by the following formula: ∆P = Rate of increase in input cost – 2% (i.e. expected yearly increase in productivity) You can see that if input costs increase at a faster rate than 2%, the price of water will rise, while if the input costs increase at a slower rate than 2%, the price will decrease. Thus, if the regulated monopoly can increase its productivity greater than 2%, it can keep the additional cost savings for itself. This type of regulation gives the monopolist a real incentive to reduce its costs because all cost savings beyond the ‘cap’ belong to him. Obviously, consumers will also benefit because of lower prices or at least smaller increase in prices than would occur with other regulated method. An important aspect of regulation has been anti-trust laws, but they will be explored in the chapter on oligopoly. It must be stressed that capitalist states regulate monopolies with the primary objective of maximizing welfare–––i.e. the value of goods produced and consumed in civil society. As we have repeatedly stressed goods are valued solely in terms of the contribution their production and consumption makes to shareholders’ value (i.e. capital accumulation). Capitalist state regulators sometimes regulate markets and firms for non capitalist purposes. For example nationalizing the educational system (with some exceptions) following the implementation of the Beveridge Report in Britain during the late 1940s was justified on the basis that every citizen has a natural right to education. But as several researchers have pointed out successor British governments have increasingly adhered to capitalist rules in pricing educational sector products and this has led to a commercialization and denationalization of almost all segments of British education. This is because the educational system is “locked in” to civil society ––it has to buy its inputs and sell its output to civil society and the tax payers’ money which finances education sector investment depends upon income generated by the tax payers within the circuit of capital and their tax paying ability depends on their performance as valued ultimately by capitalist markets. Capitalist states are thus necessarily subservient to capitalist markets.

We have of course not discussed regulatory policies of non capitalist states. This is because capitalist firms ––competitive, monopolistic, oligopolistics or otherwise–––are not allowed to exist in non capitalist state orders. An Islamic state will for example seek to universalize private property and maximizing consumption / welfare or share holders value will not be its regulatory objective. The Islamic state will regulate economic transactions with the objective of promoting the moral impact of economic activities on the activities of individuals. It will try to promote consumption patterns, production relations and distribution structures so that the virtues of faqr, taqwa, wara and zuhd are universalized and avarice and jealousy disappear from society. This is however not an appropriate topic for a book on microeconomics which seeks to describe the functioning of capitalist individuals, markets and states. 13.6: Competition Mania Unveiled: Yet Another Untold Story of Economics We have already exposed an important inconsistency in neoclassical theory of consumer behavior (see chapter 8). This is the time to unveil another equally important weakness of the neoclassical theory of firm. Based on the neoclassical theory of firm as discussed in the previous and current chapters, all major microeconomics text books teach two strong welfare (consumption maximizing) propositions about competition: Perfectly competitive industries produce an aggregate quantity at which the equilibrium market price equals the marginal cost of production, whereas a monopoly produces a lower quantity at which marginal cost equals marginal revenue. The level of output is lower and the price higher under monopoly than under perfect competition (refer to figure 13.11) Perfect competition results in the maximization of consumer surplus, whereas monopoly results in a transfer of some consumer surplus to the producer as well as a deadweight welfare loss (see figure 13.11) This model of competitive markets based on self-centered individuals leading to efficient resource allocation is presented as one of the most powerful results of economic reasoning in support of legitimizing liberal state policies to promote competition and remove monopolies. However, almost every proposition in this generally accepted neoclassical theory of the firm either abounds with logical fallacies, starting with one that has been shown to be false since 1957—the horizontal demand curve of the competitive firm—or applies under highly restrictive conditions. These problems may be categorized into two broad categories: one of unrealistic or incorrect assumptions about the function of capitalist order and the second of internally contradictory assumptions. We will see that when these fallacies are corrected, nothing of substance remains in the neoclassical argument: (a) price equals marginal cost ceases to be the profit-maximizing equilibrium, (b) competition does not lead to price equaling marginal cost, (c) monopoly in general can be expected to generate a higher level of consumer welfare than competitive firms, and (d) standard cost-curve aggregation of monopoly and perfect competition is only valid in highly restrictive circumstances. Here, we analyze some of these problems, along with their implications. The full-fledge proof of these problems requires the use of mathematical tools that are beyond the scope of this book. Therefore, we will try to develop as much understanding of these problems as is possible using a graphical approach.

13.6.1: Horizontal Demand Curve Fallacy An essential part of the argument for perfect competition is that each firm is so small that it can’t affect the market price and, therefore, takes it as given. As a result, the demand curve, as perceived by a firm, is effectively horizontal at given market price. The firms are also so small that they do not change their output in response to a change in output by another firm. This behavior of firms is termed conjectural variation and it says that conjectural variation in competitive markets is zero. Both of these assumptions mean that the slope of the single firm’s demand curve is zero: market price does not change when a single firm changes its output. Given this horizontal demand curve, marginal revenue equals price and the firm maximizes profit where price equals marginal cost of production. This guarantees allocative as well as cost efficiency. Thus, the key in this efficiency result is the assumption of the horizontal demand curve facing a firm. However, both of these assumptions are inconsistent. To begin with, note that the two assumptions say that if a single firm increases its output by one unit, then total industry output must also increase by one unit because other firms do not react to the changes in output by one firm. Therefore, if the market demand curve is negatively sloped, then an increase in total market output must mean a fall in the market price, regardless of how small this fall might be. To have a graphical intuition of this result, look at figure 13.14 which shows a market demand curve for an industry with a large number of firms. Consider the slope of the demand curve between points A and B consisting of a change in output and in price. Figure 13.14: Slope of firm’s demand curve is identical to market demand curveΔQabDemandPriceY0PAPBYAYBΔPδPδyAB Figure 13.14: Slope of firm’s demand curve is identical to market demand curve ΔQ a b Demand Price Y 0 PA PB YA YB ΔP δP δy A B The slope is given by: Slope of Market D-curve A-and-B = Now consider points a and b. The slope between these points is given by: Slope of Market D-curve a-and-b = It is clear that both of these slopes must be equal. This is because the demand curve is a straight line and the slope of any tiny line segment is equal to the slope of over all section . The effect of an increase in output by one firm on market price and quantity is now shown in figure 13.15. You can see that if a single firm changes its output by a small amount, say δy, then market supply curve must shift by δy amount and price will fall by δP. The market price does change because of the actions of a single firm. In this case, the demand curve facing a firm must be downward sloping and its slope will be exactly equal to that of the market demand curve. The only way market price could not react would be if all other firms reduced their output by as much amount as the single firm increased its output. In that case, market supply curve would not shift and price would remain constant. But this reaction by other firms negates the assumption that conjectural variations are zero; i.e. firms do not react to each other’s behavior.

Figure 13.15: Effect of a firm’s increase in output on market price and quantityMarket DemandPrice Y0 δP δySoS1Small shift in S-curve due to small change (δy) in output by a firm Figure 13.15: Effect of a firm’s increase in output on market price and quantity Market Demand Price Y 0 δP δy So S1 Small shift in S-curve due to small change (δy) in output by a firm The economic argument, effectively, is that if you break a large downward sloping line (market demand curve) into lots of very small lines (demand curve perceived by each firm), then you will get a huge number of flat lines. If you then add all these perfectly flat lines together again, you will get one downward sloping line. But this is mathematically erroneous. Adding up a huge number of flat lines gives a very long flat line. Similarly, breaking one downward sloping line into many small ones gives many downward sloping lines. The economic concept of a horizontal firm demand curve, and hence perfect competition, is based on a mathematical error of confusing a very small quantity with zero. The above argument is just like convincing someone that the world is flat by the following argument: ‘if you take a small enough segment of the world, say the two feet the other person is standing on, then the curvature of that sphere is so small that it is flat. Then consider the segment you are standing on, and it is also so small that it is effectively flat. Next take the angel between the two segments and it will also be so small that it is effectively zero. Finally, extrapolate your argument from these two tiny segments and the angel between them to the level of entire world: consider the segment behind the other person and that is also flat, and keep going like this to prove that the world is flat.’ Clearly, the fallacy in this argument is that while treating your immediate surrounding flat will work as an approximation, but it will not work to ignore those small but imperceptible angles if you move from the scale of one or two to the entire globe’. Interestingly, the above exposed fallacy is not a new one, the assumption—that firm faces horizontal demand curve—has been known to be false since 1957 when Stigler published a simple piece of calculus in his article “Perfect competition, historically considered”: (13.13) The capital Y stands for market output produced by all firms while the small case, y, represents the output produced by any single firm, say firm-i. The above expression makes use of the Chain Rule and both sides are literally equal. To understand this, note that the left hand side is the slope of the demand curve facing firm-i. The first part at the right hand shows the slope of the market demand curve while the second expression measures the change in market output due to change in output by firm-i. The above expression now says that the slope of the demand curve facing the individual firm always equals the slope of the market demand curve , multiplied by how much market output changes due to change in output by a single firm . Since we are dealing with competitive firms with no conjectural variations, a change in output by one firm doesn’t bring forth any instantaneous reaction by the others. Therefore, the factor “how much market output changes by a change in output by a single firm-i” is one; i.e. . As a result, the slope of the individual firm’s demand curve is exactly the same as the slope of the market demand curve:

(13.14) This argument can’t be avoided by an appeal to the proposition that competitive firms are “price takers”—so that marginal revenue equals price for competitive firms by assumption—because this simply introduces one of the two logical contradictions into the theory. It either means that the firms are irrational or they react to changes in output of others firms, and hence ‘playing-games’ becomes the characteristic feature of firms operating even within competitive markets (a phenomenon which is not consistent with competitive firms since conjectural variations are zero). Consider Figure 13.16 which shows the inbuilt irrationality involved in assuming ‘as if’ demand curve is horizontal. Clearly, if market demand curve is downward sloping, then any tiny part of it slopes down with the same value of the slope, no mater how small the difference between the two points is—if the market demand curve slopes downwards, then any increase in output (and hence in supply), no matter how small, must cause market price to fall, however infinitesimally. Thus, if a firm assumes that its demand curve is horizontal, it is behaving irrationally in the sense that it is nurturing a false belief that ‘infinitesimal small quantity equals zero’. Believing that the demand curve is horizontal means all neoclassical results regarding the superiority of competition depends upon ‘irrational behaviour of firms’. Moreover, since competitive firms are independent—i.e. output decision of one firm does not depend upon the output decision of another—if firm-i changes its output, then the rest of the industry (YR) will not change its output in response to firm-i's decision. Figure 13.16: Acting ‘as if’ demand curve is horizontal is irrationalyiP (Y)P (Y) + yiP (Y) < P (Y) + yiIrrational Belief: P (Y) + yi = P (Y)Rational Belief: P (Y) + yi > P (Y)Priceyi for ith firmDemandPriceY0P1P-ΔPY1Y +ΔYδPδy Figure 13.16: Acting ‘as if’ demand curve is horizontal is irrational yi P (Y) P (Y) + yi P (Y) < P (Y) + yi Irrational Belief: P (Y) + yi = P (Y) Rational Belief: P (Y) + yi > P (Y) Price yi for ith firm Demand Price Y 0 P1 P-ΔP Y1 Y +ΔY δP δy Mathematically, (13.15) i.e. the amount of output firm-i expects the rest of the industry to vary in response to a change in firm-i output is zero. The only way marginal revenue of firm-i can be equal to the price of output is if other firms in the industry output by others firms is reduced exactly by the amount of output increased by firm-i. FYI Box 13.3 gives the mathematics behind the thus far discussed fallacy. F Y I B O X 13.3 Mathematics of Horizontal Demand Curve Fallacy We can make the mathematics more explicit using summation notation in expression (13.13). Assuming n identical firms, total output Y is the sum of the outputs of n firms each producing yi units. Therefore: (13.3.1) The expression says that the market output Y is equal to the sum of output produced by all firm, say j in total numbers. Expanding it we have: (13.3.2) Since all firms are independent and do not react to each other’s decision, we have:

which is exactly the same as (13.14) and says that the slope of demand curve which a firm is facing in a competitive market will be exactly equal to that of market demand curve. Another reason why firm’s demand curve can’t be assumed horizontal by assumption can be illustrated using the concept of “conjectural variation”. The assumption that marginal revenue equals price for the ith firm means (13.3.3) Differentiating we have: Now introduce into this marginal revenue expression and expand: By definition, Y = yi + YR (industry output equals output of firm-i and that of the rest of the firms in the industry), we have: (13.3.4) Returning to the assumption that , the only way this is possible if . But this contradicts condition (13.15); i.e. the concept of firms’ independence or of no conjectural variations. This is “proof by contradiction” that the slope of the demand curve for the ith firm must equal the slope of the market demand curve. The horizontal demand curve fallacy can be summarized as follows: The Horizontal Demand-Curve Fallacy: The slope of a competitive firm’s demand curve can’t be zero until we assume that either (a) the firm treats infinitesimal changes as zero and, hence, behaves irrationally or (b) firms react to each others’ output and, hence, reject the firm’s independence assumption under competitive markets The crux of this fallacy is that either the rationality or independence assumption must be forsaken to derive the firm’s ‘horizontal demand curve’ for competitive markets, but economists cannot afford to compromise on either of these assumptions as they constitute the very foundations of the neoclassical theory of firm. This yet again means that the intellectually dominating neoclassical theory of the firm is based on internally contradictory assumptions. 13.6.2: No MR-Curve Fallacy Another problem with the neoclassical theory of competitive markets is the nature of its marginal revenue function. This fallacy may be seen as a corollary of the above mentioned fallacy. Economic theory asserts that a monopolist produces output where marginal revenue is equal to marginal cost and charges a price greater than marginal cost. On the other hand, it is claimed that, a competitive industry, not firm, sets price where the supply and the demand curves intersect without any mention of industry marginal revenue curve. The economic model of competitive markets thus assumes that marginal revenue curve at the market level is a function of the number of firms that produce the industry’s output—it exists when there is a single firm but disappears when there are large numbers of firms! However, the marginal revenue curve exists independent of the number of firms in the industry. If the market demand curve is downward sloping, then so must be the marginal revenue curve as is the case for the monopolist (because the total revenue function is inverse U-shaped in this case as drawn in figure 13.3). The standard demand-supply diagram must have three, not two, curves; supply, demand and marginal revenue curves.

The No-Marginal Revenue Curve Fallacy: If the market demand curve for competitive industry is downward sloping, then the marginal revenue must be less than price at all output levels as it is for a monopolist. Marginal revenue can’t equal price until we assume that the market demand curve is horizontal (however, the model of competitive markets becomes indeterminate in this case as discussed below) 13.6.3: ‘P = MC Maximize Profit’ Fallacy This fallacy of ignoring the marginal revenue curve for the competitive market at industry level creates a serious paradox between the firm and market aspects of the model of perfect competition: if a competitive industry produces output at the intersection of demand and supply curves, then at collective level it is producing where marginal cost exceeds marginal revenue, hence resulting in non-profit maximizing behavior at the aggregate level. To understand this inconsistency, consider figure 13.17 which gives the standard market comparison between monopoly and competitive industry. In the lower panel, the monopolist sets the price where marginal revenue equals marginal cost and produces Ym quantity because this output maximizes its profit. Similarly, each competitive firm produces at a point where its MC equals MR. The competitive industry (not single firm) produces Yc output where price equals marginal cost (or supply curve) which clearly exceeds marginal revenue (since the MR-curve is below MC at Yc output level). The top panel shows the outcome of these decisions in terms of aggregate profit both for the monopoly and the competitive firms. The diagram uses standard total revenue curve consistent with downward sloping demand curve (see figure 13.3) and the ever rising total cost curve from chapter 11. The diagram also draws a profit-curve which is the difference between the revenue and the cost curves. This curve is at zero level where total revenue and costs are equal and maximum where the slopes of both these curves are parallel (not drawn in the diagram, but can easily be sketched against output Ym to confirm this statement). You can see that the monopolist produces output Ym, sells it at Pm and makes a profit of πm. On the other hand, the competitive industry produces a larger output Yc, charges a lower price Pc, and also makes lower profit πc. Clearly, the monopoly has produced where profit is maximum but the competitive industry has produced output beyond this point, so that the industry’s output past the point of monopoly output has been produced at a loss. In general, competitive firms’ behavior is not consistent with aggregate industry profit-maximization. Where did this loss come from? Of course, the loss can’t be seen in the standard graph economic text books draw for competitive markets. This loss is hidden in the detail that economic theory ignores by treating infinitesimal as zero (as discussed above). By producing at MC = P, the competitive industry has produced part of its output past the point where MR = MC, and hence has incurred loss on these additional units. But as shown above the demand curve for a single firm can’t be horizontal, and must slope downward—because if it does not, then the market demand curve has to be horizontal as well. Therefore, marginal revenue will be less than price for the individual firm. However, by arguing that an infinitesimal segment of the market demand is effectively horizontal, economic theory treats this loss as zero and summing up zero losses over all firms means zero losses in the aggregate. But treating an imperceptible quantity as zero and then adding all these zeros to obtain zero at the scale of the market level is conceptually and mathematically erroneous. The economic ideal of perfect competition is based upon a mathematical error of confusing a very small quantity with zero.

Figure 13.17: Higher output of competitive industry relative to monopoly means losses at industry levelOutputabcMCDemandRs/unitPcYc0MRYmPmACTotal CostRsπcYcOutput0YmπmProfit curveTotal Revenue Figure 13.17: Higher output of competitive industry relative to monopoly means losses at industry level Output a b c MC Demand Rs/unit Pc Yc 0 MR Ym Pm A C Total Cost Rs πc Yc Output 0 Ym πm Profit curve Total Revenue Therefore, we can conclude the following fallacy: The ‘P = MC at Maximum Profit’ Fallacy: Given that marginal revenue curve must be downward sloping, the level of output where P = MC does not maximize-profit of competitive firms because they produce beyond profit-maximizing level of output This paradox simply means that the individual rational profit-maximizing capitalist firm’s behavior leads to a collective irrational outcome. In other words, the individual and the market level aspects of the model of perfect competition are inconsistent with each other. 13.6.4: The Competition Better than Monopoly Fallacy The above criticism raises an interesting question: what will be the price and output of a competitive industry if we drop the invalid assumption that output of a single firm has no effect on the market price. The answer is that once we remove the proposition that the demand curve perceived by individual firm is horizontal, the price and output levels of a competitive industry will be exactly the same as those for the monopolist (this result is subject to a particular cost condition that we explain shortly). This result undermines all economic argumentation for more competition against less. Let’s prove this proposition. You can see from the above discussion that the economists’ claim that price and quantity are set by the intersection of demand and aggregate MC-curve relies on the erroneous proposition that the demand curve perceived by an individual firm is a horizontal one. Once we remove this fallacious proposition, the price that the competitive firm takes as given is the price determined by the intersection of the market demand and the aggregate marginal cost curves which is precisely the same price as monopolist would charge. To argue otherwise is to argue for either individual irrational behavior at the level of the firm—so that part of the output is produced at a loss—or that individually rational behavior leads to a collective irrational behavior at the level of the market—so that profit maximizing behavior by one firm leads to the industry producing part of its output at a loss. Therefore, the price that the competitive firm takes as given while adjusting its output is not a market price set by equating price with marginal cost, but a market price set by equating marginal revenue to marginal cost. If we sum up output produced by all competitive firms, the quantity produced at this price will be equivalent to the output of a monopolist. This can be seen in the lower panel of figure 13.17 where the equilibrium is at point a both for the monopolist and for the competitive firm industry while price is at point b at the demand curve. This means that corrected economic theory recognizes no intuitive difference between competitive and monopoly market structures—both produce the same welfare (consumption) outcome.

But worse is still to come for economic theory. One of the key assumptions embedded in the standard economic comparison of monopoly and competitive industry is that the marginal cost curves are identical for both monopolist and competitive industry. This is why we had only one MC-curve in figure 13.11. Effectively, this assumption says that the marginal cost of many small firms is equivalent to the marginal cost of one single large firm at all possible levels of output. This assumption is necessary because without it the marginal cost curve which would be drawn for the monopolist could be different to the sum of the curves drawn for the competitive industry. If they are different in theory, then it is impossible to say that monopoly output will necessarily be less than perfectly competitive output, and that a monopoly’s price will be higher. If the curves are different, then it would be quite possible for monopoly output to be greater and monopoly price to be lower than the competitive price, even if competitive firms did set marginal cost equal to price. This is shown in Figure 13.18. The curve MCc is the sum of all competitive firms’ marginal cost curves while MCm is the corresponding curve for monopolist. The curves are showing the possibility that the sum of the small competitive firms’ marginal cost curves (MCc) is much higher than that of the monopoly. As a result, even if the competitive industry sets price equal to marginal cost at point b, its output of Yc is less than the monopoly output of Ym—even though the monopoly’s price is much greater than its marginal cost. Similarly, the competitive industry price Pc exceeds the monopoly price Pm. Moreover, when the two MC-curves differ, then the definitive welfare comparison will also not be possible as the monopolist is producing a higher output at a lower cost and generating a greater level of consumer welfare, even though it is subject to a deadweight loss (the area not shown here to avoid complicating the diagram) while the competitive market is not. Figure 13.18: Higher consumer welfare with monopoly if marginal costs differYcYmeemecMCmIncrease in consumer surplus due to monopolyDemandPricePm < PcOutput0MRPc > MCmMCc Figure 13.18: Higher consumer welfare with monopoly if marginal costs differ Yc Ym e em ec MCm Increase in consumer surplus due to monopoly Demand Price Pm < Pc Output 0 MR Pc > MCm MCc The fallacy can be summarized in the following proposition: Competition better than Monopoly Fallacy: Given that any definitive comparison of monopoly and perfect competition is feasible under constant marginal cost, if the market demand curve for competitive industry is downward sloping, then a monopoly is identical to competitive industry. However, if the monopolist benefits from economies of scale, as expected, then monopoly may produce better results than competitive industry, even if we accept the standard economic way of comparing both of them 13.6.5: Other Fallacious Arguments Beside these technical arguments, economists also offer some other arguments in favor of competition. Here we discuss one of important ones of these.

Argument from Market Dynamics One of the arguments is based upon economist’s unsound description of the dynamics of market mechanism. This argument is explicated with most clarity in the microeconomics textbook by Schotter which tries to provide a reassuring link between perfect competition and the real world: that profit-maximizing behavior converges to the perfectly competitive ideal as the number of firms in the industry increases—i.e. if we begin with monopoly business and leave the world alone to the individual’s self-interest, it would automatically converge to the perfectly competitive model. The idea is that markets, if left free from government protection, are characterized by entry from new firms whenever super-normal profits exist. This mechanism tends to make markets reasonably competitive, if not perfectly competitive. However, this picture of market presents an exactly opposite description of what actually happens in capitalist order—i.e. when we begin with perfect competition, the market mechanism tends towards monopoly (one large firm prevailing) or at best towards oligopoly (few large firms operating in the whole market). This point is lacking in economics textbooks because the formal treatment of the economic process outlined in those books neglects the implications of technological advancements for the breakdown of competition. In fact, the very nature of competition itself induces changes in the market mechanism that undermine perfect competition. The process can be seen by the fact that under the given structure of competition, firms are always under social pressure to introduce new technological innovations quite rapidly in the production process. So because a single firm has to face market price as a constraint as it cannot affect it in competitive conditions, the only way to increase profit is the reduction in costs. The cost-reducing and output-increasing innovations help make more profit for those firms which introduce them first, but the very act of innovation tends to increase gap between competitive capitalists. This happens due to two reasons: first, the growth of output due to technological advancement decreases market price and this reduction in price eliminates those firms from the market which are slow in innovating because prices have fallen lower than their minimum unit cost of production. Secondly, the higher technological invention incorporated in the production process also means a higher fixed cost of production which implies higher entry cost (as explained above in section 13.4.4). This constraints and limits the potential increase in the number of firms within the market. Moreover, since technology usually translates into higher production, therefore, the introduction of higher technology means that fewer, much larger, producers are needed to satisfy the requirement of any given market. The above tendency is further enhanced by the existence of increasing returns to scale. The standard economic theory assumes that monopoly has no scale-advantages over a perfectly competitive firm. But, in general, this assumption of scale-invariant costs is invalid because large firms do benefit from returns to scale. Increasing returns to scale occur when the cost of production rises less rapidly than the output as the scale of production increases. The concept applies in numerous ways. For a substantial range of output, a large blast furnace will be more effective than a smaller one, a large ship than smaller one, a large car factory than a smaller one. If large firms do have cost advantages over small ones, then given free competition, the large firms will drive the small ones out of business. In reality, no capitalist market can sustain hundreds or thousands of competitive firms for a long time because economies of scale are always there to be exploited. Hence, increasing returns to scale means that the perfectly competitive market is unsustainable. It will, over time, break down to a situation of either monopoly or oligopoly. The theoretical response of economists to this dilemma has been to presume constant returns to scale. With constant returns to scale, the size of the firm does not matter; a small firm will be as effective as a large one. But the reality is that size does matter because economies of scale are an important part of the reason that all capitalist industries are dominated by a small number of large firms.

Similar to technical advancements and increasing returns to scale are the problems of indivisibilities in production. Once an entrepreneur controls more and more resources, the size of that firm increases relative to the market and one entrepreneur may become powerful enough to affect the price of a good by varying output rather than accepting it as a fact for decision making—this is the situation called imperfect competition. The argument is further strengthened if the given firm can constraint entry either by manipulating information (say by advertising to influence consumer motivation), by having patents on production technology or by using an active pricing strategy. Thus the very logic of market mechanism—profit-maximization—tends to reduce, and not increase, the number of competitors and changes the nature of competition in the market. Veblen (1904) has rightly commented that the result of historical process has been the transformation of industry from a larger number of small producers to that of a few larger producers. 13.6.6: Abandon ‘one for all’ policy Economics has championed the idea that the best guarantee of social welfare; i.e. consumption maximization, is competition and therefore society ought to pursue the model of perfect competition as its ideal. We have seen that this economic bias in favor of small firms and against monopolies is almost totally misplaced. Economic theory of policy encourages the abolition of existing monopolies or the use of competitive approaches to the provision of public services when a state monopoly approach would be superior in welfare / consumption maximizing terms. Above all, this fallacious economic theory is used as policy guide to promote free trade and finance throughout the world for capital accumulation and welfare maximization. However, this does not mean that monopoly markets do not have costs or are necessarily ideal for capitalism. There could be plenty of reasons why monopolies can be a ‘bad thing’ for capitalist order. For example, they can obstruct potential competitors, set higher markups and use monopoly powers to exploit other markets. The neoclassical argument against monopolies has directed attention away from the real qualitative issues confronting capitalism to the simple issue of whether a monopoly exists. This simplistic criterion treats all monopolies as tainted instead of attacking monopolies for particular types of behavior and assessing whether or not that behavior serves capitalist order affectively. The type of blind-belief economic theory bestows upon its believers and its resulting attitude can be sensed in the following passage by Ishrat Hussain, the former governor of State Bank of Pakistan: “I will now turn to the economic rationale of privatization that is not fully understood by many. In particular, there is a popular view that it is okay to sell the loss making enterprises but retain the profit making entities such as PTCL and PSO in the public sector. It is true that the budgetary stress and commercial bank borrowing factors are not valid in such cases but there is a larger economic case for the divestiture of even such profit making enterprises. The main logic behind this divestiture is that it will promote efficient allocation of scarce resources (and) optimal utilization of resources”

The economic argument can therefore lead to monopolies being broken up where there were no signs of such behavior or where there were extremely good reasons why a single firm was more efficient in providing maximum consumption possibilities than a number of competing firms. Far from being a guide about how to achieve greater capitalistic efficiency, economic theory may even encourage the dismantling of efficient companies and replace them with inefficient ones. This is guaranteed when the firms are natural monopolies. Public firms, subject to regulation, will perform far better than privatized firms under a similar regulatory regime in maximizing welfare/consumption. Ironically, the recent wave of privatization from 1999 onwards has been concentrated in telecommunications, energy and other public utilities where the market simply cannot be competitive and is near natural monopoly case. Probably, the proper manner in which the issue of ‘monopoly versus competition’ in capitalism should be approached is on a case by case basis where the merits of one form or the other of organizing capitalist production could be considered. Delvin has argued that a country should privatize a state-owned enterprise if this would result in a positive net change in social welfare/consumption. This occurs when the social value of the privatized firm and the net social value of the public sector’s proceeds from the sale are greater than the social value of the firm under public ownership. Thus, the effect of a different regime of asset control, in this case a shift from public to private control, must lead to an improvement in asset management for it to be superior to the previous asset control regime. Governments, however, do not necessarily embark on detailed cost-benefit valuations of the public enterprise sector to determine whether privatization is appropriate. Instead, they often rely on formal, though fallacious, economic frameworks to decide whether a privatization program should be initiated. The main factors supporting the privatization process have been more general in nature, although important differences between regions and countries exist. Privatization is neither a necessary nor a sufficient condition to improve enterprise performance and welfare maximization. It is not necessary because enterprise performance can be improved through management reforms in public enterprise. It is not sufficient because privatization in and of itself, in the absence of an adequate regulatory and legal framework, can cause loss of consumption/welfare, as the Chilean privatization experience in the 1970s painfully demonstrated. Finally, the question of objectives is of fundamental importance when addressing the issue of performance. Many public enterprises are formed to provide a specific good or service, often for a particular population group. In such cases, providing the good or service was the goal, not profitability. In addition, some public enterprises are formed in order to meet other socioeconomic goals. These include job creation, promoting industrialization and defending national interests. This list of objectives may make public enterprise less efficient. However, capitalist states do assign appropriate weights to these objectives while evaluating the performance of any particular monopoly. Whether a change in ownership is necessary to improve capitalist efficiency will depend on a host of factors, but in any case this points to the need for reform of public enterprise and not its auction.

Why Economics Preach Free Competition? It is time again to raise the same question at this point: why does economic theory since Adam Smith’s time continue to extol the welfare superiority of perfectly competitive markets despite the fact that capitalist order necessarily destroys itself? This is because economic theory’s primary purpose is ideological and normative (not positive or discursive). Economic theory justifies capitalist order as a completed project which has resulted in the possibility of the final triumph of universal reason over both Nature and Passion (religion). That is why Hegel saw capitalist order as the end of history. At history’s end when everyman is equally rational and equally knowledgeable there is no room for the type of exclusion that monopoly implies. In this world of perfect knowledge, perfect equality must reign. Cost must be at its minimum and therefore MC must equal AC. The demand curve must be horizontal for if it is downward sloping this means that some demand remains unsatisfied—an impossibility in capitalism’s utopia (as in Marx’s full-blown communism). But the supply curve also should be horizontal–––everyman should be able to produce whatever he wishes at a uniquely determined ‘optimal’ cost (MC must equal AC). But if both supply and demand curves are horizontal (and co-incidental) both price and output levels become indeterminate. To avoid this indeterminacy economics presents state where men are rational (and this rationality is reflected in the relations between them as depicted in the model of perfectly competitive markets) but the conquest of nature is not yet complete. That is why cost curves slope upwards and the production process and the associated relations of production are seen as essentially technical phenomenon. It is this scarcity which justifies the science (Economics) that provides a paradigm for the determination of a unique price-output configuration in every specific situation of scarcity. Economics is an imperfect science because it does not have a framework for conceiving the overcoming of scarcity––that is why technological change is typically regarded as exogenous to the economic process. But economics does have a moral project––to make everyman more rational and the perfectly competitive model provides a heuristic basis for promoting capitalist rationality in civil society. Men in capitalist order have to be forced to be rational in capitalist sense—how to achieve this objective is the purpose of economic policy. Moreover when men behave ‘rationally’ they necessarily prey upon each other. Civil society is conflict ridden, vicious, exploitative, cruel, savage and fragmented. Men maximize welfare at each others expense. Competition is a brutal, ruthless, blind and egotistical process which tears men apart. This is the social reality of capitalist order reflected partially in the monopolization of capitalist markets. Economics must shut its eyes to this reality if it is to continue to justify capitalism on moral grounds. It does so by continuing to extol the virtues of perfect competition.

Key Concepts Absolute barriers are those that rule out new entry whatsoever over some time horizon Average-cost-pricing means setting price equal to average cost of production. This is usually practiced in case of natural monopolies Competitive advantage means delivering the same service at a lower cost, called cost advantage, or greater service for the same price, called differentiation advantage Deadweight loss is the net loss in social welfare resulting from any other than competitive market approach, say by monopoly power. It is measured by the difference between output (produced and made available for consumption) by the perfectly competitive firm on the one hand and the monopolist on the other Dominant firm model is a market with one firm having a market share of more than 50%, though other small firms do exist with negligible market shares Franchise monopoly is a monopoly business created out of state granted legal rights or protection Imperfect competition means market structure where any of the single conditions of perfectly competitive markets are missing or lacking Inertia shopping rule says that consumers tend to buy from the firm that charges the lowest price, but if he is already buying from a firm and another firm enters the market with a lower price, he gives his current firm a chance to meet the entrant’s price before shifting his demand Limit pricing is a pricing strategy used by existing firm by setting a price such that an entrant can’t make profits at that price Marginal-cost-pricing means setting price equal to marginal cost of production Monopoly is a business dominated by single firm which ignores pricing reaction of any other firms to its pricing decision Monopoly power refers to the extent to which a firm can control market price Natural monopoly is a business with increasing returns to scale at the level of the whole market. The result of such a business structure is that the average total cost (ATC) curve keeps declining as firm expands its operation Price cap regulation is a regulatory method designed to encourage efficient production by allowing firms to share in any cost savings that they have achieved in production process Price setting behavior means firm is facing downward sloping demand curve and hence can set price Privatization is the sale of state owned enterprise to private individuals Rate of return regulation means setting a maximum rate of return on invested capital that a utility is allowed to earn Relative barriers are the ones which place a new entrant at a disadvantage, but they are not insurmountable ones Sustainable monopoly is natural monopoly that can prevent entry and keep others out of market Chapter Summary A monopolized market structure is characterized by (a) the existence of a single producer (b) a strongly differentiated product with no close substitutes (c) insurmountable barriers to entry in the market For practical purpose a monopolized market is defined as a market where the market share of the dominant firm is about or above 50 percent and this firm is the price setter. This is also called the dominant firm model

The dominant firm can ignore the reaction of other firms to its price setting behavior The demand curve facing the monopolist is downward sloping––not horizontal as in the case of the perfectly competitive firm. The monopoly firms can change price by changing the level of output produced. The monopoly firm is a price setter in this sense Demand elasticity is a constraint on the monopoly’s ability to set the price of its choice The marginal revenue for a monopolist is always lower then the price at all levels of output Profits are maximized for the monopolist at the output level where marginal revenue equals marginal cost. Price is the corresponding point on the average revenue / demand curve––this is the maximum price the consumers are willing to pay for this output level of the monopolist. This is the profit maximizing price and this price is greater than marginal cost at this level of output. The shut down rule for the monopoly is the same as that for the perfectly competitive firm i.e. the firm should shut down if Total Revenue < Variable Cost in the short run Total Revenue < Total Cost in the long run The marginal cost curve is not the supply curve for the monopolist. The monopoly has no specific supply curve. The output a monopoly produces depends on its MC and its demand curve––hence both are needed to determine supply and many different demand curves can be drawn through the same point having different slopes. Hence a unique shape of a monopolist supply curve cannot be derived A rule of thumb for monopoly pricing is that mark up over marginal cost should equal the negative of the price elasticity of demand. The knowledge of the elasticity of demand should provide the basis of the ‘optimal’ (i.e. profit maximizing) mark up over MC which should determine the monopolistic price. The greater the elasticity of demand the closer is the monopolists’ price to MC The Lerner Monopoly Power Index measures monopoly on the bases of the percent excess of the price the monopolist is charging over MC Barriers to market entry leading to the creation of monopoly structures include (a) franchise rights (b) patents (c) copy right and (d) trade marks. Franchise rights are usually justified on economic grounds as rewards for undertaking large and risky initial investments A natural monopoly is a business with increasing returns to scale at all levels of market demand––ATC declines as output expands––and having more than one firm in the market is therefore inefficient. As long as the market cannot sustain more than one efficient (minimum cost) firm, the market is a natural monopoly whatever the slope of the ATC A natural monopoly that can prevent entry is called a sustainable monopoly. In this case ATC decreases every where up to the whole level of the market If there is “consumer inertia”–– i.e. consumers continue to buy from the monopolist at a price higher than that of a competitor for a specified time period—the monopolist need not lower its price to prevent market entry Relative barriers also include large investment requirements and capital market imperfections. These barriers are usually so high that there are very few entrepreneurs in capitalist order. Most people become wage laborers. Even managers are wage laborers risking other people’s money not their own

Relative barriers also include competitive advantages of existing firms taking the form of either cost advantages and / or product differentiation advantages. Entry occurs as outside firms overcome these advantageous but in capitalist order those who enter monopolized markets are usually not new firms that are starting up business but firms from other sectors of the economy that are expanding the scope of their operations through mergers and acquisitions In capitalist order capitalist property replaces private property. In capitalist property all wealth is dedicated to the sole purpose of capital accumulation and hence capitalist property is controlled by managers who have the capability of using wealth for the sole purpose of accelerated capital accumulation Universalization of capitalist property means abolition of private property. It also means necessary increase in the concentration and centralization of capital. A handful of conglomerates dominate (are price setters in) all major markets and the increased popularity of “supply change management” shows increased integration of new firms within production and distribution structures dominated by these conglomerates Increased concentration of capital leads to a restructuring of competition, competition becomes more intense. It takes the form of competition within the firm among its workers and different organizational units and competition among different strategies based on speculation about the future. Neither perfect competition nor perfect monopoly is compatible with capitalist order. Capitalist market are typically oligopolistic State regulation of monopoly is justified on grounds of decrease in the sum total of consumer and producer surpluses yielded by monopoly pricing as against pricing by perfectly competitive firms. Dead weight loss is the amount of total surplus lost (called social welfare loss) due to monopoly pricing. Deadweight loss measures the difference between output (produced and made available for consumption) by the perfectly competitive firm on the one hand and the monopolist on the other Instruments for regulation of monopoly include: Price regulation usually practiced in the case of natural monopolies along with government subsidization that compensates for the loss created by the excess of ATC over the regulated price level Regulation of rate of return. A “fair” rate of return (above which profits are taxed away) is determined on the basis of estimation of what investors regards as an acceptable rate of return on investment sufficient to maintain the desired level of production in the monopolized sector. A market price is fixed to ensure that the monopolist does not earn a rate of return which exceeds the investors’ acceptable rate of return on the desired level of investment But estimation of required rate of return on investment is problematic for this requires valuing the capital stock of the monopoly producer. Changes of regulated price (to ensure a ‘fair’ return) must be frequent as cost and market conditions are in a continuous process of change. Hence there are long and expensive regulatory lags in price adjustments. The regulatory process offers fertile ground for corruption benefiting bureaucrats. Regulation authorities are easily penetrated by private monopolists and price regulatory processes are manipulated to serve the cause of multinationals

Price caps. Both price and rate of return regulations create an incentive for increasing cost and ignoring efficiency by the monopolist. Price caps are fixed producing incentives for firms to reduce costs greater than those in the price cap determining formula The purpose of state regulation of monopoly in capitalist order is only production / consumption (welfare) maximization—it is nothing else. Production is valued solely in terms of the contribution that is made during the production and distribution process (of the goods and services) to capital accumulation. Non-capitalist states will not regulate markets for these objectives An Islamic State will abolish capitalist property, seek to universalize private property and regulate production, consumption and distribution of goods and services mainly to promote the moral impact of these activities on the lives of the people. State regulation of production by an Islamic State will be for promoting Ihsan, Zuhd and Faqr Neoclassical economics regards perfectly competitive markets to be superior to monopolized markets because: Perfectly competitive markets are supposed to produce output at the point where MC = MR = P. Monopolized markets produce it a point where MC = MR < P. P is therefore expected to be higher and output lower under monopoly Consumer surplus yielded by perfectly competitive markets is expected to be greater than that by monopolized markets which are characterized by the existence of ‘deadweight loss’ But this welfare superiority of perfect competitive markets is based on several unrealistic assumptions A major false assumption is that the perfect competitive firm faces a horizontal demand curve. This is based on the view that each firm is so small that it has to take the market determined price as given. This is summed in the Horizontal demand Curve Fallacy Neoclassical theory omits any mention of a market marginal revenue curve in its analysis of price-output determination for perfectly competitive market. The MR curve is assumed to exist for the individual firm but not for the whole market If the perfectly competitive industry’s equilibrium output is determined by the intersection of the Average Revenue (i.e. demand) curve and supply curve while the AR / demand curve is downward sloping then the MR curve must be below the AR curve at equilibrium. Therefore the perfectly competitive market is behaving (capitalistically) irrationally. It is producing an equilibrium output at a level where MC > MR–– it is incurring a loss not maximizing profit. If we assume that market demand is the summation of the demand of each firm in the market and that each firm is accepting the same price (< MR) then each firm must be behaving (capitalistically) irrationally, i.e. incurring a loss––not maximizing profit If we abandon these assumptions no difference remains in the determination of equilibrium output-price configuration in the case of perfectly competitive and monopolized markets Another dubious assumption of neoclassical theory is that the MC curve is the same for monopolized and competitive markets. This is not so, in a particular capitalist market (say oil or electricity or railway transport). It is not possible to say that in principle a monopolist’s price will always be higher and a monopolist’s output always lower than that of a perfectly competitive market. If the market MC of the perfectly competitive firms is higher than the MC of the monopoly, the monopoly’s price will be lower and its output higher than that of the perfectly competitive market. The monopolist may be producing a higher level of welfare, despite deadweight loss

In fact monopolies have typically been welfare superior to non-monopolies in capitalist order. That is why maturing capitalist order is always characterized by (imperfect and incomplete) monopolization of markets (for goods, services and finance) As Schumpeter showed almost a centaury ago capitalist markets require monopolization. This is because risky technological innovation is both driven by and nurtures monopolization. Continuing technological change––a key feature of capitalist order––reduces output prices and increases entry investment costs, both monopolization facilitating features of capitalist markets which are also characterized by increasing returns to scale. Scale economies necessarily undermine the sustainability of small firms Welfare (consumption) maximization and capital accumulation can often be promoted by market monopolization. Public monopolies usually are more efficient as providers of efficient levels of output-price configurations in capitalist order than are private monopolies (or oligopolies) especially in the ‘natural monopoly’ markets. Privatization is neither a necessary nor a sufficient condition for improving firm efficiency in capitalist order. It can often lead to a loss of welfare in civil society Economic theory’s continued idealization of perfect competition as being ‘welfare superior’ to monopoly reflects the ideological and normative character of Economics. Economics justifies capitalism as a uniquely rational way of life in which all inequality and zero sum conflict has been eliminated and in which all men possess complete knowledge about how to maximize their welfare given specific scarcity constraints. Production is optimally efficient and consumer welfare is maximized. The perfectly competitive model presents this vision. Economics closes its eyes to the reality of capitalist order where competition is usually conflictive and where men maximize their individual welfare at each others’ expense (If I win you must lose). Market monopolization reflects this reality of civil society. Economics must ignore this reality if it is to continue to serve as the ideology justifying capitalist order Review Questions What are the characteristics of a monopolistic market structures? Compare the demand curve facing a monopolist firm with that of a perfectly competitive firm? Can the monopolist firm set any price it want to or are there any constraints on its price setting? With the help of diagrams illustrate the differences between profit-maximizing equilibrium of a monopoly and a perfectly competitive firm What is the shut down rule for the monopolist? Is it different from the shut-down rule for perfectly competitive firm? What is the supply curve for a monopoly firm? How can a monopoly firm determine its ‘optimal’ price? How is it different from the one set by competitive firm? What is the Lerner Monopoly Index? Does it provide an accurate measure of the extent of monopoly in a market? What are the main barriers to entry in a monopoly markets?

What is a “natural monopoly”? Is the State Bank a “natural monopoly”? Is KESC a natural monopoly? What is the difference between capitalist property and private property? “There can be neither sustainable perfect competition nor sustainable perfect monopoly in capitalist order.” Do you agree? What is the justification for state regulation to monopoly and which instruments are likely to be the most effective? What is the purpose of state regulation of monopoly and oligopolistic markets in capitalist order? State and evaluate the orthodox neoclassical arguments for state regulation of monopoly. Are these arguments valid? What are the assumptions on the basis of which economists claim that perfectly competitive markets are welfare superior to monopoly? Schumpeter argued that “capitalism needs monopolization of markets.” Discuss Under what circumstances can monopoly markets yield a higher level of welfare and be more efficient than perfectly competitive markets? Why does economic theory continue to idealize the perfect competitive market although empirical evidence shows that it cannot exist in capitalist order? Chapter 14 MONOPOLISTIC COMPETITION AND OLIGOPOLY The previous chapter discussed how firms with monopoly power can choose prices and output levels to maximize profit. However, in many industries several firms compete with each other having some market power. This chapter deals with models of imperfect market structures other than pure monopoly that can give rise to monopoly power. The chapter begins with description of decision making under monopolistic competition and then goes on to develop oligopoly models. 14.1: Monopolistic Competition Up to the early 1920’s, economic theory appreciated only two major market structures: perfect competition and monopoly. Interestingly, oligopoly models (e.g. duopoly) were treated as intellectual exercises rather than real world situations despite the fact that the real world was characterized by oligopolistic competition. It was by the late 1920’s that dissatisfaction spread against economic modeling of the business world in the shape of perfect competition. This was because of the fact that the idealized economic theory could not explain empirical facts—the ultimate objective of any scientific theory. Table 14.1 compares real world capital homes with the picture of real world portrayed by economic theory. Table 14.1: Comparing real world capitalist firms with standard economic theory Dimension Real World Capitalists Firm in Economic Theory Size From corner store to Microsoft Small size Operation From one outlet to almost all countries Single industry and location Product diversity From single product (wheat farm) to numerous (Sony) From one industry to many Single and homogenous product Ownership From sole proprietorship to multinationals Privately owned sole proprietor Structure From one person operations to multi-departmental From sole operations (production to sale) to specialization in manufacturing, wholesale, retail, marketing, consulting

No internal structure considered No specialization: firm does everything from manufacturing to sales Apart from these factors, widely used advertisement and other selling practices in real businesses could also not be accommodated by the model of perfect competition. And above all, actually existing capitalist firms expand their output with falling average costs without ever becoming infinitely large, as the model of perfect competition would predict with falling average costs. The dissatisfaction with economic theory brought about a long series of arguments and publication which began the ‘Great Cost Controversy of the 1920’s’ a summary statement of which can be seen in Sraffa’s article. Sraffa pointed out that the falling average cost dilemma could be resolved theoretically by taking account of the fact that individual firms face down-ward sloping demand curve which constraints their ability to sell output beyond a certain limit. This line of argument was adopted by a number of other economists, such as Chamberlin and Robinson, and the tradition gave rise to the model of monopolistic competition. To understand the nature of the market model proposed by Sraffa and other economists, let’s first define monopolistic competition. 14.1.1: Structure and Implications Following features are assumed to classify a market as monopolistically competitive: There are large number of buyers and sellers in the industry The products offered for sale by sellers are differentiated, yet they are close substitutes There is free entry and exit in the market Firms’ decisions are independent of one another; i.e. no conjectural variations exist You can see that monopolistic competition is similar to perfectly competitive market in the sense that there are many firms in the industry and no significant entry barriers exist. However, it differs from perfect competition because the product is differentiated—each firm sells a brand of the product that differs in quality, appearance or reputation and each firm is the sole producer of its brand. Laundry detergents, bath soaps, toothpastes, shampoos are some examples of this type of industry. Marketing as Essential Ingredient of Firm Chamberlin suggested that in monopolistically competitive markets, the demand for a product is determined not only by its price, but also by the style of the product and selling activities of the firm. Thus he introduced two additional policy variables in the theory of firm; (a) the product itself and (b) selling activities. Thus the demand curve will shift if: the firm changes the style of its product or other selling strategy competitors change their price, style or selling policies Note that product differentiation is intended to distinguish one’s product from another in the industry. The difference among goods could be real or merely superficial or cosmetic. Real differentiation exists when either the specifications of the product or the services offered by the product are different. On the other hand, superficial differentiation means that the products are basically the same, yet the consumer is persuaded somehow that the products are different. Such differentiations are established by advertisement, differences in packaging, differences in design, or by brand names.

The concept of advertisement and other marketing activities by firms makes selling-cost an important element of total cost of production. Selling-expenses in general either shift the demand curve or make it less elastic by strengthening the preferences of consumers for the advertised product. What about the shape of selling-cost curve and its effect on average total cost curve? Chamberlin assumes that selling-cost curve will be U-shaped implying that there are economies as well as diseconomies of advertising as output expands. This is shown in figure 14.1. At the initial stage expansion in output will not require an increase in advertisement expenditures by the same amount, and this will lead to a fall in average selling-expenditures. However, beyond a certain level of output, the firm will have to spend more on selling-activities per unit of output in order to attract customers from other firms. This means that adding a U-shaped selling cost curve into standard average total cost curve will yield a U-shaped average total cost curve as shown in figure 14.1. Figure 14.1: Effect of selling-cost on average cost curveY0Rs/unitATCwithout selling costATCwith selling costAverage selling cost curve Figure 14.1: Effect of selling-cost on average cost curve Y 0 Rs/unit ATCwithout selling cost ATCwith selling cost Average selling cost curve Advertising is exclusive to capitalism. Non capitalist societies have no tradition of organized advertising. The purpose of advertising is to create a product image which appeals to the consumer’s psyche and imagination and excites his passion. An Islamic society which seeks to minimize consumption and abstains from exaggerated usually false claims about product and service characteristics of course has no place for an organized advertising industry. Prior to imperialist conquest, no Muslim country had an advertisement industry. On the other hand Islamic banks make extensive use of advertisements and their media messages are usually indistinguishable in their emphasis on material benefits from those of conventional banks. Islamic banks have been fully integrated into capitalist finance. The advertising industry, like all other capitalist industries, is profit driven. Profits can be maximized by serving non utility maximizing needs (remember utility can only be measured in terms of consumption units). So Haj related services can be advertised in capitalist societies. The nature of the service or product advertised does not influence the orientation of the advertising industry. That is why if profit maximization is rejected as an organizing principle for the conduct of business the advertising industry will collapse. Monopoly Power and Negatively Sloped Demand Curve Product differentiation gives rise to a negatively sloped demand curve for the product of an individual firm. This means that the firm has control over the price of its product. In other words, he is not a price-taker, but has some degree of monopoly power to exploit. If the firm increases its price, it will lose some but not all customers, while if it reduces its price it will increase its sales by attracting some customers from other firms. But its monopoly power is limited because consumers can easily substitute other brands. Therefore, though the demand curve in figure 14.2 is downward sloping, it is highly elastic. The amount of monopoly power a firm enjoys depends on its success in differentiating its product from those offered by other firms in the industry.

Figure 14.2: Demand curve facing a firm in monopolistic competition0Rs/unitYD Figure 14.2: Demand curve facing a firm in monopolistic competition 0 Rs/unit Y D 14.1.2: Output and Pricing Decision: Equilibrium of the Firm The name of this market structure as ‘monopolistic-competition’ comes from the facts that it shares elements of both monopoly and competition—product differentiation creates brand loyalty and gives rise to a negatively sloped demand curve and, hence, to monopoly power while easy entry conditions shows the potential for earning profits which will attract new entrant and, hence, maintain constant competitive pressure of competition. Both of these features are reflected in the equilibrium price and output decision of a monopolistically competitive firm. Short-Run Equilibrium Figure 14.3 shows the short-run equilibrium of a monopolistically competitive firm. Since the demand curve for this firm’s product is negatively sloped, so its MR-curve is below its demand curve as discussed in the previous chapter. Profit-maximizing output Ymc is found at the intersection of MR and MC-curves. Since the corresponding price Pcm exceeds cost of production, the firm earns super-normal profits in the short-run as shown by the shaded rectangle in the left hand panel of Figure 14.3. Long-Run Equilibrium In the long run, this profit will induce entry by new firms. As they bring competing brands in to the market, the existing firm may opt for one of the two options available to it: active response or passive response. Figure 14.3: Equilibrium of monopolistic firm in the short-run and long-runMCPSRYYSRm0Rs/unitDSRMRATCEA ProfitPLRYYLRm0Rs/unitDLRMRATCFlrMC Figure 14.3: Equilibrium of monopolistic firm in the short-run and long-run MC PSR Y YSRm 0 Rs/unit DSR MR ATC E A Profit PLR Y YLRm 0 Rs/unit DLR MR ATC Flr MC Passive response: if the firm responds passively, it does nothing and ultimately will lose its market share in favor of new entrants and its demand curve will shift down, as in the right hand panel of figure 14.3 (it should be noted that average and marginal cost curves will also shift in the long run adjustment of the firm, but we have not discussed these changes for simplicity’s sake). Where would this process end? The long run equilibrium will be achieved where no potential for super-normal profits exists in the market. This happens when the long-run demand curve, DLR, is tangent to the firm’s average cost curve. Here profit maximization implies a quantity of YLR, the price of PLR and zero profits because price equals average total cost of production. Note that the firm still has monopoly power; its long run demand curve is negatively sloped because the firm’s particular brand is still unique. But entry and competition by other firms have driven its profit to zero. Active Response: if the existing firm goes for an active response, it will have to engage itself in selling activities and product service enhancement in order to maintain its market share. Increased selling activities and additional value creation means that its average cost curve will shift upward. Since the market is getting more and more congested due to the entry by new firms, more and more selling expenses would be required to keep customers loyal to the firm’s product. Again the long-run equilibrium will be achieved when ATC-curve is just tangent to long-run demand curve of the firm. We leave the diagram for this particular case as a practice for interested students.

Thus, in both cases monopolistically competitive firms tend towards zero economic profit in the long run. There will be no further entry into the industry because equilibrium profits are normal. The equilibrium is also stable because any firm will lose by either increasing or decreasing the price from PLR. 14.1.3: Efficiency of Monopolistic Competition We have seen that monopolistic competition is somewhat similar to perfectly competitive markets—the most desirable ones from the perspective of economic theory as they are economically efficient. What about the efficiency of monopolistic competition? To answer this question, let’s compare the long run equilibrium of a monopolistically competitive equilibrium with that of perfectly competitive. Figure 14.4 makes this comparison explicit. It is obvious from the two panels that at the long run equilibrium of competitive we firm have MC = MR = ATC = P, while for monopolistically competitive firm MC = MR and ATC = P but P > MC. As a result of this difference in equilibrium conditions, price will be higher and output will be lower in monopolistic competition as compared to the competitive model. However, profits will be normal in both models. Though there would be many small firms in monopolistic competition, each will be producing an output at a cost higher than the minimum level. Since each competitive firm is assumed to face a horizontal demand curve; so the zero-profit point occurs at minimum average cost as shown in the left hand panel. But the demand curve for a monopolistic firm is downward sloping, so the zero-profit point is to the left of minimum average cost. Figure 14.4: Comparing competitive and monopolistic competition equilibrium Figure 14.4: Comparing competitive and monopolistic competition equilibrium MCPCYYc0Rs/unitMR = ARATCEPLRYYLR0Rs/unitDLRMRATCFlrMCYcExcess capacitya MC PC Y Yc 0 Rs/unit MR = AR ATC E PLR Y YLR 0 Rs/unit DLR MR ATC Flr MC Yc Excess capacity a This means that according to standard economic measures of efficiency, there are two sources of inefficiency in a monopolistically competitive industry. First, unlike competitive market, equilibrium price exceeds marginal cost which means there is allocative inefficiency. If output were expanded to the point where the demand curve intersects marginal cost curve, total surplus could be increased (this analysis is very similar to comparison between competitive and monopoly markets). Second, the monopolistically competitive firm operates with excess capacity as its output is below Yc which minimizes average cost of production. The excess capacity is conventionally measured by the difference between the ideal output Yc corresponding to the minimum average cost level and the output actually produced in the long run by monopolistic firms, YLR. This excess capacity is treated as inefficient because average cost would be lower with fewer firms in the industry—monopolistic competition leads to ‘too many too small’ firms in the industry. Justifying Excess Capacity The immediate question arising from the above discussion is if monopolistic competition is inefficient, should it be subject to capitalist state-regulation? For two reasons, the answer is probably no. First, in monopolistically competitive markets, monopoly power is small. Since no firm has significant market power, therefore, any deadweight loss from monopoly power in this market structure would be very small and the cost regulation may exceed this.

Second, and most important, whatever inefficiency monopolistic competition creates is balanced against an important “benefit” that it provides; i.e. product differentiation. Most capitalist consumers—individuals who treat utility-maximization as an end in itself—value the ability to choose among a wide variety of substitute products. The gain from this product choice range could easily outweigh the inefficiency resulting in this market structure. In fact economists, e.g. Chamberlin, have argued that even the term excess-capacity associated with monopolistic competition as a symbol of inefficiency is misleading. The criticism of excess capacity and misallocation of resources is valid in figure 14.4 only if we assume that there is a firm facing a horizontal demand curve and, hence, Yc is the socially desirable level of output (after the discussion in last chapter, you should by now be able to reject this economic postulate of horizontal demand curve). Chamberlin argues that if the demand curve is downward sloping and the firms enter into active price competition with easy entry conditions, Yc cannot be considered as the socially optimal level of output. Since consumers desire an expanding variety of products, product differentiation reflects the desires of consumers who are willing to pay higher prices in order to enjoy a wide product range. The higher cost resulting from producing to the left of minimum average total cost is thus socially desirable in capitalist societies. This means that the difference between actual output YLR and the minimum cost output Yc is not a measure of excess capacity; rather a measure of the ‘social cost’ of producing and offering variety to the capitalist consumers. The output YLR is, hence, a kind of ideal for a market characterized by product differentiation. If government somehow forces monopolistic firm to produce output where price equals marginal cost, the firm will have to produce at a loss in the long run (you can see that MC-curve intersects demand curve at point a which is below ATC-curve in figure 14.4). Any pricing policy aiming at the equalization of price and marginal cost would force the firm to close down in the long run. Thus, according to standard economic theory, the capitalist state is faced with a dichotomy: with monopolistic competition output is lower than society would ‘ideally’ like to have, but the socially desired P = MC can’t be achieved without destroying capitalist order and the ‘preference for preference’ itself. 14.2: Oligopoly: Meaning and Equilibrium Oligopoly is a unique form of capitalist market structure in that, though it is the most prevailing market structure in capitalism yet, unlike other market models, there is no hard-and-fast model that can fully explain how these markets operate—i.e. it is difficult to explain the behavior of the firm operating under oligopolistic market structure. Further, it is also not easy to give a rigid definition of what oligopoly is. However, it is always nice to begin with a working definition.

14.2.1: Structure of Oligopoly Table 13.1 (of chapter 13) shows that the product may or may not be differentiated in an oligopolistic market; what matters is that only a small number of firms supply most or all of the total output. Oligopoly is the most prevalent market structure in mature capitalist societies. Examples include automobile, steel, petroleum, computer, air-line and surgical and electrical equipments almost everywhere in the world. Another important feature that differentiates monopolistic competition from oligopoly is entry-exit conditions. To see the importance of this point, let’s compare the market for toothpaste and automobiles. Both are characterized by product differentiation. However, it is relatively easy for firms to introduce new brands of toothpaste that might compete with, say, Colgate or Medicam and so on. If the profits or selling Colgate are large, other firms will spend the money (for development, production, advertisement and promotion) to introduce new brands of their own. On the other hand, the large investment requirements and economies of scale involved in the production of automobiles make entry by new firms difficult. This means that the toothpaste market is monopolistically competitive while the automobile industry is better characterized as an oligopoly. This implies means that firms make large profits in the long run because of significant entry barriers. Firm Interdependence One of the important differentiating factors of oligopoly market structure is firm’s interdependence—the decision of one firm is also affected by decisions of others in the industry. This makes management of an oligopolistic firm a complicated matter because pricing, output, advertisement and investment decisions involve strategic considerations. The word strategy involves the existence of ‘other than you’ and it means making plans taking account of the behavior of others. An oligopolistic firm takes into account how its actions will affect its rivals and how the rivals are then going to react. This situation is very similar to a game where the plans and actions of one player or team are directed affected by those of his rival. To take an example, suppose because of declining sales and compiling losses, Pepsi is considering a 10 percent price cut to stimulate demand. While doing this, it must think carefully about how Coca-Cola will react to this action. It is possible that Coca-Cola might not react at all or might cut its price slightly. If so, then Pepsi will enjoy substantial increase in its sales at the expense of its rival. But it is possible that Coca-Cola might cut prices to match Pepsi’s prices. In this case, both firms might be selling more but making less profit because of the lower prices. And worse could happen if Coca-Cola reduces its prices by more than Pepsi did, say, to punish Pepsi and this in turn might stimulate a price-war leading to a substantial fall in profits for both the firms. This means that a firm must carefully weigh all of the possibilities resulting from the possible responses of its competitors.

The strategic situation gets more complex when we note the fact of reaction to reaction—when making a decision, each firm must weigh its rival’s reaction, knowing that these rivals will also weigh its reactions to their decisions. This process of decision, reaction, reaction to reaction and so forth is dynamic, evolving over time. While making any decision and evaluating its potential consequences, the manager of the oligopolistically competitive firm must assume that his competitors are also “rational”—i.e. profit maximizers. In short, one must put oneself in the other’s place before making any decision. This shows that non-profit maximizing––non capitalist–––firms cannot survive in oligopolistic markets. Non capitalist firms must transform themselves–––must become profit maximums–––if they are to effectively respond to the strategy of their oligopolistic rivals. There is thus no room in capitalist markets–––which are usually oligopolistically structured–––for Islamic producers and merchants. Oligopolistic markets transform Islamic businesses into capitalist (profit maximizing) firms. If Islamic businesses–––businesses which are instruments for earning Allah’s approval and promoting Islamic virtues–––have to be revived the traditional Islamic bazzar must be reconstructed. This requires a deliberate elimination of the capitalist property form and of all capitalist financial contracts and this is a task which can only be accomplished by an Islamic state. Recreating the social dominance of the Islamic bazzar is an important responsibility of the Islamic state. In this section, we will discuss some of the important models that give an explanation of the behavior of firms competing with each other under oligopolistic market conditions. Specifically, we will examine four models of duopoly, which is the limiting case of oligopoly. The next section will take account of market models resulting from firm’s collusion. Defining Oligopoly as Market Concentration Many text books differentiate between monopolistic and oligopolistic market structures on the basis of number of firms in the market; i.e. a market is oligopolistic if the number of firms in that market ranges between two to ten or twelve. However, this line of characterization is fallacious as well as misleading because it gives very little attention to the structure and intensity of competition in the markets. If, say, we have fifteen firms operating in a market with two of them enjoying more than sixty percent of the market share while the rest have only the remaining 30 percent or so, then such a market structure can’t be characterized as monopolistic even though the number of firms is more than twelve. For example, consider the case of petroleum sales companies in Pakistan with many firms recently emerging in this market. However, Shell, PSO and Caltex are the dominating forces in this particular industry in Pakistan while the others are minnows. Therefore, the ‘number of firms’ criterion will wrongly classify petroleum sales industry of Pakistan as monopolistic. It is for this reason that economists, especially industrial economists, have developed other and more complex criteria to define market structures. One of them is the concentration ratio which attempts to measure the market concentration of output.

The concentration ratio measures the size of the largest firms’ share in total market sales. In other words, these ratios refer to the degree to which production in any specific industry is concentrated in the hands of a few large firms. It is traditional to consider four-firm and eight-firm concentration ratios, denoted by CR4 and CR8; however, they can be calculated for any number of firms as we see below. The idea behind the concept of concentration ratio is that the pattern of sales distribution among firms in any market can help identify underlying market structures and the level of imperfection. Sales are more evenly distributed among firms in a competitive industry, while it is concentrated heavily among a few firms in oligopoly. In the extreme case of a monopoly, sales are concentrated in a single firm. Thus, a market is said to be more concentrated (and hence imperfectly competitive), the fewer the number of firms in production or the more unequal the distribution of market shares. Consider the following shares of six firms in an industry arranged in decreasing order: Table 14.2: Calculating cumulative market share Firm Market Share of Each Firm Cumulative Market Shares 1 0.45 0.45 2 0.25 0.70 3 0.15 0.85 4 0.10 0.95 5 0.4 0.99 6 0.1 1.00 The last column calculates the cumulative percentage shares of the firms as: Cumulative share of n-firms = Sum of n-firms shares The concentration ratio can now be defined for any n number of firms as: For 2-large firms: CR2 = 0.70 For 3-large firms: CR3 = 0.85 For 4-large firms: CR4 = 0.95 and so on. In general, the concentration ratio for n-firm can be defined as: (14.1) where Si stands for the share of ith firm while M is total market or industry sales. We can plot the cumulative percentage of sales against the cumulative number of firms from largest to smallest. The resulting curve is called the concentration curve as shown in figure 14.5 for the given data in table 14.2. A number of features should be noted about this curve. First, the curve is concave from below because the firms are arranged from largest to smallest in terms of their market share which means that each additional firm will add smaller number to cumulative market share. If it is the case that all firms are of equal size; i.e. have equal market shares, then the concentration curve would be a straight line. Thus the concavity of this curve reflects the inequality of firm size in an industry. Figure 14.5: Drawing concentration curveNo of firms cumulative from largestConcentration curve0.25100.50.751234Cumulative percentage of market share Figure 14.5: Drawing concentration curve No of firms cumulative from largest Concentration curve 0.25 1 0 0.5 0.75 1 2 3 4 Cumulative percentage of market share Consider figure 14.6 with concentration curves for three hypothetical industries A, B and C. You can see that the total number of firms operating in any industry are indicated, and can be compared, by the intersection of the curves with 100 percent output level. For instance, industry A is operated by Fa number of firms while Fb firms are producing in industry B, and so on for industry C (not shown in the diagram). Further, given the above definition of market concentration, we can say that concentration is high in an industry if its concentration curve lies everywhere above that of another industry. This means that industry A is more concentrated than industries B and C; i.e. for any number of n-large firms, such firms control a large proportion of market sales or output. For example, the four largest firms in industry A account for 90% of sales in this industry while the same number of firms in industry B and C make up 60% of output in these industries. However, such a unique ranking of industries becomes difficult when the concentration curves cross each other as in the case of industries B and C in this diagram. In fact their ranking depends upon whether we are taking concentration ratio of less than four or more than four firms in the industry. If we take CR for less than four firms as bench mark, then industry C is more concentrated than industry B, but according to CR for more than four firms industry B turns out to be more concentrated. In this case, it is not possible to rank industries uniquely by market concentration since such a ranking assumes particular weighting to different parts of the concentration curve (the details of this discussion are beyond the scope of this text, interested readers should see texts on industrial economics).

Figure 14.6: Analyzing concentration curvesNo of firms cumulative from largestA9040Cumulative percentage of market shareBC60100FbFaE Figure 14.6: Analyzing concentration curves No of firms cumulative from largest A 90 4 0 Cumulative percentage of market share B C 60 100 Fb Fa E This is a general problem associated with all concentration indices. Another problem with concentration ratios is that the ranking of industries depends upon the choice of variable in question. Industry A may be more concentrated than B in terms of sales, but vice versa if we consider profits or assets as the measure of market concentration instead of sales. Despite these difficulties, we can yet infer some of the following general conclusions from this analysis: Concentration ranking principle: Concentration ratio ranks an industry as more concentrated than another if its concentration curve lies above that of another everywhere Sales transfer principle: If sales is transferred from a small to large firm in an industry, market concentration will increase Entry condition: If a small firm enters the market, market concentration will decrease Merger condition: The merger of two or more firms will increase market concentration The point to make in this discussion is that concentration ratio is a better guide to define market structure than merely counting ‘number of firms’ in an industry as pointed out earlier. A low concentration ratio is an indicator of a high degree of competition and a high concentration ratio refers to the absence of competition. A monopoly has a concentration ratio of 100 percent—the largest possible. Roughly speaking, a market is characterized as oligopoly if concentration ratio for its four largest firms is more than 40 or 50 percent of market share. A four firm ratio of less than 40 percent is regarded as an indication of a relatively competitive market. Viewed this way, concentration ratio is a measure of market power enjoyed by n-largest firms in an industry. 14.2.2: Equilibrium in Oligopoly Markets One of the important objectives of studying any market structure is to determine the equilibrium price-output configuration—the point form where no firm would like to change its behavior. For example, we saw that a monopolist produces at the point where its marginal cost equals marginal revenue, and so on for monopolistic competition. As we have seen above that in all of the other market structures, a firm either takes price or demands as given and ignores the behavior of its competitors. However, in oligopolistic markets, a firm’s choice of output and price is also partly dependent upon the choices of its competitors. How can we define the concept of equilibrium in this changed scenario? Recall that we have so far defined equilibrium as a position when firms are doing the best they can and have no reason to change their decision. The same concept of equilibrium is also true for oligopoly markets with slight modification. Here each firm will try to do its best given the behavior of its competitor. Since this concept was first introduced by John Nash in 1951, therefore it is defined ass Nash-equilibrium. It is an outcome or position in which no firm would like to change its behavior given the behavior of its opponents. The question that arises in mind at this point is: what should you assume or expect about your competitors’ behavior? Because the other firms are also behaving rationally (i.e. maximizing profit), it is natural to assume that the competing firms will also try to do their best given what you are doing. In short, each firm while choosing its own decision takes into account its competitor’s decision by assuming that the other firm is also trying to maximize its own profit. The concept may seem abstract at first but will be easily understandable when we apply it in the next section on non-collusive oligopoly.

14.3: Non-Collusive Oligopoly While discussing about oligopoly, it is important to make distinction between collusive and non-collusive oligopoly markets and firms. An oligopoly market is said to be non-collusive when the firms in the market do not collude (join their hands together) and therefore have to be attentive of the reactions of other firms when making price decisions. This section elaborates a number of different models used to analyze the working of oligopoly markets. 14.3.1: Cournot Duopoly Model Duopoly, as the word indicates, means two-producers. The earliest of duopoly models was presented by Augustin Cournot in 1838. He devised this model to explain the behavior of quantities, prices and profits in a two firm market. In his model both the firms produce homogenous goods and decide how much to produce simultaneously. To understand his model, let’s take up the case of our water-supply monopoly firm from the previous chapter. With the existence of another firm, after successful entry by another firm, the water supplier now needs to understand what the industry might look like with a competitor around—for example it needs to know the kind of market equilibrium it now faces. It should be noted that the price a firm receives depends upon total output of the two firms they supply in the market, and not on its individual output. This means that their demand curve takes on the following form: (14.2) i.e. market price P is a function of joint output of both duopolists; Y1 and Y2. The cost function for both the firms can be expressed in its typical form: (14.3a) (14.3b) You can see from the three equations that while the price depends upon joint output, each duopolist’s cost function is determined by its own output level. For the sake of simplicity, suppose that cost function takes on linear form which means that marginal cost, and hence average cost, is constant, say amount c per unit of output. Given this demand and cost structure, the Cournot model answers the basic question ‘what will be the equilibrium output levels of the two duopolists?’ Here equilibrium means a pair of output levels, one for each firm, which once attained will leave no incentive for any firm to change its output. Output Decision of Cournot Duopolist The essence of Cournot model is that each firm will assume that the other firm will keep its output fixed at the existing level when it changes its own output. In other words, each firm will treat the output of its competitor as constant and then decides how much to produce. More technically, we can say that conjectural variations are zero. Figure 14.7 shows how this works for firm 1. Though each firm knows that its own profit depends upon the output of other firm, but the problem is that it does not know the output choice of its competitor. Figure 14.7: Output decision of a duopolistMR (0)Y0Rs/unitD (0)MCaMR (50)D (50)bY1b = 25Y1a = 50MR (75)D (75)cY1c = 12 Figure 14.7: Output decision of a duopolist MR (0) Y 0 Rs/unit D (0) MC a MR (50) D (50)

b Y1b = 25 Y1a = 50 MR (75) D (75) c Y1c = 12 Let’s say firm 1 thinks that firm 2 will produce nothing at all. Then firm 1 faces market demand curve denoted as D (0), which means the demand curve for firm 1 assuming firm 2 produces zero. The diagram also plots the corresponding marginal revenue curve MR (0). Firm 1’s profit-maximizing output is attained at point a with output Y1a, say 50 units, where MR equals MC. So if firm 2 produces zero, then given market demand and cost functions, firm 1 should produce Y1a output. What if firm 2 produces a higher level of output, say Y2a = 50 units? In this case, the market demand curve facing firm 1 will shift down by an amount 50. The reason for this shift is simply that since firm 1 treats firm 2’s output as given, so it can supply only that part of market demand which is not served by firm 2; i.e. if Y = Y1 + Y2, then Y1 = Y – Y2. The new demand curve for firm 1 is denoted D (50) and corresponding marginal revenue curve is labeled MR (50). Firm 1’s profit-maximizing supply is now Y1b, say 25 units, the point where MR intersects MC curve. Continuing with this line of reasoning, if firm 1 thinks that firm 2 will produce a yet higher level of output, say 75 units, then firm 1’s demand curve will be further shifted down by 25 units as labeled D (75) associated with MR (75). Here firm 1 will produce at point c supplying output Y1c = 12 units. Finally, if firm 2 produces 100 units, then firm 1’s demand and marginal revenue curves will be at vertical axes (not shown in the diagram) and it will produce nothing at all. Reaction or Best Response Function of Cournot Duopolist The above discussion shows that depending upon the output level chosen by firm 2, we can define the output level that represents the best response—profit maximizing—for firm 1. The process is to locate demand curve for firm 1 associated with output chosen by firm 2, and then find the profit maximizing output level for firm 1. We have seen that the profit maximizing output of firm 1 is inversely related to output level it thinks firm 2 will produce. This relation is called reaction function of firm 1 to firm 2’s output denoted as Y1(Y2) in figure 14.8. Figure 14.8: Reaction functions of Cournot duopolistsY10Y2AReaction function of firm 1; Y1(Y2)D50100C10075BReaction function of firm 2; Y2(Y1)5012 Figure 14.8: Reaction functions of Cournot duopolists Y1 0 Y2 A Reaction function of firm 1; Y1(Y2) D 50 100 C 100 75 B Reaction function of firm 2; Y2(Y1) 50 12 Firm 1’s output is placed on the x-axis while y-axis measures the output level of firm 2. It is important to realize that each point on this reaction function represents the optimal choice or best response of firm 1 to a possible output level of firm 2. We have shown four of the possible output combinations as points A, B, C and D as discussed in figure 14.7. We can make a similar kind of analysis for firm 2 in order to determine its reaction function and find its best response to each level of output that it thinks firm 1 might produce. Firm 2’s reaction Y2(Y1) function is shown in figure 14.8 (we come to the slopes of two reaction functions below). You can again see that the optimal or profit maximizing output level for duopolist (firm 2) is a decreasing function of that of another duopolist (firm 1).

Determining Cournot Equilibrium In equilibrium, each firm will determine its output on its own reaction function which shows the amount of output a firm will produce given the output of its competitor. The point of intersection, Ce, of the two reaction curves represents the equilibrium as shown in figure 14.9. The resulting set of output levels, Y1e for firm 1 and Y2e for firm 2, is called Cournot equilibrium. When firm 1 is producing Y1e output, the best response of firm 2 is to produce Y2e output. Similarly, if firm 2 produces Y2e, then best response of firm 1 is to produce Y1e. If both firms choose these output levels, neither firm will have an incentive to change its choice. In Cournot equilibrium, each duopolist is producing an amount that maximizes its profit given what its competitor is producing. Figure 14.9: Stable Cournot equilibriumY10Y2acCeReaction function of firm 2; Y2(Y1)Y1eCournot EquilibriumbdeReaction function of firm 1; Y1(Y2)Y2eY1aY2aY2bY1b Figure 14.9: Stable Cournot equilibrium Y1 0 Y2 a c Ce Reaction function of firm 2; Y2(Y1) Y1e Cournot Equilibrium b d e Reaction function of firm 1; Y1(Y2) Y2e Y1a Y2a Y2b Y1b Stability of Cournot Equilibrium The theory says that the duopoly model will be in equilibrium if the two firms produce Y1e and Y2e quantities. But what is the guarantee that the two firms will actually tend to choose these output levels? To see the process that takes outputs towards their equilibrium levels, let’s assume that the firms are initially producing outputs different from their equilibrium levels, say at point a on the reaction function of firm 2 in figure 14.9. You can see that at this point firm 1 is producing output Y1a which is higher than its equilibrium quantity while firm 2 is producing output Y2a which is lower than its equilibrium output level. At point a firm 2 is on its reaction function but firm 1 is not. When firm 2 chooses an output level Y2a, firm 1’s reaction function indicates that it will decrease its output from Y1a to Y1b at point b. However, with the output of firm 1 at Y1b, the reaction function of firm 2 shows that it will now increase its output from Y2a to Y2b at point c. This process goes on like this until we reach point Ce, the Cournot equilibrium point. It is important to note that the process in figure 14.9 is convergent—if allowed to continue, it will lead the firms to converge on equilibrium quantities Y1e and Y2e. In other words, the equilibrium is stable. Unfortunately, convergence on the equilibrium depends on how we draw the reaction function. Figure 14.9 draws the reaction functions such that the one for firm 2 is flatter than the one for form 1. Figure 14.10: Unstable Cournot equilibriumY10Y2sqCeReaction function of firm 1; Y1(Y2)Y1eUnstable EquilibriumrpReaction function of firm 2; Y2(Y1)Y2eY1sY2rY2pY1qY1p Figure 14.10: Unstable Cournot equilibrium Y1 0 Y2 s q Ce Reaction function of firm 1; Y1(Y2) Y1e Unstable Equilibrium r p Reaction function of firm 2; Y2(Y1) Y2e Y1s Y2r Y2p Y1q Y1p If the opposite is the case—the one for firm 2 being steeper than that for firm 1—we have the situation as depicted in figure 14.10. With these shapes of reaction functions, markets do not converge to equilibrium. However, it is true that if the market ever reaches the equilibrium quantities at point Ce, it will remain there but we cannot rely on the process of convergence to bring about equilibrium. To grasp this point, let’s once again begin with a point beyond equilibrium, say p where firm 1 is producing Y1p and firm 2 is producing Y2p. You can see from firm 1’s reaction function that it will tend to increase its output towards Y1q when firm 2 is choosing output Y2p, hence moving further away from the equilibrium. With the output of firm 1 not at Y1q, the reaction function of firm 2 shows that it will decrease its output from Y2p to Y2r; moving it further away from the equilibrium as well, and so on it goes. Obviously, this process is divergent—at each stage, it moves the two firms further away form the equilibrium position. The discussion in the following sub-section illustrates Cournot model using a mathematical function. Though it involves a bit of mathematics, but we have not presented it in an FYI Box because it directly adds to the understanding of the Cournot model and, moreover, the model in the next section is developed on the basis of this particular example.

Linear Demand Curve Example of Cournot Duopoly Model Consider two firms facing a linear demand curve: (14.4a) where Y is total output produced by the two firms; i.e. Y = Y1 + Y2. For the sake of simplicity, assume that marginal cost of production is identical and constant for both the firms (the result we derived here will not change with different and rising marginal cost assumptions): (14.4b) hence MC1 = MC2 = 2 (14.4c) Firm 1’s total revenue function is given by: Replacing (14.3a) for P we have: or (14.4d) The marginal revenue function is just the incremental revenue ∆TR1 resulting from a change in output ∆Y1 (derived by applying differentiation): (14.4e) Similarly, total and marginal revenue functions of firm 2 are given by: or (14.4f) (14.4g) ow setting marginal revenues equal to marginal costs for each firm and solving for output of the firm gives reaction function. Reaction function for firm 1: MR1 = MC1 or (14.4h) Reaction function for firm 2: MR2 = MC2 or (14.4i) We know that the equilibrium output levels are found at the intersection of the two reaction functions. Mathematically, the solution values are given by solving (14.4h) and (14.4i) simultaneously as: or (14.4j) Substituting Y1 from (14.4j) into (14.4i) we have: (14.4k) Since the two firms were assumed to be identical in cost structures, therefore we have equal solution values for both the firms. The total output supplied in the market is: and the market price is: Profits of the duopolists are: and also The graphical representation of reaction functions (14.4h), (14.4i) and Cournot equilibrium is given in figure 14.11. Again, Firm 1’s reaction function shows its output Y1 as a function of firm 2’s output Y2 and so is the case for firm 2’s reaction function. The Cournot equilibrium is at the intersection of the two curves where each firm is maximizing its profit given the output of its rival. Welfare Properties of Cournot Duopoly What about the welfare properties or efficiency of duopoly outcome? More specifically, how does Cournot duopoly compare with competitive and monopoly market structures? We have seen in the last chapter that economists compare all market structure with their idealized model of perfect competition in order to evaluate its desirability. What if we apply this criterion on duopoly model? As anticipated, duopoly firms are in between the welfare results (when welfare is measured in terms of consumer and producer surpluses) produced in competitive markets and those that occur under monopoly. To prove this, let’s continue with out numerical example. Thus far, in the above example, we had assumed that the two firms compete with each other. Suppose that the two firms decide to collude and make joint output decision to maximize total profit (the distribution of resulting profit is a secondary issue here). Under this case, the firms would behave like a monopolist and their total profit is maximized by choosing output Y such that marginal revenue MR, not MR1 or MR2, equals marginal cost. Total revenue for the two firms is

(14.4l) So marginal revenue is (14.4m) Figure 14.11: Cournot Duopoly exampleY10Y2EcReaction function of firm 2; Y2(Y1)16Cournot EquilibriumCeReaction function of firm 1; Y1(Y2)4848162424EmCompetitive Output Contract Curve1212Collusive duopoly or Monopoly Output Contract Curve Figure 14.11: Cournot Duopoly example Y1 0 Y2 Ec Reaction function of firm 2; Y2(Y1) 16 Cournot Equilibrium Ce Reaction function of firm 1; Y1(Y2) 48 48 16 24 24 Em Competitive Output Contract Curve 12 12 Collusive duopoly or Monopoly Output Contract Curve Setting MR equal to MC, which is 2 in this example, and solving for Y we have or (14.4n) which means that if duopolists behave like a collusive-duopoly or monopoly, then they should produce 24 units. Any combination of outputs Y1 and Y2 that adds up to 24 maximizes total profit. If all is produced by firm 1, we have equilibrium on the horizontal axis at quantity 24, and alternatively on the vertical axis quantity 24 if firm 2 supplies the whole market. If both agree on splitting the market and profits evenly, then each will produce 12 units and we have monopoly equilibrium point Em. The line drawn between the two monopoly outputs, 24-24, is monopoly output contract curve. It has the property that any output along this line is such that total output on the market will be the monopoly output. The points along this line differ only according to the amount each firm individually supplies to the market. It is easy to see that collusive-duopolists will charge a higher price Rs 26, than so non-collusive Rs 18. Finally, we can calculate competitive output by equating, according to standard economic theory, price with marginal cost and solving for Y: or (14.4o) So if the two duopolists are forced to behave like competitive firms, they would jointly produce 48 units and charge a price Rs 2 , equal to marginal cost of production. In this case, their profits are driven down to normal or zero economic profit level. The amount of output produced by each firm, again, would depend upon the distributional share they agree on. If they agree to share market equally, each will produce half of the total output; i.e. 24 and we have competitive equilibrium at point Ec. Similar to the monopoly contract curve, we can draw a line between the two competitive output levels 48-48 passing through Ec called competitive output contract curve—along all points on the line, total output equals optimal or competitive quantity. You can now see that the Cournot equilibrium point Ce is strictly in between monopoly and competitive lines. Since price decreases as quantity produced increases, it must be true that price and quantity are in between monopoly and competitive levels at the Cournot equilibrium. This proves the premise that non-collusive duopoly market outcomes are between monopoly and competitive ones in terms of social welfare. 14.3.2: Stackelberg Duopoly Model: First Mover Advantage The previous model assumes that the two duopolists; say our water-supply monopolist and the new entrant, make their output decisions simultaneously. In other words, the Cournot model treats firms symmetrically. However, it is more reasonable to assume that the new entrant will treat the existing water-supply firm as a kind of leader and will view himself as a follower. When this is the case, the market situation is said to be asymmetric with one firm being the leader and the new entrant taking the role of follower. You can think of the situation by imagining a new firm starting to manufacture automobiles in Japan in competition with Toyota. Clearly, a theory that treats all firms in this market symmetrically would be unrealistic. The Stackelberg model takes account of such market asymmetries. This model is merely an extension of Cournot model but allows asymmetrical behavior in a duopolistic model. It assumes that the leading firm sets its profit-maximizing output first; taking into consideration the quantity it expects the follower to produce in reaction to its (leading firm) choice. Though the follower also tries to maximize its profit, but it takes the output of leader as given. As we explain, this assumption allows the leader to predict the follower’s output choice. To see how this situation works, again continue with the example from previous section. Suppose firm 1 is the Stackelberg leader while firm 2 is the Stackelberg follower. Since firm 2 makes its output decision after firm 1, it takes firm 1’s output as fixed. Therefore, firm 2’s profit maximizing output is given by its Cournot reaction function as found in (14.4i)

(14.4i) What about firm 1, the leader? In order to maximize its profit, firm 1 chooses output Y1 so that its marginal revenue equals marginal cost. Firm 1’s revenue function was Figure 14.10: Stackelberg Duopoly exampleY10Y2Reaction function of firm 2; Y2(Y1)16Cournot EquilibriumReaction function of firm 1; Y1(Y2)4848162424ES1212Stackelberg Equilibrium with firm 1 as leaderESStackelberg Equilibrium with firm 2 as leaderCe Figure 14.10: Stackelberg Duopoly example Y1 0 Y2 Reaction function of firm 2; Y2(Y1) 16 Cournot Equilibrium Reaction function of firm 1; Y1(Y2) 48 48 16 24 24 ES 12 12 Stackelberg Equilibrium with firm 1 as leader ES Stackelberg Equilibrium with firm 2 as leader Ce Since TR1 depends on Y2, firm 1 must anticipate how much firm 2 will produce. The leader knows that firm 2 will choose Y2 according to reaction function (14.4i). Therefore, firm 1 can predict the choice of firm 2’s output level from its reaction function. Substituting (14.4i) in revenue function of firm 1, the leader, for Y2 we have or or (14.4p) so its marginal revenue is (14.4q) This revenue function incorporates the reaction function of firm 2, the follower. Setting marginal revenue equal to marginal cost give profit-maximizing output choice for firm 1: (14.4r) Substituting this output of firm 1 into the reaction function of firm 2 gives its output level, given the output of firm 1: (14.4s) Market price facing both firms will now be Rs 14. The profits for both firms can be calculated as For firm 1: , and For firm 2: Point Es on the reaction function of firm 2 in Figure 14.12 shows the Stackelberg equilibrium. Note that the total output produced by the two duopolists in the Stackelberg model [= 36 = 24 + 12] is greater than that of in Cournot model [32] while price is lower. Interestingly, the model predicts that the leader will produce more than the follower and, hence, make larger profit. This means that going first gives advantage, called the first mover advantage. If we assume firm 2 to be the leader and firm 1 as follower, the situation would simply reverse in favor of firm 2 because the two firms are assumed to be identical in cost structures. In that case, firm 2 will produce 24 units while firm 1 set a quantity of 12 units. The profit levels would also simply reverse in numbers. The extent to which firm 1 can move on the reaction function of firm 2 to find its profit-maximizing point depends upon the cost and revenue structures of firm 2. Two Many Cooks Spoil the Curry Moving first is advantageous in the Stackelberg model because no matter what your competitor does, your output will be larger. To maximize its profit, the laggard rival must take your larger output as given and set a low level of output for itself. However, so is the case as long the other firm is willing to accept the role of follower. What if both firms try to behave as leaders? Clearly, assuming for itself the position of market leader and treating other as follower guarantees larger profit for each firm as shown above. But the model becomes unstable when both try to assume the leading role—the situation known as Stackelberg disequilibrium. The crux of this situation is that when both firms try to become the leader, there expectations will not be fulfilled and one of three outcomes may result:

Both firms will get involved in price-war until one firm, probably the financially weaker one, will surrender and agree to act as follower while the other will succeed in becoming the leader. This process will bring about Stackelberg equilibrium Both firms will converge to a Cournot equilibrium position and share the market and profits Both firms will collude and produce monopoly output The Cournot and Stackelberg models are alternative explanations of oligopolistic behavior. The answer to the question which one of the two is a more appropriate description of capitalist order depends upon the nature of industry. An industry composed of roughly similar sized firms none of which has leadership position, the Cournot model more appropriately explains the behavior of firms in this industry. Conversely, if some firms in the industry take leading position in, say, introducing new products or setting price, then the Stackelberg may be more realistic. 14.3.3: Bertrand Duopoly Model: Criticism of Cournot An aspect of the Cournot model that seems odd is the fact that it presents firms competing in market by choosing quantities of goods they produce. Normally, we observe that firms compete through prices they charge for their products. For example, price is an important dimension in which automobile companies compete with each other. Clearly, the fact that firms compete through prices is at odds with the assumption of the Cournot model. The economist Joseph Bertrand developed a different kind of duopoly model in 1883, usually referred after his name as Bertrand model. Demand Function of the Bertrand Duopolist In this model, firms sell identical products and consumers choose to buy from the firm that charges the lowest price (the assumption of identical products will be relaxed below). Therefore, firms set prices and leave quantities to be determined by the market. This is exactly opposite to the Cournot model. The two firms face a demand function with the following characteristics: If firm 1 charges a price higher than that of its rival, the demand for its product would be zero as all people will purchase from firm 2 If it charges a price below its competitor, it will capture all the demand (D) in the market (the model assumes that all firms have enough production capacity to supply the entire market. We relax this assumption below to see its implications for the result derived in this section) If both firms charge equal price, each firm would supply half of the market demand This type of demand function can be expressed in algebraic form as: (14.5) The first line says that of firm 1 sets price below that of firm 2, all consumers will buy from firm 1 and it will be selling as much as market wants at that price, D(P1). The second tells that if firm 1 and firm 2 set the same price, they will split the market between them at that price. The meaning of third line also goes like this. Bertrand Equilibrium and its Efficiency What is the equilibrium in this model? Equilibrium for this model would be a pair of prices that once attained would leave no incentive for any firm to change its price, given the price of its competitor. What set of prices will take firms to this equilibrium position? If you think about this situation minutely, you would realize that the equilibrium prices will be those prevailing in competitive market due to the incentive to cut prices—i.e. both firms would set prices equal to marginal cost of production: P1 = P2 = MC. No firm would have any incentive to change its price from this level because if increased it price slightly, it will lose all of its customers to other firm and would be worse off. On the other hand, if it reduced its price, it would capture the entire market but would lose money on every unit it produced because price is now less than marginal cost. Hence neither firm 1 nor firm 2 has any incentive to deviate from this price level—each is doing the best it can given what its rival is doing. Why can’t we have equilibrium where firms charged the same but higher than marginal cost price so that each firm made some profit? To understand why not, suppose we have the situation P1 = P2 > MC so that prices set by two firms are greater than marginal cost. Since the two duopolists are not making joint a decision, but they are competing with each other, both firms have incentive to decrease their prices and hence capture the entire market. Since by slightly under-pricing the competitor firms can increase their profit, there will remain incentive to reduce price for both the firms until they reach marginal cost of production.

Even though the Cournot and Bertrand equilibriums are the applications of the same equilibrium concept, just by changing the strategic choice variable, they lead to very different welfare-outcomes. The Cournot model predicts a price and quantity that in between monopoly and competitive levels. On the other hand, the Bertrand equilibrium results in the welfare-optimal (competitive) price, quantity and profit. Interestingly, by simply changing the basis of competition from quantity to price, the Bertrand model has produced dramatically different perception about the desirability of duopolistic market than the Cournot model. There is something intuitively unappealing about the welfare results of the Bertrand model because with only two firms in the market it is hard to believe that the price will be driven down to the competitive level—price that maximizes consumers’ welfare and minimizes producers’ profit. The Cournot model seems more appropriate as it says that price will drop gradually as more firms enter the market. The Bertrand model brings about magical results by adding just a single firm in a monopoly market. The welfare results of the Bertrand model can be contested by relaxing a number of its assumptions: Firstly, the model assumes that the firms produce homogenous products so that a firm loses all of its sales if it increases its price slightly. But in reality we observe some degree of product differentiation in oligopolistic markets. Market shares of firms are determined not just by prices, but also by other factors such as differences in design, performance and durability of the product. More importantly, advertisement and selling activities of the firms have lasting contribution in creating brand and customer loyalty. These considerations make it possible for a firm to charge higher than competitive prices for its product because it does not lose all of its customers, no matter what the rival is doing Secondly, the model assumes that the firms do not learn from their mistakes and keep on under-cutting each other’s prices instead of working out a more favorable pricing agreement between themselves. In other words, we can expect firms to collude on prices. This issue is taken in detail in the section on collusive oligopoly Another way of modifying Bertrand results is to relax its assumption that the firms face no capacity constraints and can produce as much output as demanded by the market. The next sub-section shows what happens once this assumption is relaxed as suggested by the economist Francis Edgeworth. 14.3.4: The Edgeworth Model The Edgeworth model explains how duopolists can find a more profitable equilibrium than are produced by welfare-optimal prices and quantities according to Bertrand model. The model provides a solution to the problem of price-war such that prices do not fall to marginal cost of production. However, the model does not have equilibrium of the type economics’ students normally expect to see. In Edgeworth model, prices in oligopoly markets move in cycles—as each firm attempts to maximize its profit, prices rise and fall but never settle permanently at one level. The underlying assumption used by Edgeworth is that the firms in duopolistic markets face capacity-constraints which means that neither of the firms have enough capacity to produce the quantity that would be demanded at marginal cost of production. Suppose that both of our duopolists are charging price equal to marginal-cost, and jointly, not individually, they have enough capacity to satisfy market demand. As a result of this situation, none of them is making any profit. What if one of the firms, say firm 1, increases its price above marginal cost? Clearly, all customers would like to purchase from firm 2. But since firm 2 is capacity constrained, it cannot serve everyone in the market. This means that there would be some left-out customers willing to pay more than marginal cost to buy this product. Firm 1 can now sell its product to these customers at a price greater than marginal cost of production and hence make profits. The marginal cost price is not an equilibrium position in capacity constrained markets. To see why prices will keep fluctuating in such a market, let Pm be monopoly price while Pc be competitive price and that Pm > Pc (as assumed by economic theory). Assume that each firm is individually large enough to satisfy monopoly output Ym but not competitive output Yc where price is equal to marginal cost. Now say that currently prices are set such that Pm > P1 > P2 > Pc; i.e. both firms are charging greater than competitive price and firm 1 is charging a higher price than firm 2. In this scenario, all customers would like to shift their demand to firm 2. Since firm 2 cannot satisfy the entire market, firm 1 will receive some customers. This will leave firm 1 an incentive to raise its price to P1 – ε, where ε is a small number; i.e. firm 2’s price is now closer to that of firm 1, though it is still less). Though the higher price will derive some customers away from firm 2, it will increase its profit. The price configuration in the market will now be firm 1 charging P1 while firm 2 charging P1 – ε. But this is not an equilibrium too because firm 1 want to reduce its price to P1 – ε – ε because this small reduction in price will bring a large increase in demand for firm 1 because it will capture the market from firm 2. Prices will now continue to fall until they reach marginal cost level. But since marginal-cost price is not an equilibrium position as we saw above, once one firm increases its price the process of changing the price will start once again. Thus, capacity constraints cause prices to fluctuate endlessly and never settle at any particular level—oligopolistic industry will be characterized by periods of ‘price-wars’ and ‘price-hikes’. This reinforces the idea that outcomes of the oligopolistic markets are indeterminate and economic theory cannot predict the behavior of the firms operating in oligopolistic markets.

14.4: Collusive Oligopoly We said above that one option open for oligopolistic firms is to cooperate with each other in order to maximize joint-profit instead of competing with each other. When firms are involved in such cooperative decision makings, this is called collusive oligopoly. Cooperation is profitable because it helps firms behave like a single monopolist. However, collusion may be illegal. But is it not possible for firms to cooperate with each other without colluding explicitly? If both firms can figure out joint profit-maximizing price, why can’t they just set this price hoping that the competitor would also do the same? In this section we first discuss the problem that makes such collusions unstable, if not impossible, for capitalist (profit-maximizing) firms. We then spell out the conditions that make collusive agreements more viable than it apparently appears. 14.4.1: Instability of Collusion Though collusion on prices is attractive, but the problem is that such agreements are usually not stable because each capitalist firm has strong incentives to cheat and sell to some customers at a price below the agreed price, say Pa. It is reasonable to think that once cheating starts, a price-war will begin resulting in the break down of collusion. To understand this phenomenon, consider a typical Bertrand price competition example. Table 14.3 points to a situation that the two duopolists face. Each firm has two strategies: cheat or respect the agreement. Each cell in this table shows the profit level for both firms given their particular strategies. The first entry in each cell is for firm 1 while the second one is for firm 2. For example, the upper-left hand corner of this pay-off matrix says that if both the firms keep their agreements and work cooperatively, each receives a pay-off of Rs 2 millions. The upper-right hand cell tells us that if firm 1 keeps the agreement while firm 2 cheats, then firm 1 receives Rs 2.5 millions while firm 2 yields Rs 0.5 million (the cheater is better-off). Similarly, the lower-right hand corner shows the profit levels when both the firms cheat; each yields Rs 1 million. Finally if firm 2 cheats and firm keeps its agreement, firm 1 receives Rs 0.5 million while firm 2 earns Rs 2.5. Table 14.3 has now converted the market situation into a game where each firm is trying to do its best, given the behavior of its competitor. Table 14.3: Pay-off matrix for collusive duopolists Firm 2 Cooperate Cheat Firm 1 Cooperate 2, 2 0.5, 2.5 Cheat 2.5, 0.5 1, 1 We can now answer the question ‘why is it difficult for capitalist firms to behave co-operatively and earn higher profit?’ You can see that if both firms cooperate, each receives Rs 2 millions. However, the problem is that each firm makes more money by cheating no matter what the other firm is doing. To see this, consider the decision making process for firm 1. Ask yourself: what should firm 1 do if firm 2 agrees to cooperate? Clearly firm 1 has two options: if it cooperates, it will receive Rs 2 millions but if it cheats it will receive Rs 2.5 million. This means that if firm 2 cooperates, the best response of firm 1 is cheating (because that is more profitable). Now ask: what should firm 1 do if firm 2 cheats? Again firm 1 has two options: if it cooperates, it receives Rs 0.5 million but if it cheats it receives Rs 1 million. Once again, cheating is more profitable option to firm 1. The situation of firm 2 is also similar to that of firm 1: it also does best by cheating no matter what the firm 1 is doing. This shows that cheating is the dominant strategy for both the firms and each will be tempted to cheat, not cooperate in the market. Thus cheating by both firms is the only equilibrium point in this situation. The lesson of this outcome is that collusive agreements are inherently unstable and vulnerable to cheating by all the parties involved in that agreement. Unless the firms can sign an enforceable legal agreement, neither of them can expect their competitors to work cooperatively.

This illustrates the essentially conflictive nature of capitalist order. All economic agents in capitalist order maximize gain at each others’ expense, and not by co-operation. Exploitation is thus built into capitalist market structures. It is the task of the capitalist state to regulate this exploitation and set limits to its practice. Application Box 14.1 gives an example of the relative failure of even enforceable legal agreements. A P P L I C A T I O N B O X 14.1 Cooperation difficulties at OPEC OPEC (Organization of Petroleum Exporting Countries) is a collusive cartel of twelve countries; namely Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Its primary goal is to safeguard and ensure the member countries interests, individually and collectively. It also seeks to ensure the stabilization of prices in international oil markets. However, OPEC has found it difficult to control oil prices effectively due to disagreements among its members. Widespread cheating by member countries on producing quotas is one of the many problems that OPEC has faced in trying to enforce price fixing rule. This is a reflection of the basic weakness of collusive agreement as discussed in the text. Oligopoly Markets as Prisoner’s Dilemma Prisoner’s dilemma illustrates a classic example of the problem faced by oligopolistic firms; i.e. the problem of breaking promises. The story goes as follows. Consider two thieves who have been accused of collaborating in a crime and they have been arrested by the police. Both of them are kept in separate jails and cannot communicate with each other. The officer asks each of them to confess. If both of them confess, each will receive a prison term of 5 years indicated by the upper-left hand vector of table 14.4. If neither of them confesses, the case might be difficult to settle, so the prisoners can expect to plea bargain and receive term of 2 years as shown by the lower-right hand vector of the pay-off matrix (the pay-offs will be in negatives numbers because imprisonment creates disutility). However, if one prison confesses while the other does not, the confessor will be imprisoned for only 1 year while the other one will be sent to jail for 10 years. What would you do if you were one of these prisoners? Table 14.4: Pay-off matrix for prisoner’s dilemma Prisoner 2 Confess Don’t confess Prisoner 1 Confess -5, -5 -1, -10 Don’t confess -10, -1 -2, -2 We can see that the prisoners face a dilemma. If they could somehow agree not to confess, then each would go to jail for only two years. Since they can’t talk or trust on each other, if any of the prisoners does not confess, he gives the other prisoner the possibility of gaining advantage over him by not confessing. You can easily work out that no matter what one prisoner does in this situation, the other finds it in his own interest to confess (we leave this as an exercise for you). Therefore, both of them will confess and go to jail for five years—an outcome that is not the best one for either of them!

The discussion shows that oligopolistic firms find themselves in prisoner’s dilemma. They have two strategies: either compete aggressively to capture larger share of the market at the expense of their competitors; or cooperate to co-exist with competitors, setting higher price and sharing higher profits than if they compete. But just like the two prisoners, each firm has an incentive to renege on its promises and undercut its competitor. Though both the firms can do better by cooperating as table 14.3 shows, but they can’t trust each other. As long as the pay-off matrix does not change, even communication among the playing parties cannot help maintain cooperation in this prisoner’s dilemma situation. The pay-off structure must represent gains from trade if cooperation has to be supported. 14.4.2: Making Collusion Stable Does the above discussion mean that oligopolistic firms always get involved in intense competition resulting in low profits? From the preceding section, one apparently gets an impression that all collusive agreements among oligopolistic firms are doomed to failure as they are inherently unstable. However, the instability outcome is based on a number of assumptions and if these assumptions are relaxed, it may turn out that collusive agreements are more feasible than one might think. Let’s work out the conditions that make collusion viable. Repeated Games and Stability of Collusions In our prisoner’s dilemma game, the prisoners were given only one opportunity to confess. In other words, the game was to be played once and only once between the two prisoners or the duopolist. Such games are called one-shot game. However, in reality firms interact with each other in the marketplace repeatedly and set output and price over and again. This repeated interaction among facilitates collusion because it permits firms to punish a cheater by lowering their price once the defection of cheater is known. Consequently, if we treat a collusive arrangement as a repeated game instead of one-shot game, then collusive arrangements can become much more stable. Repeated interaction allows firms to develop reputations from which trust can arise. Consider an industry made up of three or four firms that have co-exited for quite sometime, such as in Pakistan air-line industry. It is possible that the managers of the firms might get tired of losing money because of price-wars. This might create an implicit understanding among all firms about maintaining high prices and not lowering price to take away market share from its competitors. Although each firm will have the temptation to undercut its competitors, its managers know that the gains will be short lived as the competitors will definitely retaliate resulting in price-war and lower profits in the long run. However, it should be remembered that the repeated game solution of prisoners’ dilemma game is not without limits. This resolution might not be relevant for all oligopolistic markets. Some managers who are not content with the moderately high profits are more aggressive in nature and therefore prefer to compete aggressively in order to capture larger market share. Implicit understanding is also difficult to develop when firms have different cost structures and different assessments of market demand because this makes agreement on ‘correct collusive price’ difficult. Firm 1 might believe that the correct price is Rs 15 while firm 2 thinks that it should be Rs 13. When firm 2 sets a price Rs 13, firm 1 can view this as an attempt to undercut its price (Rs 15) and can retaliate by lowering its price to Rs 12, hence leading to price-war. Collusive agreements are therefore short-lived because of an element of mistrust among capitalist firms.

The Kinked Demand Curve Conjecture Stable collusion on price among oligopolistic firms can be created even without repeated game assertion. The kinked-demand curve model spells the possibility of price-rigidity in oligopolistic markets. The model explains why oligopolistic firms could be reluctant to change currently prevailing market price even if their costs or demand conditions change. According to this model, each firm faces a demand curve which is kinked at the prevailing market price Po (point a) as shown in figure 14.13. What is the meaning of such a demand curve? The kink in demand curve is created on the assumption that any action one firm to raise price from the prevailing one will not be matched by its competitor, but any action to lower the price will be matched. Above price Po, the demand curve is very elastic which means that if firm 1 raises its price above this level, others will not follow its action and firm 1 will lose much its sales and market share to its competitors. Figure 14.13: Kinked demand curve model of oligopolyMC1YY00Rs/unitAR = Doe1PoeoMCoMRoa Figure 14.13: Kinked demand curve model of oligopoly MC1 Y Y0 0 Rs/unit AR = Do e1 Po eo MCo MRo a On the other hand, the demand curve is relatively inelastic below price level Po because firm 1 believes that if it lowers its price below this level, others will try to match its action because they would not want to lose their market share. In this case, though the demand for firm 1 will increase at lower price, but its profit will fall below joint profit level (so because demand is inelastic below Po, so lowering of price will decrease revenue of the firm, recall this result from the chapter on elasticity). The demand curve has higher price elasticity in the upper part of the kink segment than on the lower part which means that the firm would experience more fall in its sales by increasing price than the rise in its sale after reduction in price. Thus, the dotted line segments of the demand curve Do are irrelevant from firm’s point of view. Due to the kink in demand curve, the marginal revenue curve is discontinuous at the kink point of the demand curve. The MR-curve has two segments: the upper segment corresponds to the upper portion of demand curve while the lower one corresponds to the less elastic one. The equilibrium of the firm is defined by the point of the kink where it is producing Yo output and charging Po price. This is because at any point to the left of the kink, the MC-curve is below the MR-curve, while to the right of kink the MC is larger than the MR. The MC-curve passes through the discontinuous segment of MR. You can see that there is a range within which costs may change without affecting the price and output decisions of the firm. So long as the MC-curve passes through the discontinuous segment of the MR-curve, the firm maximizes profit by producing Yo and charging price Po as shown in figure 14.13. This price-output configuration is consistent with a wide range of costs. The greater the difference in price elasticities of the upper and lower parts of the kinked-demand curve, the wider the discontinuity in the MR-curve and, hence, the wider the cost conditions compatible with the equilibrium price. Thus the kinked-demand curve model can explain price-rigidity in oligopolistic markets.

Figure 14.14: Limitation of Kinked demand curve modelY0Rs/unitDoP1D1Po Figure 14.14: Limitation of Kinked demand curve model Y 0 Rs/unit Do P1 D1 Po Though the kinked-demand curve is attractive, however, it should be noted that it does not define the level at which the price will be set in the market—i.e. does not explain the price at which kink would occur. Figure 14.14 draws two demand curves with kinks occurring at different price levels. The model can’t define which of the two kinks (i.e. prices) will materialize in the market. Since the kinked-demand conjecture does not explain the height of the kink, therefore it is not a theory of pricing or price-determination. In fact it is tool for explaining price-rigidity—why the price, once determined in one way or another, will tend to remain constant in oligopolistic markets. Remember that the kink in demand curve is generated due to the uncertainty and interdependence in the decision making of oligopolistic firms. 14.4.3: Cartel Pricing Analysis Cartel is special category of business venture where oligopolistic firms directly agree to cooperate in setting price and output levels. The objective of such a business arrangement is to reduce the uncertainty arising from mutual interdependence of the firms. By agreeing on price-output configuration, firms can maximize industry or joint profit, just as a monopolist does. Cartels are usually considered illegal as it distracts market efficiency. However, they do exist either because anti-trust laws are poorly enforced in some capitalist countries or because law does not prevent countries (or companies owned by foreign governments) from forming cartels. OPEC is an international agreement of oil producing countries. An All-Inclusive Cartel First consider the case of a cartel including all firms of an industry—i.e. no firm is left out of the cartel. Usually, cartels are managed by a central agency to which firms delegate the authority to decide not only the total quantity and the price, but also the share of production and profit among the members of the cartel. Figure 14.15: Cartel pricing-output and allocation decision0Rs/unitYMCbATCbPjPanel (b)Ybeb0Rs/unitYMCa + bDMRPjPanel (c)Yj0Rs/unitYPjMCaATCaPanel (a)Yaea Figure 14.15: Cartel pricing-output and allocation decision 0 Rs/unit Y MCb ATCb Pj Panel (b) Yb eb 0 Rs/unit Y MCa + b D MR Pj Panel (c) Yj 0 Rs/unit Y Pj MCa ATCa Panel (a) Ya ea E E From this perspective, a cartel can be viewed as a large single monopolist operating in a market to maximize its joint profit. To analyze this situation, assume that there are two firms in the cartel with the cost structure given in panels (a) and (b) of figure 14.15. By horizontally summing up the MC functions of firm (a) and firm (b) we get the market MC-curve; MCa+b in panel (c). The central agency sets MCa+b equal to MR in order to find joint profit-maximizing quantity and price for the cartel. Thus total output produced is Yj which would be sold at price Pj. The output is allocated among the firms on the basis of equating MR with individual firm’s MC functions. Thus, firm A will produce Ya at point ea while firm B will produce Yb at point eb (note that Ya + Yb = Yj). We find that the firm with the lower average cost (here firm B) produces a larger amount of output. However, it should be noted carefully that the larger output of B does not guarantee her larger share in the profit as well. The aggregate industry profit is the sum of the profits of the two firms given by the shaded area. The distribution of output is usually decided by the central agency for each member of the cartel.

Cartel as Dominant Firm The analysis becomes slightly different when all firms do not participate, or are not included, in the formation of the cartel. In this scenario, the cartel is formed only among the large-firms (in terms of market share) while the rest are left out of it. An example of such a cartel is OPEC which leaves out many oil producing countries (such as Indonesia which left OPEC in 2008). This type of cartel resembles what economists call the dominant firm model. The other firms (non-cartel) will behave like small competitive firms since they take the price set by the cartel as given. Since this type of cartel accounts for only a portion of total market supply, therefore it must take into account the production response of its non-cartel producers while setting its price. To see how it works, consider figure 14.16 where Do is the market demand while SSF is the supply curve of the small non-cartel firms (the sum of their marginal cost curves). Figure 14.16: Deriving cartel’s demand curveSSFP1Y0Rs/unitEoDoP2P3Small firms’ supplyLeaders’ demandd2AY0Rs/unitDcarMRP1P2P3Do Figure 14.16: Deriving cartel’s demand curve SSF P1 Y 0 Rs/unit Eo Do P2 P3 Small firms’ supply Leaders’ demand d2 A Y 0 Rs/unit Dcar MR P1 P2 P3 Do Given these curves, the dominant firm will now determine its demand curve. At each price, the leader’s demand will be equal to the difference between total demand, Do, and small firms’ supply at that price. For example, at price P3, the demand for the cartel’s product will be zero because all the market demand is supplied by small firms at this price (point Eo). On the other hand, small firms will sell nothing at or below price level P1, so the cartel faces the entire market demand curve. You can see that as price falls from P3 to P1, the demand for cartel’s product increases. At price P2, the total market demand is d2 of which P2A is supplied by the small firms while the remaining Ad2 by the cartel. Between prices P1 to P3, the cartel faces the solid line demand curve as drawn in the right hand panel of figure 14.16. Hence, cartel’s demand, Dcar, is simply the difference between market demand, Do, and small firms’ supply, SSF. The diagram also depicts MR-curve corresponding to cartel’s Dcar curve. The cartel (or dominant firm) chooses its profit-maximizing output, Ycar, where its MCcar equals MR as shown in figure 14.17. The MC-curve for the cartel is drawn below the supply curve for non-cartel firms because the dominant firm is expected to have lower costs than do non-cartel producers. Figure 14.17: Dominant cartel’s price-output decisionY0Rs/unitDcarPoDoSSFMCcarYcarYSFYTEoacbMRPcd Figure 14.17: Dominant cartel’s price-output decision Y 0 Rs/unit Dcar Po Do SSF MCcar Ycar YSF YT Eo a c b MR Pc d The price, Po, is given at the cartel’s demand curve Dcar (point a). Since the smaller firms are price takers, at market price Po, they sell output YSF determined at their supply curve, SSF (point b). This means that total output supplied is YT = Ycar + YSF, given at the market demand curve Do corresponding to price Po (point c).

From the above analysis we can derive two general rules for the successful operation of a cartel. First consider figure 14.18 which shows a cartel facing a relatively flat (elastic) demand curve and has a cost structure very similar to non-cartel members. That is why MCcar is drawn only slightly below the SSF-curve. The cartel price is given at P1. Note that if the cartel is forced to behave like a competitive firm, the price will equal marginal cost of the cartel’s production which is given at point d (where MCcar-curve intersects demand curve, Dcar) in figure 14.17 and at f in 14.18 (some of the points are omitted in this diagram to keep it simple). You can see that the cartel facing inelastic demand curve enjoys much more monopoly power as compared to the one facing elastic demand curve (recall from chapter 13 that monopoly power is measured by the difference between price and marginal cost). Alternatively, monopoly power can also be viewed as the ability of a firm to raise its price above competitive price level. When the cartel has substantial monopoly power, it can raise its price above competitive level without any fear of response from the non-cartel members. However, when the supply of non-cartel producers is relatively price elastic (i.e. SSF-curve is flat as in 14.18), the ability of the cartel to substantially increase price above competitive one is reduced because the non-cartel firms can easily expand their supply of prices do increase. Figure 14.18: Dominant Cartel’s price-output decision with little monopoly powerY0Rs/unitDcarPoDoSSFMCcarYcarEoaMRPcf Figure 14.18: Dominant Cartel’s price-output decision with little monopoly power Y 0 Rs/unit Dcar Po Do SSF MCcar Ycar Eo a MR Pc f Thus, cartelization is more successful when: Market demand for the product must not be price elastic Either the cartel should be almost all-inclusive (it controls nearly all the market supply) or the supply of non-cartel firms must not be price elastic. Since the two conditions are empirically valid for very few commodities, many international cartels have failed. Application Box 14.3 compares the case of OPEC with that of CIPEC (International Council of Copper Exporting Countries) to illustrate why the former was successful while the later was not. A p p l i c a t i o n B O X 14.3 OPEC Vs CIPEC Historically considered, OPEC has been a successful cartel in terms of making super-normal profits while others are either doing poorly (e.g. CIPEC) or have failed to survive. One reason why OPEC has been successful is that the demand for oil is price inelastic as it has very few alternatives. Secondly, OPEC has been much more cost efficient than non-OPEC producers of oil. Both of these conditions give OPEC considerable monopoly power in the oil production industry. On the other hand, CPEC (consisting of four countries: Chile, Peru, Zambia and Congo) accounts for less than half of world copper supply. Further, the cost of producing copper in these countries is only slightly lower (except for Chile where it is higher) than that of non-CIPEC producers. Moreover, the demand for copper is also price elastic as other materials such as aluminum can easily be substituted for copper. All these factors imply that CIPEC enjoys little monopoly power. This means that its potential to charge price above competitive price level is very low as non-CIPEC countries can easily increase their supply to world if CIPEC raises copper price.

Moreover political factors play a major role in determining cartel success. OPEC pricing strategy has been frustrated by Saudi Arabia and Nigeria which have disregarded output quotas. Saudi Arabia has usually acted to serve American interests within OPEC and has been willing to sacrifice national economic gains to guarantee political support from America. America has tried to use OPEC as an instrument for disciplining and persecuting Iran and Venezuela. Saudi Arabia has been the preferred American tool for this purpose. 14.4.4: Mergers and Acquisitions Mergers and acquisitions (M&A) is an important dimension of oligopolistic markets. Merger represents the decision of a number of independent firms to form a single corporation. The new firm can act as a cartel; i.e. enjoys the power to decide upon the output quota of each plant. Acquisition, on the other hand, represents the absorption of one company by another one; i.e. one of the companies remains while the other one ceases to exit as a separate entity. Usually, the smaller of the firms is merged into the larger. It may refer to the purchase of assets from another company, the purchase of a definable segment of another entity such as subsidiary, or the purchase of an entire company (usually called take-over). For example, we had a recent example of acquisition in Pakistan when Standard Chartered Bank purchased ANZ bank. However, in the modern literature, the terms mergers and acquisitions are usually used interchangeably for a number of different activities. For example, the Competition Ordinance 2009 of Pakistan treats followings as a form of mergers: two or more companies, previously independent of one another, merge to form a new company in such a way that they cease to exist as separate legal entities one company is absorbed by another with the latter retaining its legal entity and former ceasing to exist one or more persons or other companies who or which control one or more companies or acquire direct or indirect control of the whole or part of one or more other undertakings Motives for Mergers Companies enter into M&A for a variety of reasons. Some use merger as a means to achieve growth while others seek to diversify their businesses. In any case, the motive behind any proposed merger is important to assess its rationale. Followings are some of the reasons why companies opt for M&A: Synergy One of the most important motives for merging is to seeking synergy—the situation that the whole of the combined company will value more than the sum of its parts. Synergies created through mergers either reduce costs or enhance revenues for the company. Growth Companies’ managers always find themselves under pressure to grow. One way of growing is to make investment internally (i.e. organic growth) or by purchasing the necessary resources externally (i.e. external growth). Typically, it is easier for firms to grow externally and M&A help in this regard. Usually, M&A take place when a firm is operating in a mature industry.

Increasing Market Power Merger can be a great source of increasing market power when an industry is occupied by few competitors or when market share is sufficiently concentrated. Such a market allows firm to have greater influence on market prices. Acquiring unique capabilities & resources Mergers is also undertaken in order to pursue competitive advantages or obtain lacking resources. When cost-effective and internal creation of key capabilities is difficult, company may seek to acquire them from elsewhere. Some other reasons, such as diversification, are also cited for the justification of mergers, but we would now like to move to the issue of oligopoly-regulation resulting from M&A practices. 14.4.5: Antitrust Laws: Regulating Oligopoly Though explicit cartels are considered illegal, M&A are usually allowed in most capitalist countries, even rationalized, on the ground that it helps attain better utilization of resources by benefiting from economies of scale. However, such practices do call forth regulation because they can result in the accumulation of significant market power in the hands of a firm. Anti-trust legislation is justified in capitalist countries on the grounds that market dominance by a firm (or a group of firms) may lead to concentration of market output, distorted commodity and factor price structures and significant aggregate welfare / consumption reduction for society as a whole. We have seen in the last chapter that in the case of natural monopoly, direct price regulation can be used. But this option is not easy to implement in case of oligopoly firms. Here, the ideal strategy is to prevent firms from acquiring excessive market power in the first place, and to limit the use of market power if it has been acquired some how. In order to promote a competitive society, most countries have antitrust laws and regulatory bodies which prohibit mergers and acquisition that impede, or are likely to impede, competition. Such laws are intended to keep markets competitive. In Pakistan, we have the Competition Commission of Pakistan (CCP), formerly Monopoly Control Authority (MCA), which looks after the enforcement of rules and regulations regarding antitrust laws. The Commission mentions following as its objective statement: “to provide for a legal framework to create a business environment based on healthy competition towards improving economic efficiency, developing competitiveness and protecting consumers from anti-competitive practices” CCP ordinance declares participation in cartel an administrative offense punishable with fines which may extend to twenty five million rupees. However, the Competition Commission may grant exemption in respect of some cartel (or M&A) agreements, which substantially contribute to: improving production or distribution promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit; or the benefits of that agreement clearly outweigh the adverse effect of absence or lessening of competition

Regulation Methodology The important question now arises is how do the regulating bodies, such CCP, determine whether any merger in question will hamper market competition? Earlier, the regulating bodies across the world used market shares (discussed above) as bench marks to determine market power when deciding upon whether a particular merger violates antitrust laws. By using industry concentration rations and the market shares of the acquirer and the target firms, companies could themselves determine in advance whether the merger would be challenged or not by the regulating body. However, the ‘market-share approach’ proved too simplistic. This is the reason why antitrust laws enforcing agencies have shifted to a new measure of market power called Herfindahl-Hirschman Index (HHI) defined as: (14.6) By squaring market shares, the index gives most weight to the larger firms in the industry. Regulators calculate the HHI based on post-merger market shares. Given its value: if market shares results in an HHI of less than 1000 (HHI < 1000), market is not considered to be concentrated and challenge is unlikely if market shares results between HHI of 1000-1800, market is considered moderately concentrated and challenge is likely if market shares results in an HHI of greater than 1800 (HHI > 1800), market is highly concentrated and calls forth intervention and regulation from the regulators Let’s work out an example to see how HHI index is calculated. Consider an industry with 10 firms and the market shares as given in table 14.5(a). Table 14.5(a): Hypothetical data of 10-firms’s market shares Company 1 2 3 4 5 6 7 8 9 10 Market Share (%) 25 20 10 10 10 5 5 5 5 5 To calculate HHI, first square the market share of each firm [see table 14.5 (b)]. Adding them gives HHI = 1,450 which indicates that this industry is moderately concentrated. To see what happens if firms 2 and 3 make a merger, list down the market shares for all firms including that of the sum of firm 2 and 3 and add them after squaring. You can see that the HHI has jumped by 400 points to 1,850. The large change in HHI combined with the high post-merger HHI value shows that this merger would most like invoke objections from the regulating authorities. On the other hand, if companies 9 and 10 were to combine, the HHI would climb only 50 points to 1,500. This merger is less likely to ask for regulation because the post-merger HHI is only slightly higher than that of pre-merger HHI. Table 14.5(b): Calculation of Herfindahl-Hirschman Index Pre-Merger Post-Merger: Firms 2 and 3 Post-Merger: Firms 9 and 10 Firm Market Share (%) Market Share Squared Firm Market Share (%) Market Share Squared Firm Market Share (%) Market Share Squared 1 25 625 1 25 625 1 25 625 2 20 400 2+3 30 900 2 20 400 3 10 100 4 10 100 3 10 100 4 10 100 5 10 100 4 10 100 5 10 100 6 5 25 5 10 100 6 5 25 7 5 25 6 5 25 7 5 25 8 5 25 7 5 25 8 5 25 9 5 25 8 5 25 9 5 25 10 5 25 9+10 10 100 10 5 25 HHI = 1,450 HHI = 1,850 HHI = 1,500 HHI Change = 400 HHI Change = 50 Source: Adapted from CFA readings on Economics Apart from the HHI value, regulating bodies also consider some other factors to make regulations flexible. This additional information may include market power measured by price elasticity of demand for the product, efficiency of the firms in the industry, or financial viability of the potential merger candidates etc. This shows that regulating oligopoly firms is not an easy task. The regulation becomes more difficult when the merging company has a global presence. In this case, merging firms fall within multiple jurisdiction of regulatory control. Global companies face dozens of regulatory agencies with different standards, formalities and requirements. For example, in 1999 Coca-Cola acquired Cadbury Schweppes beverage brand which involved sales and production in more than 160 countries requiring antitrust approval in more than 40 jurisdictions around the world. Regulations for cross border M&A have not been developed and there is no international agency responsible for their regulation.

Oligopoly Redefined We used concentration ratio as a tool to define oligopoly in the above discussion. However, market structures can also be differentiated on the basis of HHI. In a perfectly competitive market, the HHI is very small (probably less than 1). For example, if each of the largest 50 firms in an industry has a market share of 0.1 percent, then HHI would be: For 50-firms competitive markets Similarly, we can see that HHI will be: For monopoly market A market with HHI less than 1,000 is considered relatively competitive. A market in which HHI lies between 1,000 and 1,800 is regarded as moderately competitive. But a market where HHI is greater than 1,800 is classified as uncompetitive. 14.5: Conclusion This chapter has presented the orthodox microeconomic theory which seeks to explain the functioning of oligopolistic markets. The most marked feature of this theory is its indeterminacy. In the most widely prevailing and most common of all capitalist markets, neo-classical microeconomic theory has the lowest explanatory power. Oligopolistic markets are most prevalent but least predictable in capitalist order. Standard microeconomic theory cannot specify what changes in cost structures will trigger changes in equilibrium prices. How can the ‘prisoner’s dilemma’ which oligopolistic firms typically face be overcome? When will prices converge towards their “equilibrium” levels in oligopolistic markets and when will they diverge? What determines the distribution of monopoly profits between duopolists, dominant firms and non-dominant ‘price takers’? What erodes the stability of collusive agreements? etc. This once again demonstrates that economic theory has very limited explanatory power. It does not tell us how prices are formed, output levels are decided upon, factor proportions are determined, profits and incomes are distributed in actually existing real world capitalist markets–––management theory does explain this (although imperfectly). Economic theory is normative. Economics is a moral science which shows how markets and all agents within markets ought to behave on the basis of the absurd assumption that rationality/self-interestedness ought to be universal and hence all individualities should collapse into that of a natural, omniscient archangel representative agent. This fictional Ubermensch (superman) has never existed and capitalist markets can, therefore, never be what economic theory expects them to be. Key Concepts Acquisition represents the absorption of one company by another one Antitrust laws refer to the rules and regulations prohibiting actions that restrain, or are likely to impede, competition Asymmetric in economics refers to a state in which two agents (buyer Vs. seller or seller Vs. sellers) carry inharmonious and unequal status Bertrand model is that oligopoly model which says that firms produce a homogenous good, each firm treats the price of its competitors fixed, and all firms decide simultaneously what price to charge Cartel is a form collusive business venture where all or some oligopolistic firms directly agree to cooperate in setting price and output levels in order to maximize their joint-profit

Collusive oligopoly means firms involve in cooperative decision makings in order to maximize their joint-profit Concentration ratio measures the size of the largest firms’ share in total market sales. This ratio refers to the degree to which production in any specific industry is concentrated in the hands of a few large firms Cournot model is an oligopoly model in which firms produce a homogenous good, each firm treats the output of its competitors as fixed, and all firms simultaneously decide how much to produce Dilemma represents the problems which arise when addressing an issue the resolution of which leads to several equally unacceptable consequences Dominant strategy is the optimal strategy or option no matter what the opponent does Duopoly is a market where two firms compete with each other Edgeworth model of oligopoly provides a solution to the problem of price-war such that prices do not fall to marginal cost of production. It explains the cyclical behavior of prices in oligopoly markets External growth is a companies’ expansion in sales or output achieved through the purchase of necessary resources externally (i.e. via mergers and acquisitions) Herfindahl-Hirschman Index is a measure of market concentration that is calculated by summing the squared market shares for competing firms in an industry Merger represents the decision of a number of independent firms to form a single corporation Monopolistic competition refers to a market structure characterized by many sellers competing with each other on differentiated products and facing easy market entry conditions Nash equilibrium is a set of actions where each player does the best it can, given the best of its competitor Non-collusive oligopoly means that the firms are competing with each other in the oligopoly market instead of joining hands together and therefore have to be attentive of the reactions of other firms when making price decisions Oligopoly is a market structure in which few firms compete with each other while entry barriers are significant One-shot game is one in which players take actions and receive pay-offs only once Organic growth is the growth in companies’ sales or output achieved by making investment internally (i.e. excludes growth through M&A) Pay-off matrix refers to a tabular representation of profit (or payoff) to each player given its decision and the decision of its competitor Price-rigidity is a characteristic of oligopolistic markets which explains why firms can be reluctant to change prices even if costs or demand change Prisoner’s dilemma attempts to demonstrate why two agents might not cooperate even if it is in their best interests to do so Reaction function is the relationship between a firm’s profit-maximizing output and the amount of output it believes its competitor will produce Repeated game is one where actions are taken and pay-offs are received by players over and again Stackelberg model of oligopoly in which one firm sets its output before other firms do Strategy is the rule or plan of action defined for playing a game

Chapter Summary Actually existing capitalist firms do not correspond to the assumptions underlying the neo classical theory of the firm. They are large and growing larger with no obvious ‘optimum size’ since they have falling ––– not rising average costs as output expand. Hence a need for a more realistic model of the behavior of firms. The theory of monopolistic competition recognizes that products are differentiated and not homogeneous as assumed by perfect competition models. Moreover in monopolistically competitive market, the marketing activity of firms also determines sales. The selling cost is therefore an important element of total cost. Selling cost can shift the demand curve or make it more elastic. Conventional theory assumed that the selling cost curve was U-shaped and adding it to total costs makes the total cost curve also U-shaped. Monopolistically competitive capitalist firm have some control over price –– the demand curve they face is downward sloping but usually highly elastic. The monopoly power of such a capitalist firm depends upper the extent of its success in differentiating its product. Long run equilibrium in monopolistically competitive market will entail an elimination of super normal profits and an equalization of prices and average costs. However monopolistically competitive markets will not be efficient. Price will be greater than marginal cost in such markets where as in perfectly competitive capitalist markets price well equal marginal cost. Monopolistically competitive firms produce output at a cost higher than that of perfectly competitive capitalist firms. There is allocative inefficiency in monopolistically competitive markets. Monopolistic firms also operate with excessive capacity. There are too many small firms in monopolistically competitive models. Capitalist state refrains from regulating monopolistically competitive markets because (a) cost of regulation may exceed efficiency loss (b) higher prices may be preferred by capitalist consumers for ensuring access to a wider range of products. Mature capitalist order typically takes the form of olegopolistic product, services and factor market (with unskilled labour being the only major exception). Olegopolistic markets are those dominated by a small number of firms. Entry to olegopolistic markets is highly restricted firms make large profits in olegopolistic markets because of their significant entry barriers. In an oligopolistic market firms are interdependent. Decisions of one firm affect decisions of all other oligopolistic firms. Strategies must take account of other firms in the market who will react to actions taken. The chain of reaction can extend indefinitely. Hence game theory provides an appropriate theoretical framework for the analysis of oligopolistic markets. The concentration ratio is used to characterize oligopolistic markets. The concentration ratio measures the market output share of the top four or eight firms. The choice of the number of firms to measure the level of concentration influences market ranking. Concentration levels will also be different in terms of the variables on the basis of which they are measured sales, output or profit.

In an oligopolistic market a firm’s choice of output and price is partly dependent on the choices of its competitors. Oligopolistic markets are characterized by Nash equilibrium. This is an equilibrium position in which no firm can gain by changing its output level or price given the price and output levels chosen by its competitors. Non collusive oligopolistic markets are those in which firms do not collude and therefore have to take account of and react to other firm’s actions. In a Cournot duopoly the price a firm charges depends upon the total output of the market. Cost to a firm however depends upon the level of output of that firm. In the classical Cournot model of duopoly each firms will assume that the output of its competitors will remain constant in deciding how much to produce. However although this firm knows that its profit depends upon the output decision of its competition, it does not know how much output the competitor will produce. The profit maximizing output of a firm is inversely related to the output level it thinks it’s competitor will produce. This is the reaction function of the firm in response to anticipated output levels of its competitor The reaction function shows the amount of output a firm will produce to maximize profit given the output of its competitor. Equilibrium in the duopolistic market is given by the intersection of the reaction function of the two firms in the market. This is the Cournot equilibrium. Firm is producing a profit maximizing output level given the level of output chosen by its competitor The stability of Cournot equilibrium position depends upon the slope of the reaction functions of the two firms in the duopolistic market. Whether production by the two duopolistic firms will converge or diverge towards the equilibrium position is indeterminate. Welfare generated by duopoly market structures is indeterminate but lower than that of perfectly competitive markets and higher than that of monopolistic markets Collusive oligopolistic firms charge a price and produce an output identical to that of a monopoly firm. Non colluding oligopolistic firms will, economic theory says, charge a lower price and produce a higher output. The Cournot equilibrium point is between the pure competition and the pure monopoly output-price configuration. So output produced by non-collusive oligopolistic markets is lower than that in perfectly competitive markets and price is higher The Cournot model assumes that the two duopolistic firms make output/price decisions jointly. This is unrealistic usually one duopolistic is the leader and the other is a followers. This situation is described as ‘asymmetric’. The Stackelberg model extends the Cournot model to take account of such asymmetry. The leading firms takes it’s output decision first on the basis of its estimate of the follower’s output level. The follower takes the output level of the leader as given and seeks profit maximization on this basis. This allows the leading firm to predict the follower’s output level. Total output produced in the Stackleberg equilibrium is higher and price lower than in the Cournot equilibrium ––– the Stackleberg equilibrium is therefore welfare superior. However in this situation the leader will produce a greater output and have a higher profit than the follower’s––this is the advantage of going first

If leadership is contested by the follower firms a price war may be initiated and the outcome of such a conflict is uncertain. It may result in (a) defeat of one of the firm (b) market sharing or (c) collusion. The Bertrand duopoly model seeks to determine not the equilibrium output but the equilibrium price level in a duopolistic market. These equilibrium prices would be the prices prevailing in competitive markets. Equilibrium duopolistic market prices will be equal to marginal cost. This result holds on the basis of the assumptions that the duopolistic firms are independent price setters and do not collude. This is in sharp contrast to the Cournot model finding which show that the equilibrium duopoly price and output will be somewhere between the perfect competition and pure monopoly price-output configuration The Bertrand model is unrealistic because of its assumptions of (a) product homogeneity (b) non collusion in oligopolistic markets and (c) lack of constraints on capacity expansion In Edgeworth’s model of oligopolistic markets, prices move in cycles. They never converge permanently in equilibrium. Edgeworth recognizes the reality of capitalist order constraints. Firms cannot supply to the entire market at the point where marginal cost equals price. In the face of constraints on capacity, prices must keep on fluctuating. Price wars are the natural state of existence of oligopolistic firms Collusion is inherently instable because cheating is the best option in a typical capitalist market Oligopolistic firms face a “prisoner’s dilemma”. Although duopolistic firms can both gain from collusion but they cannot trust each other, therefore both are forced to betray the other’s ‘trust’ and therefore both obtain lower profit than they would if they colluded. Collusive agreements may be unstable However collusive agreements can be stable. Firms are involved not in one shot gain but on continuous and repeated interaction. This provides opportunities for punishing those who violate collusive agreements. Implicit agreement is difficult to reach when duopolistic firms have different cost structures and different estimates of the elasticity of demand Price rigidity in oligopolistic markets is reflected in the kinked demand curve. Oligopolistic firms are reluctant to change prices when cost / demand conditions change. Above the point of the kink (the equilibrium price) the demand curve is very elastic and below it is very inelastic. The MC curve passes through the kinked segment of the MR curve. The greater the difference in the elasticity of the above and lower kinked portions of the demand (AR) curve the larger the kink. The equilibrium price and output level at the kink remains unchanged for a wide range of cost conditions. However orthodox neo classical theory does not identify the point at which the kink in the demand curve will occur The cartel represents a group of oligopolistic firms that explicitly agree on price and output levels. Firms in a cartel seek to maximize joint profits the distribution of profits in a cartel is usually determined explicitly (by the central cartel committee)

A cartel may be formed by the leading firms in a market leaving out other (usually smaller) firms. The “left out” firms are price takers. The price is the profit maximizing price of the dominant firms. A successful cartel requires inelasticity of demand on the one hand and the price inelasticity of the supply curve of the non cartel firms in the market on the other Mergers and acquisitions (M and A) are undertaken to (a) maximize shareholders value (b) maximize growth and (c) increase market power. Anti trust regulators seek to reduce oligopolistic collusion and market dominance. Anti-trust legislation to prevent “undesirable” M and A is the principle instrument used for this purpose. The Herfindahl-Hirschman Index (HHI) is used to measure market concentration. High values of the HHI are supposed to justify market regulation on obstacles imposition on M and A. Regulation may also be justified on grounds of demand inelasticity, firm inefficiency and financial viability of potential M and A participants Market regulation becomes very difficult when multi-nationals dominate a market because there is no international capitalist regulatory agency thus far in the system Review Questions “The neo classical theory of the firm does not describe real world firms in capitalist order.” Do you agree? Give reasons for your answer. Describe the main features of monopolistic markets and the demand and supply curves of monopolistic firms. With the help of diagrams, compare and contrast long run equilibrium in perfectly competitive and monopolistic markets. Are monopolistic markets necessarily “inefficient”? State and evaluate the case against state capitalist regulation of monopolistic market. Compare and contrast oligopolistic and monopolistic market structures in capitalist order. Why does economic theory recognize the need for strategic behavior in oligopolistic markets? Give an example of such strategic decision making in the Pakistan air transport industry. What is game theory? Why is a game theoretic framework useful in understanding the functioning of oligopolistic markets? Calculate the concentration ratio in the Pakistan banking industry on the basis of (a) profit (b) deposits and (c) advances. Which measure in your opinion is the most appropriate for measuring banking sector concentration? Define “Nash equilibrium. Is any market in Pakistan characterized by the possible existence of Nash equilibrium? Under what conditions would capitalist oligopolistic firms benefit from collusion? Describe the main features of the Cournot model. Under what conditions is Cournot equilibrium stable? Compare and contrast duopolistic, monopoly and perfectly competitive markets on the basis of allocative efficiency and welfare maximization using Cournot model. Compare and contrast a monopoly’s price and output determination behavior with that of (a) colluding and (b) non colluding oligopolistic firms. What are the main differences in the Cournot and the Stackelberg models of duopolistic output determination? The Stackelberg model is often regarded as more realistic. Do you agree? Does any duopolistic market exist in Pakistan?

What is meant by a “price war”? Under what conditions is it likely to occur? Suppose a price war breaks out in the Pakistan automobile industry. What will be its likely outcome? How is equilibrium price determined in duopolistic markets according to the Bertrand’s model. Contrast Bertrand’s theory with that of Cournot. Which model is more reflective of capitalist reality, Bertrand’s or Cournot’s? “The Edgeworth model describes capitalist duopolistic models most realistically.” Evaluate this claim. “Cheating is the best (profit maximizing) option in oligopolistic markets characterized by collusions.” Do you agree? Describe what is meant by “the prisoner’s” dilemma? Why does it often characterize duopolistic capitalist markets? What limits the prospects of collusion in duopolistic and oligopolistic capitalist markets? Illustrate your answer with reference to the oil distribution industry in Pakistan. How can the concept of repeated games create the possibility of collusion among oligopolistic firms? Will your answer remain the same if the game is played over a finite time horizon? “OPEC is a cartel”. What evidence can be produced to substantiate this claim? Is the Pakistan insurance industry a cartel? Give evidence for your answer. What conditions are required for the operation of a “successful” cartel? Is OPEC such a “successful” cartel? Is the Pakistani insurance industry a successful cartel too? When can mergers and acquisitions be successful? Why are they undertaken frequently in times of capitalist crisis? What are the objectives of “anti monopoly regulation”? What are the reasons underlying the continuing failure of the Competition Commission of Pakistan? P A R T F I V E Firm in Input Markets: Income Distribution Foundations and Justification of Capitalist Justice Chapter 15: Market for LandChapter 16: Market for Capital Chapter 15: Market for Land Chapter 16: Market for Capital Chapter 15 MARKET FOR LABOR The previous part of the book described the functioning of the market process in the output market. This part will seek to explain the market process in the input markets, especially in the market for labor and capital. The input market analysis outlined in this and the following chapter is meant to provide a rationalization for the distribution of income generated by the market mechanism. Neoclassical economics treats labor as one of the commodities subject to the laws of demand and supply. This chapter will begin with an outline of demand for and supply of labor and the standard economic argument in favor of allowing the markets to determine both wages and employment level. We shall then discuss the real politics behind this idealization of the market mechanism. Finally, we will illustrate the technical problems associated with the neoclassical analysis of labor markets. Labor: an inverted commodity However, before we move on to the neoclassical analysis of demand for and supply of a factor input, a small modification is required in their analytical framework. As we saw in the previous part, the demand for an output commodity is made by the consumers while its supply is made by firms. Unlike other commodities, the demand for labor is actually determined by firms while its supply is determined mainly by consumers. Thus, according to standard economics, demand for an input reflects firms’ choice to hire workers while its supply represents workers’ decision about how long to work.

15.1: Demand for Labor In A Competitive Market Given this modification, the natural way of starting input-demand analysis is to begin an explanation of the meaning of demand for an input. According to neoclassical economics the demand for factor inputs is a derived demand. The idea is that factor inputs are not valued for their own sake by consumers or firms; rather they are valuable because they can be used to produce valuable goods and services. If an input is good at producing a commodity which is not valued by consumers, the value of that input will be zero as its demand is derived from the demand for the commodities it produces. For example, the value of a Muhaddis labor or Mufassir is very little in capitalist societies because they can’t produce MBAs, engineers or scientists valued relatively highly in such societies. Therefore, in capitalist societies it is not possible to discuss demand for inputs without reference to their productivity in producing valued outputs. Remember that capitalist order ascribes values to all products and activities in terms of the contribution they make to profit maximization. Normally the muhadith cannot make much of a contribution to profit maximization and capital accumulation hence capitalist markets assign a relatively low value for his labor. However if the muhadith works to legitimize capitalist financial transactions for some Islamic bank, the value of his labor will increase dramatically. This is because his labor is now contributing significantly to profit maximization. Economists usually classify inputs into four categories: land, labor, capital and entrepreneur. The prices or rewards of these inputs are respectively called rent (r), wage (w), interest (i) and profit (π). Until the early 19th century, each of these rewards were examined by a separate set of theory. However, from the later half of the 19th century onwards, the symmetric treatment of all inputs in the production function came into fashion due to the Marginalist revolution—this point as to be discussed in detail later in this chapter. This new synthesis or framework of analyzing input markets like any other market came to be known as neoclassical economics which sees no difference between the determination of input-prices from that of other commodities. It assumes that input prices are determined in the market by the forces of demand and supply—though the difference lies in the derivation of the demand for and supply of factor inputs. This section will develop the concept of demand for labor in a perfectly competitive market under two conditions: (1) when only one input is variable; i.e. short-run analysis, and (2) when both inputs are variable; i.e. long run analysis. But before that you must understand the meaning of perfectly competitive markets for a profit-maximizing firm. The Meaning of Competitive Input Markets Recall that one of the implications of competitive markets was price-taking behavior which was the direct result of large number of sellers and homogeneity of good sold. For the input market, the assumptions are translated with the meaning that there are very many identical workers willing to supply their labor services at a given market wage rate to the firm. Neither the single laborer nor the firm can change the market wage rate determined by the forces of market demand and supply of labor. Hence, the market wage rate is given for all firms; i.e. all workers are forced to accept the market wage rate as given. This implies that the supply of labor to the individual firm is perfectly elastic as drawn in figure 15.1 which means that a firm can hire any number of workers it wants at a given market wage wo. Note that to analyze factor demand, we need to use the material from chapters 10 and 11 (production and cost) that show how a firm chooses its production inputs.

Figure 15.1: Typical firm facing labor supply curve in a competitive marketL0WageSL(labor supply curve facing a single firm)wo Figure 15.1: Typical firm facing labor supply curve in a competitive market L 0 Wage SL (labor supply curve facing a single firm) wo 15.1.1: Factor Demand with One Input Variable Given this, now ask yourself the question ‘when is it profitable for a firm to hire a worker?’ The answer is: the firm will hire a worker only if additional benefits of hiring outweigh its costs. This means that we need to compare the benefits and costs of hiring a worker. The cost of hiring a worker is simply the wage rate (w) the firm pays to the worker. For example, if the market wage rate is Rs 200/day and the firm employs one worker, then its cost will increase by Rs 200—i.e. the marginal cost of hiring one worker is Rs 200/labor. So we have a measure of the cost of hiring a worker for a firm. What about the benefits of employing a worker? Of course the benefit of hiring a worker stems from the fact that he adds to the production of goods and services for the firm. So we can say that the benefit of hiring a worker to the firm is his marginal product (MPL). For example, if a worker produces 10 tables a day, then his marginal product is 10. The problem that now arises is we can’t compare the productivity of an input (MPL) with its cost (w). To see why, try to compare the above given numbers. We said that the marginal product of a worker is 10 tables per day while its marginal cost is Rs 200 per day. How can you compare 10 tables with Rs 200? Of course there is no way of comparing tables with rupees without converting the value of tables into rupees. This means that we need to multiply the productivity of labor with the price of output in order to obtain a measure of its benefits. Thus, if, say, the market price of a table is Rs 25, then the value of output produced by a worker will be Rs 250 (=10 tables × Rs 25 / table). Multiplying the output produced by an input (MPL) with the price of output we get value of marginal product (VMP) of that input—sometimes also called marginal revenue product (however we will a make distinction between the two due to the reasons explained later). VMP simply indicates the change in revenue resulting from the sale of output produced by one additional input. Algebraically speaking, value of marginal product is given by: VMP = P × MPL Since the value of the marginal product is defined as change in revenue due to change in labor, we can write this as: (15.1) Since, as discussed in chapter 10, the marginal product of labor is assumed to keep decreasing as additional labor is hired with fixed capital, while the price of output (P) is fixed in expression (15.1), the value of marginal product of an input is also a decreasing function as shown in figure 15.2. Note that VMP-curve is above MP-curve because price (P) of the output is positive (hence when multiplied by MP will yield a higher value). We are now in a position to understand the answer to the question: ‘when is it profitable for a firm to hire a worker?’ A profit maximizing firm will hire a worker only if the value of marginal product of that worker is greater than his wage (i.e. its marginal cost). In our example, since the VMP of worker, say Nomi, is Rs 300 while his hiring cost is Rs 200, it is profitable for the firm to put him in the production process. Suppose Farooq is another worker who can produce only five tables a day. His VMP will be Rs 125 (= 5 tables × Rs 25 / table).

Figure 15.2: Relation between marginal product and value of marginal productL (labor)0MPL, VMPLVMPLMPL Figure 15.2: Relation between marginal product and value of marginal product L (labor) 0 MPL, VMPL VMPL MPL Since the wage rate is fixed for all workers, so he also costs Rs 200 to the firm. Because his VMP is less than the wage rate, the profit-maximizing firm will not hire Farooq. Hence we can derive the following rules for a profit maximizing firm: Hire more of an input if VMP > w Don’t hire (or fire) an input if VMP < w This means that the profit is maximized when the firm hires input up to the level where value of marginal product is equal to the wage rate. So the profit-maximizing demand condition for a firm in the input market is: (15.2) Table 15.1 uses some numbers to illustrate this point. Here the value of the marginal product of the first two laborers is greater than the wage rate. Therefore, the profit of the firm will increase if it hires these two laborers. However, hiring the fourth worker is not profitable. Table 15.1: Hypothetical data of a firm’s demand Labor Units (L) Marginal Product (MPL) Price of output (P) Value of Marginal Product (VMPL) Wage rate (w) Firm Decision 1 12 25 300 200 Hire more 2 10 25 250 200 Hire more 3 8 25 200 200 Equilibrium hiring 4 6 25 150 200 Don’t hire The firm will incur losses by hiring him. Therefore, the profit-maximizing level of input demand is where VMP is equal to wage rate. Figure 15.3 shows the equilibrium point of the firm at point E where VMP equals wo. To the left of E, VMP is greater than the wage rate (VMP > w), hence the firm can make profit by hiring more workers. On the other hand, VMP is less than the cost of hiring workers (VMP < w) to the right of E, therefore profits are reduced. It follows that only at point E profits are maximum. The firm employs Lo workers at this equilibrium point. We can conclude from this analysis that the MRP-curve is the demand curve of a firm for a single variable input; i.e. its short run input demand curve. Figure 15.3: Equilibrium input demand by a competitive firmLLo0Rs/unitSLVMPLEwo Figure 15.3: Equilibrium input demand by a competitive firm L Lo 0 Rs/unit SL VMPL E wo The Shut Down Rule Revisited However, a little qualification needs to be made in the above proposition regarding the input-demand curve. The qualification is related to the shut-down rule. Consider figure 15.4 where we have drawn the VMP curve along with the average revenue product curve (ARPL = P × APL). You should be able to recognize that this diagram is merely a reflection of figure 10.7 in chapter 10. The ARP-curve gives the revenue per-worker: (15.3) Expression (15.3) is based upon the facts that AP equals output per unit of labor and total revenue equals price times output. The ARP-curve can easily be seen indicating short-run shut-down decision for a firm. Chapter 12 outlined that a firm should operate only if the revenue exceeds variable cost; i.e. the total cost of the variable factor: Operate if Total revenue ≥ VC Because labor is the only variable factor in our analysis, so the variable cost consists only of wage bill:

Operate if Total revenue ≥ wL Dividing both sides gives us shut-down (as well as operation) decision per unit of labor: Operate if or Operate if (15.4) This says that if the wage rate rises above the top of the ARP-curve, as is the case above w*, then the firm should stop producing in the short-run. Thus, the VMP-curve is the demand curve for labor only at w* or below w*. The lighter parts of the two curves are no longer applicable into the firm’s decision making. Figure 15.4: Short-run demand-curve of a factor for a competitive firmLL*0Rs/unitSLARPLhw*VMPLShort run demand curve for labor Figure 15.4: Short-run demand-curve of a factor for a competitive firm L L* 0 Rs/unit SL ARPL h w* VMPL Short run demand curve for labor Digression on Similarity between Input-Output Markets Before moving ahead, you should note an important similarity between input and output market equilibrium conditions for a firm as specified by microeconomic theory. The factor market equilibrium condition says that VMP should be equal to the wage rate: (15.2) While the output market profit-maximizing position is that marginal revenue should be equated with marginal cost of production: Dividing (15.2) by MPL we get: Since price equals marginal revenue for a competitive firm, we can write this as: (15.5) According to expression (11.10) from chapter 11, the right hand side of the above equation is the MC of production. So the above condition reduces to: The equation (15.5) states that both the hiring and output choice of the firm is dictated by the same rule: choice of input or output is determined at levels where the marginal revenue (from the sale of output) equals the marginal cost (from the purchase of inputs). Changes in Input Demand Consider what happens to labor demand if the wage rate increases from wo to w1. You can see in the left hand panel of figure 15.5 that labor demand decreases to Lf as equilibrium point shifts to point f. We thus see that the demand for a factor input is negatively related to its price. Now think of the effects of an increase in output price P on input demand. Clearly this will shift the value of marginal product outward as shown in panel (b) of figure 15.5. The equilibrium moves to point g which implies an increase in input demand to Lg. This means that input demand is increasing as output prices increase. Changes in the use of capital services, the fixed factor, will also affect variable input demand in a similar fashion the output prices—increase in capital stock will make each unit of labor more productive, hence the VMP-curve will shift outwards. Hence we can state the short-run demand for a factor as: (15.6) which says that short-run demand for a factor, say labor, is a function of input and output prices as well as amount of capital stock used. Figure 15.5: Changes in input demand by a competitive firm(a) Effect of increase in input priceLLo0Rs/unitSLoVMPLwoSL1fw1LfLLo0Rs/unitSLoVMPoEwogShift in VMP-curve due to change in PLf(b) Effect of increase in output priceVMP1

Figure 15.5: Changes in input demand by a competitive firm (a) Effect of increase in input price L Lo 0 Rs/unit SLo VMPL wo SL1 f w1 Lf L Lo 0 Rs/unit SLo VMPo E wo g Shift in VMP-curve due to change in P Lf (b) Effect of increase in output price VMP1 15.1.2: Factor Demand with Two Inputs Variable Demand for a factor input becomes more complicated when we have choice involving two variable inputs. In this case, the value of marginal product is no longer the input demand curve of a firm because a change in the price of one factor leads to changes in the use of the others. This second change can shift the marginal product curve of the input whose price initially changed. In fact, the change in, say, the wage rate can be decomposed into two effects: substitution effect and output effect. The algebra of this decomposition is: (15.7) The problem is how to sign the two effects on the right hand side. Substitution Effect of an Input Price Change The substitution effect is a straight forward one. Consider figure 15.6 where 0A is the original expansion path of the firm which shows the cost-minimizing input combinations for producing different levels of output at given input prices, wo, io. What if wage rate decreases? Clearly, at any given level of output the effect will be to bias the input-choice towards substituting more labor for the now relatively expansive factor; i.e. capital. Keeping output constant at Ya we can isolate the pure-substitution effect of a change in input price. The shift in the expansion path is unambiguous as shown in the figure. Reduction in the wage rate decreases the slope of the iso-cost line and it becomes flatter (the dotted line). The tangency moves from A to B with an increase in the use of labor associated with the decrease in wages. The new expansion path 0B employs more labor to produce the same amount of output, at all levels of output. Thus the substitution effect has a negative sign: (15.8) Figure 15.6: Substitution effect of an input price change is negative0LKOriginal Expansion pathKaLaBAYaNew Expansion path with lower wagesLbKb Figure 15.6: Substitution effect of an input price change is negative 0 L K Original Expansion path Ka La B A Ya New Expansion path with lower wages Lb Kb Output Effect of an Input Price Change The output effect is, however, not so much direct. Before we can determine the sign of the output effect, we must understand the effect of changes in input price on marginal cost of production. Recall from chapter 11 that the marginal cost is given by: Also from the cost-minimization condition (11.6) we have: (11.6) or This implies the symmetric form: (15.9) This equation can be used to study the effects of increase in factor price on marginal cost. Consider the decrease in the wage rate. When w falls, the firm will wish to substitute labor for capital along any iso-quant. The substitution of labor for capital causes the marginal product of labor to drop (because more of labor used) and that of capital to increase (because now less of it is employed). Given the marginal cost equation (15.8), say, in terms of capital:

Figure 15.7: Output effect of a factor price change is negative0YRs / unitPaYaAMCoYcMC1C0LKKaLaBAYaNew Expansion path with lower wagesLbKbYcCLc Figure 15.7: Output effect of a factor price change is negative 0 Y Rs / unit Pa Ya A MCo Yc MC1 C 0 L K Ka La B A Ya New Expansion path with lower wages Lb Kb Yc C Lc An increase in the denominator, with the numerator fixed, means the ratio must go down. This means that an increase in the wage rate will cause marginal cost to fall at all levels of output. Thus, marginal cost curve will shift down from MCo to MC1 as shown in the left hand panel of figure 15.7. What, then, is the output effect of a wage decrease? Given that a fall in wage rate shifts the MC-curve to the right, the profit-maximizing supply of the firm increases from Ya to Yc. The relevant iso-quant is now Yc, to the right of Ya. The new tangency point for Yc iso-quant is attained at a higher iso-cost line, say at point C. Thus, the output effect (from B to C) is a negative relation between the price and the use of any normal factor—factor whose use increases with the increase in output. Putting this together with the substitution effect (from A to B), we can sign the total effect (from A to C): so because each of the two terms added together are negative. The vigilant students will notice that the analysis in this section is very similar to the effects of a price change on the demand for a commodity discussed in chapter 8. This decomposition of the total effect of a factor price change tells us that the slope of the factor demand curve must be negative. Again, the independent variables determining the choice of productive factors (in a competitive market) are the prices given by the market—both of inputs and output. (15.10) Graphing the use of labor against wage rate (L-w space) produces a labor demand curve. How would this labor demand curve be different from the one we discussed above (with one input variable); i.e. why is a VMP-curve not the labor demand curve for a firm in the long run? We have just seen that a fall in wage rate motivates a firm to expand its capital equipments in the long run (compare the use of capital at points A and C) in figure 15.7. This will cause the marginal product of labor to increase because now there is larger quantity of capital with which labor is combined. Increase in MPL shifts the MP-curve to the right. This means that a fall in factor input price, given the output price P, causes the VMP-curve to move to the right when more than one inputs are used in the production process. This is shown in figure 15.8 where initial equilibrium is shown at point A at wage wa. As wages fall to wb, the equilibrium moves to point BS in the short run at the given VMP-curve, VMPo. But the VMP-curve shifts to VMP1 in the long run. The long run equilibrium point is attained at point BL with LL quantity of labor demanded. The locus of points A and BL is the long-run demand for an input by a firm. You should note that the long run demand for input is more elastic than both of the VMP-curves. This greater elasticity of the long run labor demand curve reflects the fact that firms can substitute capital for labor in the production process. FYI Box 15.1 summarizes the key factors responsible for the determination of demand for a factor input by an individual firm.

Figure 15.8: Long-run demand for a factor by a competitive firmLLa0Rs/unitDLVMP1AwaVMPoBSBLLsLLwbLong-run labor demand curve Figure 15.8: Long-run demand for a factor by a competitive firm L La 0 Rs/unit DL VMP1 A wa VMPo BS BL Ls LL wb Long-run labor demand curve F Y I B O X 15.1 Determinants of the Demand for an Input The demand for a factor input depends upon the following variables: The price of the input in question—the higher the price of an input, the lower its demand and vice versa Marginal product of the input—the higher the productivity, the higher the demand for an input Price of the commodity produced by the input—the higher the output price, the higher will be the demand for input Quantity of the other factors combined in the production process—increase in capital stock increases the marginal product of labor and hence its demand Prices of the other inputs—as changes in other inputs prices affects the demand for an input Technological progress—improved technology increases the marginal product of an input and thereby its demand 15.1.3: Market Demand for an Input The next step is to derive the market (or industry) demand curve for an input by all the firms. Algebraically, at each wage rate the competitive market demand curve for an input is the sum of the demands by each of the i firms: (15.11) However, a small qualification should be noted rather carefully regarding the summation of individual firm’s demand curve to obtain market demand for an input. Remember that the market demand for an input is not the simple aggregation of individual firms’ demand for input. This is so because when the price of an input falls, all firms, and not any single firm, in the industry will seek to hire more of this input. Consequently, hiring of more inputs by all firms will lead to more output produced by the industry. The supply curve of this commodity shifts to the right implying a fall in its market price. Since output price is one of the factors determining input demand, the VMP-curve will shift to the left in response to fall in output price. For example, when the wage rate is wa, the firm is at point a on VMP-curve VMPo in figure 15.9. Summing up the labor demand by all firms at wa, we obtain the market demand at point A in the right hand panel. Now suppose the wage rate decreases to wb. If only a single firm were to change its demand decision for input, it would move along VMPo to point like b employing Lb workers. However, since the wage rate has decreased for all firms in the industry, price of the output falls which causes the VMP-curve to shift from VMPo to VMP1. This means that after the fall in wage rate, the firm finds its equilibrium at point c, and not at b. By aggregating horizontally the demand for all firms we obtain point C in the right hand panel. However, if the fall in output price was not taken into consideration, one would over-estimate the demand for labor at point B as shown by the lighter line in the right panel. It should be noted that point B is no longer relevant to the market demand curve for labor. The relevant market labor-demand curve is the darker line in the right hand panel.

Figure 15.9: Deriving market demand curve for an input0LRs / unitLAAHorizontal sum with product price unchangedLBwawbBCLCActual market demand curveShift in VMP due to change in output price0LRs / unitLaaVMPoLbVMP1wawbbcLc Figure 15.9: Deriving market demand curve for an input 0 L Rs / unit LA A Horizontal sum with product price unchanged LB wa wb B C LC Actual market demand curve Shift in VMP due to change in output price 0 L Rs / unit La a VMPo Lb VMP1 wa wb b c Lc 15.2: Supply of Labor: The Ideology of The Indifferent Worker In this section we will seek to derive the supply curve of labor. The labor supply decision is seen as an individual’s choice between work and leisure. In fact the labor-leisure choice is itself an outcome of what economists call the ‘time allocation problem’. 15.2.1: Time Allocation Problem The basic idea is that an individual has available with him 24-hours a day to allocate among different set of activities. A person’s options to do with time are reduced to two uses: market labor (or work) and leisure. Both of these activities are seen as mutually exclusive. Work or labor hours refer to the amount of time an individual chooses to offer to the market at a specific wage rate, whereas the time spent off the job is leisure. To graph this choice of an individual, we will make use of the ‘leisure-income’ space. Figure 15.10 shows the basic set up for analyzing time allocation problem of an individual according to microeconomic theory. Note that there is an upper limit to the availability of time to an individual—maximum of 24 hours a day, 168 hours a week and so on. That is why we have drawn a vertical line at 168-hours mark. Also note that each point in this space represents not only the amount of leisure hours (R) but also the number of work hours (L) along the horizontal axis. For example, point A (120, 48) represents a consumption of 120 leisure hours per-week. This means that the worker would be spending the remaining 48 of 168 hours at market work or labor; i.e. 168 – 120 = 48 hours. Since work (L) and leisure (R—for rest) are mutually exclusive and exhaust the possible uses of time, we have the condition: (15.12) The linear relation between L and R implies that we can measure both labor as well as leisure hours along the horizontal axis. The origin for labor hours is at the 168 point with R = 168 and L = 0—the work hours are measured from right to left in this diagram. Figure 15.10: Set up of the time allocation problemR (Leisure hours)1200IncomeA480168L (work hours)048Io68010068B Figure 15.10: Set up of the time allocation problem R (Leisure hours) 120 0 Income A 480 168 L (work hours) 0 48 Io 680 100 68 B Preferences for Leisure and Income Figure 15.10 also depicts a normally shaped indifference curve Io passing through point A and B. This curve shows the ‘preference’ of the individual between leisure and income. For example, Nomi is indifferent between points A and B—i.e. between the options of ‘120 hours of leisure and 48 hours of work’ which earns him an income of Rs 480 per week’ and ‘100 hours of leisure and 68 hours’ from which he earns Rs 680 per week’. Both these options, A and B, are valued equally by the individual because they yield equal utility to him—these points fall on the same indifference curve. The indifference curve for leisure-income choice is drawn convex to the origin for the same reason it was so drawn for the choice of consumption goods discussed in chapter 6—as an individual has less and less amount of leisure available to him, the marginal utility of leisure hours keeps on increasing to him and, thus, he requires increasing amounts of income to sacrifice one extra hour of leisure for work. Also note that the indifference curve ends after hitting 168-hours line because no choices are available beyond this point.

Budget Set for Leisure and Income Suppose that the only way Nomi can get money to spend is by selling his labor services in the market at a competitive wage rate, say wo. This means that the market offers Nomi a wage rate w per hour, and he can choose his preferred number of hours to work. In other words, as a capitalist worker Nomi is a quantity-adjuster in the competitive labor market. Figure 15.11 depicts the standard budget set AR for the capitalist worker. Figure 15.11: Solution of the time allocation problemAR (Leisure hours)Re = 1230IncomeE45w =Me168L (work hours)0Le = 45Io168wR Figure 15.11: Solution of the time allocation problem A R (Leisure hours) Re = 123 0 Income E 45w =Me 168 L (work hours) 0 Le = 45 Io 168w R To understand how it is generated, think of moving from point R towards the origin 0. In this movement, the leisure hours are decreasing while the work hours are increasing thereby. When Nomi moves left from R, each hour spent on working earns him w amount of income. This income is measured along the vertical axis. The budget set can now be expressed by an equation: which says that the income of the worker equals the number of work hours times the market wage rate. Making use of the relation , we can insert leisure (R) as an argument in this equation: The right hand side expresses the sources of income for the capitalist worker. To convert this equation into standard form (having two commodities on the left hand side) given the fact that we have R and M on our two axis, just bring the second term to the left side: (15.13) This equation has a clear economic meaning. The left hand side says that the price of an hour of leisure is w—i.e. a capitalist worker has to ‘buy leisure’ at a price of w. This is so because in order to enjoy an hour of leisure, capitalist worker reduces his market work by one hour which costs him a loss of income by w amount. So the left hand side of expression (15.13) states the trade-off between leisure and income. The budget line AR has a slope of –w which measures the rate at which a capitalist worker can substitute leisure for income. The right hand side tells us that the total resources available to a worker for allocating between work and leisure are 168w—the capitalist worker is actually being paid for each and every hour of his life. The right hand side is therefore called worker’s full income. The kind of thinking expressed here will definitely seem odd to a non-capitalist individual, say a religious person like Abdullah. However, this clearly reflects the true essence of rationality underlying economic science—it simply assumes that all of the resources available to society (whether physical or human) are originally meant for and should be subject to the accumulation of capital, and any deviance in the use of resources from this end actually reflects a cost to society. Economic science motivates you to devote your each and every single hour to make money in the market; i.e. contribute to profit / welfare maximization. If you happen to spend an hour away from the capitalist work, it asks you to treat it as a ‘cost’ generating activity by calculating its opportunity cost. For example, if Abdullah devotes an hour to offer prayer, or to serve his parents, or may be to visit his relatives, economic rationality demands that he should consider these activities as ‘costs’ since he could have made money by working in the market instead of indulging in such non-market activities. Participation in non-market activities may be rational provided they are expected to generate higher levels of income in the future, such as students in pursuing capitalist academic disciplines, e.g. business administration, science or engineering etc. Given this conception of rationality, it is no surprise that we see the downfall of the family system in America and Europe where the capitalist rationality has assumed the dominant expression in the lives of overwhelming majority of individuals.

We should remind ourselves that the analysis of input demand and supply presented by microeconomic theory is quite useless when we consider factor pricing in non-capitalist societies. Thus, the Prophet (SAW) has described the laborer as “God’s beloved” and in his great work Ihya-ul-Uloom al-deen Imam Ghazali (RA) describes the purpose of all work–––tilling land, craftsmanship, merchandizing, soldering, public administrative service–––‘as means for acquiring the pleasure of Allah’. Production and trading, like praying and almsgiving, are seen as religious activities in both Islam and Christianity. In both Christian and Islamic societies, the level of wages and the length of the time period devoted to production and markets were not determined on the basis of considerations of utility maximization by labor and profit maximization by merchants and traders. Indeed wage labor was a rarity in non-capitalist Islamic and Christian societies where a large proportion of the labor force was self employed. Choice for Leisure and Income The choice of the capitalist worker along the budget line AR occurs at the tangency point between the budget line and his indifference curve. This is shown at point E where he chooses to work for, say, 45-hours a week and enjoys 123-hours in leisure. His income will equal 45w (say Me) amount. 15.2.2: Changes in Labor Supply Let’s analyze the effects of an increase in market wage rate, say from w to w*, on the work decision of the capitalist worker. The budget line will get steeper to become BR in this case rotating around the point R in figure 15.12. This is the case because each hour offered for work will now bring him a higher wage rate than before. What happens to the equilibrium of worker; i.e. in what direction will he change his work-leisure decision? The increase in wage rate creates two effects: the substitution effect: leisure now becomes more expansive to consume (as the forgone wage has increased). This will induce the worker to substitute work for leisure which means lower consumption of leisure and more hours for work the income effect: since the worker is a seller of labor services, the higher price for labor increases his income. If leisure is a normal good, then its demand will increase after increase in the wage rate which will reduce the supply of labor This means that the substitution and income effects of a wage change work in opposite directions on the labor supply decision of a worker. The total effect will, thus, be indeterminate. Let us develop this analysis to illustrate this point more clearly. Substitution Effect of a Wage Change The substitution effect is examined by projecting the new price budget line at the old demand point. In figure 15.12, the substitution budget line is CD passing through the old demand point E. The expected substitution away from leisure is observed from E to F along CD. This change is expected because as the price of leisure (the wage rate) increases, the worker is motivated to substitute leisure with more work hours as the new equilibrium is to the left of E at F. Thus, the substitution effect is negative with respect to leisure—increase in wage decreases the consumption of leisure by a worker (alternatively increases the supply of labor).

Figure 15.12: Substitution effect of a wage increaseEAR (Leisure hours)Re0Income45w =Me168L (work hours)0Le168wRB168w*DCFRfLf48w =Mf Figure 15.12: Substitution effect of a wage increase E A R (Leisure hours) Re 0 Income 45w =Me 168 L (work hours) 0 Le 168w R B 168w* D C F Rf Lf 48w =Mf However, you should note that the separation of the substitution effect of a wage change is not only irrelevant but also unintuitive—a point not often discussed in the standard economics text books. To see why, note that when the budget line is determined by relative prices and income of the consumer, as is the case in the choice of goods discussed through chapters 6 to 8, we can hypothetically change income of the consumer to keep him on the original equilibrium point. On the other hand, in the case of time allocation problem, the y-intercept of the budget set is determined by the wage rate but its x-intercept is given by the maximum physical number of hours available in a week. No doubt that the budget line, in this case, can be pivoted by altering the wage rate, but it cannot be moved in or out by changing the length of the day—this as far a physical impossibility. You can see in figure 15.12 that it is exactly this unintuitive shift in the budget line that is required to separate the substitution effect of a wage change (look at the x-intercept of the substitution budget line CD which is less than 168 hours). Consequently, it makes no sense to separate the effect of a wage change partly into the substitution effect. Similarly, the fact the substitution effect will always induce more work hours is irrelevant in the sense that everyone will always have 168hours to allocate between work and leisure—there is no point in ‘substituting’ here as it is simply a negative linear relation between the two. Income Effect of a Wage Change The income effect is shown by shifting the substitution budget line CD to the actual new budget line BR in figure 15.13. If both income and leisure are normal goods, their demand will increase due to increase in the wage rate. This means that the tangency point at budget line BR will fall to the right as compared to point F, such as at G. Since this point falls between E and F, this means that the negative substitution effect is greater than the positive income effect. Therefore, the demand for leisure has decreased in total (and supply of labor has increased) while moving from E to G. Figure 15.13: Income effect of a wage increase with substitution effect larger than income effectEAR (Leisure hours)Re0Income45w =Me168L (work hours)0Le168wRB168w*DCFRfLf MfGRgLg Figure 15.13: Income effect of a wage increase with substitution effect larger than income effect E A R (Leisure hours) Re 0 Income 45w =Me 168 L (work hours) 0 Le 168w R B 168w* D C F Rf Lf Mf G Rg Lg However, there is no guarantee that the point G will fall to the left of point E. The equilibrium can also move to its right at point H as shown in figure 15.14. In this diagram, the positive income effect more than offsets the negative substitution effect which results in an increase in the consumption of leisure (and a fall in labor supply) following a wage rise. Figure 15.14 shows the possibility of having a negatively sloped labor supply curve as the work hours have been reduced from Le to Lg after increase in the wager rate. If we draw the points E and H in a labor-wage space, we will see a negative relation between wage rate and supply of labor in the market as shown in figure 15.15. This possible negative slope of labor supply curve is termed a backward bending labor supply curve.

Figure 15.14: Income effect of a wage increase with income effect larger than substitution effectEAR (Leisure hours)Re0Income45w =Me168L (work hours)0Le168wRB168w*DCFRfLfMfHRhLh Figure 15.14: Income effect of a wage increase with income effect larger than substitution effect E A R (Leisure hours) Re 0 Income 45w =Me 168 L (work hours) 0 Le 168w R B 168w* D C F Rf Lf Mf H Rh Lh Note that figure 15.15 draws two regions for labor supply curve: initially positively sloped and then bending backward at higher wages. What is the meaning of this typical labor supply curve? Slope of the Labor Supply Curve Of course, according to standard economic theory, joining all price-consumption points for all wage rates in a wage-labor space generates the labor supply curve. The labor supply curve is shown to be positively sloped initially on the assumption that when wages are relatively low, increase in wage rates induces a worker to supply more labor hours in the market. But as wages become high enough, say at point G, a further increase in wage rates will be followed by a reduction in working hours because the worker has achieved a certain minimum standard of living. Suppose Nomi’s existing wage rate is Rs 1,000 per hour and you are choosing to work 8-hours a day (hence making Rs 8,000 a day). A further increase in your wage, say to Rs 2,000 an hour may actually induce you to work for less number of hours, say 6-hours a day, because now this will earn you more amount (Rs 12,000 a day) than working 8-hours at initial wage rate. Economists claim that by aggregating such well-behaved labor supply curves of all workers we can obtain the market supply of labor which looks like the curve drawn in figure 15.15. Figure 15.15: Typical labor supply curve with backward bending regionL (Work hours)Le0w (wage rate)SLHweEGLhLgwgwh Figure 15.15: Typical labor supply curve with backward bending region L (Work hours) Le 0 w (wage rate) SL H we E G Lh Lg wg wh 15.3: Equilibrium in the Labor Market We have once again developed the two blades of the scissors. Given the input demand and supply curves, a competitive labor market is in equilibrium when the wage rate clears the market; i.e. quantity demanded of labor equals its supply. Figure 15.16 shows such a point at E where equilibrium or market wage rate is we and the employment level is Le. Since each point of the labor demand curve measures the benefits of hiring an additional unit of labor (i.e. VMP) and the wage rate reflects the cost of employing a laborer, the marginal benefits (the VMP) and marginal costs (the wage rate) are equal at point E. According to economic theory, any intervention in the market mechanism will create inefficiency and hence is undesirable. Application Box 15.1 gives an example of using labor market model to tackle an issue of shortage of labor in a competitive market. Figure 15.16: Labor Market EquilibriumL (Work hours)Le0w (wage rate)SLEweDL Figure 15.16: Labor Market Equilibrium L (Work hours) Le 0 w (wage rate) SL E we DL A P P L I C A T I O N B O X 15.1

Shortage of PhD Faculty in Public Universities in Pakistan The Higher Education Commission (HEC) has been struggling hard for about a decade years to hire PhD faculty for public universities. The objectives behind the HEC move are to make postgraduate studies at public universities more successful and more rigorous. However, the HEC has found it difficult to attract many PhDs because the private sector universities usually offer a much more handsome salary package as compared to public universities. In order to attract the PhD faculty and eliminate the shortage, the HEC has introduced the Tenure Track System (TTS) which promises a competitive salary package to the PhD faculty but imposes strict conditions (e.g. the faculty member must produce two quality research papers every year and so on). Such conditions, though justifiable, have made PhD faculty reluctant to opt for TTS—of course, why accept any conditions when the private sector is ready to offer the same amount without any conditions? An important aspect of market wage determination is the emergence of economic rent at the equilibrium point. Economic rent is the payment for a factor over and above what is required to keep it in its current use; i.e. the difference between the payments actually made to an input and the minimum amount that must be paid to keep it in its current use. Figure 15.17 makes this point. The equilibrium wage rate is we and equilibrium quantity of labor supply is Le. At this point, the total payments actually made to the workers are equal to the wage rate (0we) times the number of workers employed (0Le). So: Payments made to workers Figure 15.17: Economic rent arising in competitive labor marketsL (Work hours)Le0w (wage rate)SLEweDLAEconomic Rent Figure 15.17: Economic rent arising in competitive labor markets L (Work hours) Le 0 w (wage rate) SL E we DL A Economic Rent This payment can be divided into two parts. To see how, first recall that the upward sloping labor supply curve gives the information about the amount of labor that will be supplied at each level of the wage rate. This means that the minimum amount required to employ 0Le labor in the market is given by the area below the labor supply curve SL to the left of equilibrium labor supply Le: Minimum Payments needed for 0Le workers = Now note that in a competitive labor market, in fact all workers receive this equilibrium wage rate we. But this wage rate is needed to obtain only the marginal (or last) worker. This means that all infra-marginal workers earn payment over and above what is needed to employ them in the market. Thus, the remainder amount is the economic rent flowing to the workers as a group: Economic Rent = Amount Actually Paid – Amount Needed to be Paid This is shown by the shaded area in this diagram. The economic rent, in this sense, can be interpreted as producer’s (or factor’s) surplus, as Alfred Marshal termed it. This discussion makes it clear that a factor input, such as labor, receives an economic rent as long as its supply is less than perfectly elastic; i.e. as long as it is not a flat curve. You can see it by drawing a diagram yourself that economic rent will be zero with a flat labor supply curve. Thus, the more inelastic the supply of a factor input, the larger will be its economic rent.

As a corollary, this means that if a factor input has perfectly inelastic (or fixed) supply, all of its payments will be economic rent because the input must be supplied no matter what price is actually paid—its present use is not affected by whether its price is high or low. Alternatively, such an input will have no opportunity cost as it has no alternative usage. The supply of land may be seen as one of such factors because total area of productive land is available in fixed amount at any point in time. Figure 15.18 illustrates the case for such an input. With the supply of rental houses fixed at SLf, its price (also termed as rent) is completely determined by the demand conditions. For example, if demand for rental houses increases to D1, their price increases to r1. The economic rent paid to rental house owners would thus increase from an amount EoSLf0roto E1SLf0r1. Figure 15.18: Economic rent of a perfectly inelastic input, e.g. landRental Houses0r (rental rate)SLfE1r1DoD1roEo Figure 15.18: Economic rent of a perfectly inelastic input, e.g. land Rental Houses 0 r (rental rate) SLf E1 r1 Do D1 ro Eo 15.3.1: The Politics behind Labor Market Analysis We discussed the politics behind studying perfectly competitive product markets in chapter 12. Let’s briefly discuss the underlying politics advocated by neoclassical economists via their input market analysis. When capitalist market structure emerged after the fall of Christian societies in Europe, it brought with it one of the most striking aspects of ever increasing inequality among the poorest and the richest. These social inequalities raised questions about the desirability and justice of capitalist order. Some theorists argued for over throwing market capitalism in favor of some other variants of capitalism (such as socialism). Economists right from the time of Adam Smith have been struggling to justify the market mechanism—i.e. they seek to prove that market outcomes are the most just. Smith tried to prove that the income distribution generated by market forces is exactly the one that would prevail in natural (non market order) order. Similarly, Malthus also argued that income inequalities arose from the laws of nature itself. However, it was not until the development of neoclassical economics in the later half of the nineteenth century that a full fledge justification for naturalizing social inequalities was offered. The model of wage determination discussed in this chapter is a representative of neoclassical analysis that attempts to rationalize social inequality of capitalist society. Two of its features deserve brief description. ‘Can’t Beat the Markets’—disintegrate the unions Economists like Ricardo and Sraffa believed that the determination of wages had nothing to do with the productivity of workers. Rather, to them, wages are determined by the bargaining process (or by natural and biological laws to Ricardo) between unorganized masses of laborers and organized group of firms. Since, according to these economists, firms are more organized and powerful as compared to workers, this means that the decisions about who is to be employed and at what wage rate are not the outcomes of anonymous market forces. These decisions are products of the power struggles where people are discriminated against and exploited by the firms. From this argument, these economists legitimize the need for assisting unemployed workers through union collective bargaining and state institution.

However, in order to deny these political rights to the workers, the neoclassical model of demand and supply points out that the wages paid to the workers are actually determined by impersonal forces of the demand for and supply of labor. Hayek, one of the leading theorists of liberalism, says that within market, distribution of income and input prices are not designed by the intentions of any single individual and that no single individual can foresee what each participant will get in the market. Therefore, the distribution of income generated by the market mechanism cannot be regarded as just or unjust unless proved that it was created by fraud, violence or special privileges. It is for this reason that Hayek proposes the term ‘dispersion’ rather than ‘distribution’ of income because, he believes, no one distributes income in a market order. If a government attempts to improve workers’ incomes by imposing minimum wage laws, then this will create unemployment (see chapter 4). The neoclassical model of wage determination maintains that state intervention in the labor market in the name of protecting workers via minimum wage laws actually hurts the cause of workers themselves. Thus, no one can do better for workers than the market! Based on this analysis, neoclassical economists like Hayek reject trade unions, which they term labor monopolies. They believe that trade unions are a greater threat to the smooth functioning of competitive market order than monopoly firms because, while monopoly firms are treated as ‘bad’ and hence subjected to strict regulations; trade unions are usually given special privileges—privileges not enjoyed by any other association or individuals in capitalist societies—in the form of complex discriminatory laws. Further, they believe that these laws are usually used against the workers themselves by denying them the right of free association and free movement. These economists feel that such powers of unions are no longer a reflection of the fact that they are paid less than their productivity in the market, but a result of the false general acceptance of the views in the field of labor policy that it is in the public interest to comprehensively and completely organize labor, and that in the pursuit of this aim the unions should be as little restricted as possible. However, the economists’ normal opposition to labor unions, to interventionist labor market policies and to attempts to reduce income inequalities is not very well grounded, as we will see in the next section. A case for unionized labor can be presented following exactly the standard microeconomic logic. To Each According to his Contribution While many intellectuals disliked market capitalism for engineering social inequalities, neoclassical economists ask us to celebrate it as an objective reality: ‘the best of all possible worlds’. Their economic model argues that the growing gap between the poor and the rich is simply the reflection of the higher productivity of those who get higher returns in the market. So the second piece of advice for policy makers stemming from neoclassical labor market analysis is that a person’s income is determined by his or her contribution to the profit making production process. Market wages simply reflect the marginal productivity of workers. Given the propositions that (a) wages are determined by impersonal market forces and (b) wages reflect the contribution of workers to output, thus lends support to the argument that highly paid workers (such as managers of large corporations, stock and money market traders and brokers etc.) deserve these high payments simply because these economic agents are more productive than workers, such as manual laborers. Another important aspect of market wages is that not only do they incorporate the productivity of workers but also reflect their voluntary participation in the labor market process because the very activity of ‘supplying labor in the market’ simply reflects workers’ freely determined preferences towards work and leisure. The emergence of ‘economic rent’ at equilibrium wages, as shown in figure 15.17 then shows that participation in labor markets makes workers better off than not participating in it. This implies that labor markets are not a source of subjugating or exploiting workers. Quite contrary, it is a means of expressing their productivity with freedom. No one forces anyone to do anything for anyone in the market; everyone participates in the market because it is in his/her own interest to do so.

Thus, no matter whatever society may believe is a fair wage or a socially desirable level of employment to be, it is ultimately the market which ought to decide what wages should be offered and the level of employment. Both of these market outcomes will be just because they reflect workers’ productivity on the one hand and their work-leisure choices on the other. Thus, the competitive labor market equilibrium reflects the neoclassical slogan: ‘you get what you deserve and deserve what you get’. 15.4: Problems with the Neoclassical Theory and Policy Package We saw in chapters 12 and 13 that neoclassical models of output markets have many internal contradictions. This is also the case with the neoclassical analysis of the labor market as outlined in the preceding sections. Here we discuss four of those problems. You will see that the neoclassical policy package is dependent upon a fallacious picture of actually existing capitalist world order. 15.4.1: Backward Bending Labor Supply Curve: The Case for Interventionist Labor Policy Figure 15.15 depicted a well-behaved positively sloped labor supply curve derived from an individual’s labor-leisure preferences. However, standard economic theory provides no guarantee that such a shaped supply curve will exist. We can as easily derive a negatively sloped labor supply curve for all wage levels as shown in figure 15.19. The diagram shows that the labor supply by a worker decreases as wage rate increases and vice versa. You can see that the tangency moves from E to F and G as wage rate increases (and the budget lines moves out). One way of conceiving such a labor supply curve is to note that the standard positive relationship between labor supply and wages implies that a fall in the wage rate is followed by a reduction in hours offered for work. Consequently, the worker’s income—the product of hours worked and the wage rate—falls for both reasons (due to reduction in work hours as well as wage rate) and hence at a faster rate than the fall in the wage rate. This standard economic analysis means that after a fall in the wage rate the workers will substantially reduce their incomes, and simultaneously devote more time to leisure activities. However, this economic reasoning is quite unappealing because it begs the question: ‘how can one enjoy leisure time without income in capitalist society?’ Probably, the only leisure activity available in a capitalist society without any cost is ‘sleeping’ (a homeless person might give a different answer though). In reality, most leisure activities are ‘active’; i.e. they cost money. Chapter 9 explained how the capitalist business venture converted leisure into a commercialized activity in order to enhance its profitability. In capitalist countries, one can’t think of enjoying leisure time without watching T.V. channels, visiting parks, dancing at bars etc., all of which entail monetary costs. Figure 15.19: Negatively sloped labor supply curve derived from the time allocation problemER (LH)Re0Incomewe24L (WH)0LeRGRgLfwgwfFRfLgL (WH)Le0wewfSLwgweLfLgfg

Figure 15.19: Negatively sloped labor supply curve derived from the time allocation problem E R (LH) Re 0 Income we 24 L (WH) 0 Le R G Rg Lf wg wf F Rf Lg L (WH) Le 0 w e wf SL wg we Lf Lg f g The only way workers can behave according to the principles of standard economic is when they already have some alternative sources of income at their stake before entering the market. Only then they can afford to reduce work hours in response to a fall in the wage rate. But assuming this to be the case is to assume that workers are the owners of ‘capital’—i.e. they have their own means of production! Though this may be true for a small minority within capitalist societies, for the majority of the people work is no longer an option. It is a necessity. Thus, under normal circumstance, it makes more sense to assume that a fall in the wage rate is more likely to induce laborers to work more hours in order to maintain their standard of living—hence the possibility of negatively sloped labor supply curve. Technically speaking, the income effect of a wage change is more likely to dominate the substitution effect. The picture becomes even more gloomy if we conceive of the downward sloping labor supply curve in terms of extreme positions: very low (wl), very high (wh) and also perhaps some intermediate or middle wage levels (wm) as shown in figure 15.20. At very low wage levels, the individual’s work hours are likely to be very high. This is because the tangency point between a very flat budget line and indifference curve is likely to be near the origin (zero point of leisure). Such a tangency point makes perfect economic sense: with lots of leisure and very little income available to the consumer, the marginal rate of substitution between income and leisure will be quite high—i.e. the consumer will be willing to sacrifice large amount of leisure (of which he has a lot) for a small increase in income (of which he has very little). Alternatively, when the wage rate is just a little above the level of subsistence, the worker will have to work a lot of hours, say 18-hours a day, just to stay alive. On the other hand, the tangency is expected to be close to the zero point of work hours for very high wage levels—why work more if wages are astronomically high. So we have obtained two points in the labor-wage space in the right hand panel, one at a very low wage rate (point l) and another at a very high one (point h). Figure 15.20: Actual labor supply curve resulting from time allocation problemLR (LH)Rl0Income24L (WH)0LlHRhLhVery low wage, wl, budget lineVery high wage, wh, budget lineL (WH)Ll0wlwmSLwgwlLhh24Actual labor supply curve Figure 15.20: Actual labor supply curve resulting from time allocation problem L R (LH) Rl 0 Income 24 L (WH) 0 Ll H Rh Lh Very low wage, wl, budget line Very high wage, wh, budget line L (WH) Ll 0 w l wm SL wg wl Lh h 24 Actual labor supply curve What about intermediate wage levels? Of course the outcome will be indeterminate, as standard economic theory says. The supply curve can take any shape in between these two extreme points (except the well-behaved positively sloped curve because it requires all consumers to have identical taste) as shown in the right hand panel. If we try to obtain aggregate or market labor supply curve by summing up many such ‘ill-behaved’ individual labor supply curves, we can end up with any shape at all; and the standard economic theory can place no limitations to prevent such awkward shapes. Thus, there is no ground on the basis of which we can unambiguously relate the aggregate supply of labor with the market wage rate. The possibility of backward bending labor supply curve is often pointed out to the students by instructors as well as textbooks, but it is then ignored on the basis of the assumption that the labor supply curves, in general, will be upward sloping. Unfortunately, there is no theoretical or empirical justification for this assumption.

The above analysis poses two serious negative implications for neoclassical economic theory. First, the ill-behaved labor supply curve implies that there could be multiple intersections of the supply curve with the downward sloping demand curve. This means that there is no guarantee for the achievement of a unique equilibrium wage in the labor market; rather we can have more than one equilibrium wage rates prevailing in the market (one may be low and another a high one) and no one can tell which one is the efficiency maximizing one. Economic theory, therefore: fails to prove that employment is determined by the supply and demand fails to prove that wages are uniquely determined by the impersonal market process Figure 15.21: Minimum wage stabilizing the inherently unstable labor marketL (Work hours)SLLe0w (wage rate)EweDLwbLdLs Figure 15.21: Minimum wage stabilizing the inherently unstable labor market L (Work hours) SL Le 0 w (wage rate) E we DL wb Ld Ls The second negative consequence relates to neoclassical policy recipe. The unwarranted economic assumption that ‘labor supply curves are generally upward sloping’ may well be tolerated if economists did not derive any strong policy recommendations from their labor market analysis. But they do derive strong policy implications such as that the minimum wage laws are not only ineffective but also harmful as they create unemployment. The truth of this conclusion depends upon the upward sloping labor supply curve. But if the supply curve is negatively sloped, the situation becomes problematic. Figure 15.21 draws both the curves as downward sloping with demand curve being steeper than the supply curve. This labor market is unstable. To see why, think of the wages below the equilibrium wage we, such as wb. Here, the labor supply (Ls) is greater than the demand for labor (Ld) which means that wages should fall in response to excess supply (unemployment). But a further decrease in wages will increase the gap between demand and supply and, hence unemployment. The market mechanism cannot spontaneously come out of this trap. This means that increasing the wage rate and setting it to we through legislation can eliminate the gap between demand and supply. Therefore, a minimum wage law can not only stabilize the labor market but also decrease unemployment. We can thus conclude that the ‘ill-behaved’ labor supply curve eliminates the concept of ‘a unique’ equilibrium wage which is the ultimate basis of economic argument against non-interventionist labor policy. 15.4.2: Market Power & Labor Market: The Case for Unionized Labor We have rejected the argument for one of the economic policy recommendations (i.e. state should not intervene in the labor market and let it free). Let’s now take the second one (i.e. workers should not be allowed to organize in unions). This policy mantra can be dismissed using models of imperfectly competitive markets. The neoclassical argument that wages reflect the value of marginal productivity of workers depends upon the assumptions that (a) the labor market is competitive (both on the demand and supply sides) and that (b) the market of the output produced by the workers is also perfectly competitive (i.e. the firm is competitive both in the labor as well as output markets). By relaxing these assumptions we can show that wages do not reflect the value of marginal product of workers; rather firms exploit them. Let us relax these assumptions one by one.

Market Power in the Output Markets What happens to labor market analysis if we assume that the firm which hires workers has some monopoly power in the output market—it is either monopoly or a monopolistic firm? Since nothing is changed by this assumption in the supply side of labor market, the labor supply curve will remain the same (of course we are assuming, for the sake of argument, that the standard labor supply curve is valid). Market power in the labor market will change the demand side of the labor market. To see how, recall from chapters 13 and 14 that when a firm is not a price taker, i.e. not a competitive firm, it faces a downward sloping demand curve for the commodity it produces. This implies that the marginal revenue curve is below the demand curve at each output level, as reproduced in the left panel of figure 15.22. This shows that marginal revenue will be less than price of the output. Under these circumstances, the value of marginal product will not be the same as that of the competitive firm. Instead, the marginal benefit of selling an additional output unit of a monopolistic firm will be less than VMP. Let’s term these marginal benefits of a monopolistic firm its marginal revenue product (MRP) to differentiate them from VMP. So we can say that the marginal revenue product curve will not be equal to it, rather below the value of marginal product (VMP) curve for a monopolistic firm. This can be seen by looking at the expression: for competitive firms Since price, P, equals MR in the competitive output market, thus MRP equals VMP. On the other hand, since P < MR under imperfectly competitive markets, the above equality does not hold in this case: for monopolistic firms This means that an imperfectly competitive firm does not measure the worth of hiring a labor by its VMP, rather by its MRP (which is less than VMP). This firm does not receive VMP by selling an additional unit of output, rather it receives MRP (as its MR is less than P). Therefore, we have shown the MRP-curve [MR × MPL] below VMP-curve [P × MPL] in the right hand panel. Figure 15.22: Demand for labor by an imperfectly competitive firm(a) Imperfectly competitive output marketsY0Rs/unitDMRYoL0Rs/unitMRPLLo(b) MRP and VMP curve for imperfectly competitive firmVMPL Figure 15.22: Demand for labor by an imperfectly competitive firm (a) Imperfectly competitive output markets Y 0 Rs/unit D MR Yo L 0 Rs/unit MRPL Lo (b) MRP and VMP curve for imperfectly competitive firm VMPL Since the labor market is assumed to be perfectly competitive, the supply of labor to a single firm is drawn as a horizontal line in the left hand panel of figure 15.23. When imperfectly competitive firms take their hiring decision along MRP-curve, instead of value of marginal product curve, they hire workers up to the point where wage rate (marginal cost of hiring) equals MRP-curve (point E). The market wage is, again of course, determined by the market demand and supply in the right hand panel, but now the market demand is constituted by MRP-curve and not VMP-curve. At monopolistic equilibrium point, wage rate is wm with Lm people getting work in the market. Note that the value that consumers place on the output produced by Lm workers is given at VMP-curve, here ve, but the workers receive a wage of wm which is less than their contribution in the output.

Thus, when a firm has monopoly power, the factor inputs receive MRP which is less than their VMP. The difference between the two was called monopolistic exploitation by Joan Robinson, a famous critic of neoclassical economics. According to her, a factor input is exploited whenever it receives a payment less than its value of marginal product. Inputs are not exploited, according to her, in the competitive markets because the wage rate equals VMP (as well as MRP): for competitive firms Figure 15.23: Demand for labor by an imperfectly competitive firmL0LmVMPLSLfwoEFLcMRPL(a) Monopolistic FirmveMonopolistic exploitationL0Rs/unitLmVMPLSLwmefLCMRPL(b) Comparison of Monopolistic and Competitive IndustriesMonopolistic exploitationwc Figure 15.23: Demand for labor by an imperfectly competitive firm L 0 Lm VMPL SLf wo E F Lc MRPL (a) Monopolistic Firm ve Monopolistic exploitation L 0 Rs/unit Lm VMPL SL wm e f LC MRPL (b) Comparison of Monopolistic and Competitive Industries Monopolistic exploitation wc The right side panel compares the competitive industry equilibrium with that of monopolistic one. Point f is the competitive industry equilibrium satisfying the non-exploitation condition. However, the equilibrium condition for monopolistic firm is given by: for monopolistic firms which means that the difference ‘ve – we’ (or ‘wc – wm’) measures the exploitation of workers resulting from the monopolistic behavior of firms. Further, the monopolistic firm, as well as the industry, is also a culprit of employing less number of workers (Lm) than what a competitive firm (industry) would do (Lc). It should be clear that this exploitation is not a result of any ‘wrong’ doing on the part of workers. Thus, according to economic theory, a firms having market power cuts workers at both ends: they hire less number of workers and pay them less than their contribution in the output. Application Box 15.2 gives some industry statistics to prove that exploitation is the hall mark of actually existing capitalist markets. A P P L I C A T I O N B O X 15.2 Evidence on Exploitation in Mature Capitalist Societies It is commonly believed that workers are exploited only in under-developed countries, such as Pakistan, where working conditions are not up to international standards. However, the preceding analysis has shown that the presence of exploitation has nothing to do with the violation of internationals standards; rather it is related to the presence of monopolistic power of the firm which guarantees the exploitation of workers in capitalist market structures. The following two tables give the structure of businesses in USA to show the market power enjoyed by the large corporations. Table 1 shows that though more than three quarters of all US firms are proprietorships-partnerships and only a one fifth are corporations, corporations capture 86% of total US revenue. Table 1: Number of firms and their revenue shares in US economy 2001 Proprietorships & Partnerships Corporations Number of Firms 80% 20% Total Revenue Controlled by

14% 86% Source: US Bureau of the Census, Statistical Abstract of the US: 2001 Table 2: Revenue shares of firms in some US industries 2001 Percentage Revenue Controlled by Industry Proprietorships & Partnerships Corporations Agriculture 50 50 Services 30 70 Construction 20 80 Retail trade 17 83 Mining 19 81 Transport 16 84 Finance 10 90 Wholesale trade 6 94 Manufacturing 3 97 Source: US Bureau of the Census, Statistical Abstract of the US: 2001 Similarly, it is evident from Table 2 that almost all the US industries are dominated by a very few large corporations. These numbers clearly illustrate that firms have considerable market power in the US market economy which means that workers are exploited even in the most mature capitalist societies such as US—the hegemon of the capitalist order. Ignoring these numbers and assuming that actual capitalist markets behave as if they were perfectly competitive is in fact to make a mockery of capitalist realities. Thus, exploitation is the hall-mark of capitalist markets because capitalism is, by default, an unjust and irrational system of life. You should note that throughout this discussion we are using the microeconomic definition of exploitation. Neoclassical theory holds that a worker is exploited (treated unjustly) when he receives a wage lower than the value of his marginal product. We show that this is always the case in monopolistic markets. Since monopolistic markets dominate all real world capitalist orders, worker exploitation in the capitalist sense (wage ≠ VMP) is universal in capitalist systems. Capitalist order is unjust even on its own terms. Monopsony: Market Power in the Input Markets Consider now the case of a firm that has monopolist power in the factor market, instead of in the output market. For simplicity, assume that the firm is the sole employer in the market, a situation known as monopsony. This could be the case when a single firm dominates the local market for a particular type of labor skill. For example, an oil refinery may be a monopsonist in its hiring of petroleum engineers in a local labor market. Since this firm is the sole buyer of workers, it faces the entire supply curve of labor and the firm is no longer a price taker. With an upward sloping supply of labor, the firm will not be able to hire additional workers without paying them a higher wage rate. Note that the firm has to pay a higher wage not only to the newly employed workers but to all existing employees. If, say, the going wage rate is Rs 200 per day before the new contract, and Rs 250 must be offered to attract new workers, then Rs 250 must be paid to the existing work force as well. You may ask the question: will not the firm hire new employees at higher wages and still pay the existing work force their old lower wages? This strategy will not be workable because the higher wages for the new workers would be hard to conceal from other workers. Of course the existing staff is not going to like these lower wages as compared to the new employees. This can create a morale problem for the firm—a worker who is paid less will produce less than what he would normally produce (if he is a utility maximizing rational economic agent).

Let’s us now explore the implications of an upward sloping labor supply curve to a monopsonist using figure 15.24. We need to examine how the wage bill [wage rate times employment level] of the firm behaves as the firm’s employment decision changes. The top panel shows the supply curve facing a competitive firm as well as a monopsonist. Suppose that the market wage rate is wo at point A. If the firm were a price taker, it would assume that its labor supply curve is a horizontal line at wo wage rate. However, since the firm is a monopsonist, it perceives that the labor supply curve is upward sloping. Note that the supply curve of labor shows the average expenditure or price that the monopsonist must pay at different levels of employment. For example, at employment level Lo, the firm must pay wo per worker. In other words, the labor supply curve is the average expenditure curve of the monopsonist. Multiplying the factor price with the employment level gives the total wage bill of the firm: Wage Bill (WB) = Wage Rate × Employment Level (15.14) When the firm is a price taker as in a competitive labor market, the wage rate is fixed. This means that the wage-bill will be a linear function of the employment level (i.e. a linear upward sloping curve in the middle panel). Under these circumstances, the average as well as the marginal expenditures (ME) of the firm will be equal to the wage rate as shown in the lower panel (the horizontal line at wo). The marginal expenditures represent the amount needed to purchase an extra unit of labor. Technically speaking, the marginal expenditure on labor is the change in total wage bill due to hiring of one extra unit of labor: Figure 15.24: Average and marginal expenditure functions of monopsonistLoL0Wage BillCompetitive wage billwo LoaMonopsonist wage billSlope of the monopsonist wage billRs/unitLLo0abwoMEoMEmonopsonistSL or AEmonopsonistSL or AE = ME for competitive firmL0Rs/unitSL facing a monopsonistwoLoSL facing a competitive firmA Figure 15.24: Average and marginal expenditure functions of monopsonist Lo L 0 Wage Bill Competitive wage bill wo Lo a Monopsonist wage bill Slope of the monopsonist wage bill Rs/unit L Lo 0 a b wo MEo MEmonopsonist SL or AEmonopsonist SL or AE = ME for competitive firm L 0 Rs/unit SL facing a monopsonist wo Lo SL facing a competitive firm A (15.15) This expression gives the slope of the wage bill curve. With the wage rate fixed for a competitive firm, its ME will be equal to wage rate: for competitive firm But when the labor supply curve is positively sloped as is the case for the monopsonist, his wage-bill curve is not only positively sloped but also convex from below. The curve has a positive slope because hiring more workers increases the total wage bill. It is convex because the rate at which the wage bill increases keeps on increasing as more workers are hired; i.e. the slope of the wage bill curve is not constant but increasing. This is so because the wage rate goes up for a monopsonist as he employs more workers. The result of this is that the marginal expenditure (ME) curve lies above the average expenditure or labor supply curve for a monopsonist as shown in the bottom panel. These slopes reflect the fact that hiring an additional worker increases the wage bill by more than the price of this worker because all previous units employed have also to be paid the new higher price. To consolidate your understanding of why the ME-curve must be above the AE-curve for a monopsonist, consider point a in the middle panel. We have seen above that the ray coming from the origin and passing through point a in the middle panel would be the wage bill curve if the firm were a price taker in the labor market. The slope of this curve would be wo at each employment level. However, the slope of the convex monopsonist wage-bill curve is given by the tangent at point a. The convex shape ensures that the tangent must be steeper than the slope of the competitive wage bill (compare the dashed tangent with the competitive wage bill curve). Thus we find that the ME exceeds wage rate at each level of employment—hence we have ME-curve above AE or labor supply-curve in the bottom panel.

Figure 15.25: Equilibrium of monopsonist having no monopoly powerRs/unitLLm0ABwmMEmonopsonistSLVMPwcLcMMonopsonist Exploitation Figure 15.25: Equilibrium of monopsonist having no monopoly power Rs/unit L Lm 0 A B wm MEmonopsonist SL VMP wc Lc M Monopsonist Exploitation Given these curves, the monopsonist is in equilibrium when he follows the marginal principle: he compares the marginal benefits of hiring another worker with its marginal cost. If we assume that the firm is a price taker in the output market, then the marginal benefits are measured by the VMP-curve as shown in figure 15.25. The marginal cost of an extra labor unit is given by the ME function and not by the AE-curve for a monopsonist. This means that he will be hiring Lm workers at point M where VMP is equal to ME. The wage rate wm is determined at the labor supply curve (point A) corresponding to Lm employment level. If we now compare the monopsonist equilibrium with that of the competitive one at point B, we can see that the competitive industry would hire up to the point where VMP equals the supply curve SL hiring Lc workers and paying wc wage rate. The difference between the competitive wage wc and monopsonist wage wm is called monopsonist exploitation. You can see that even when a firm is a price taker in the output market but has monopsonist power (in the input market), it pays to the workers a wage less than their VMP. Further, the monopsonist also employs less number of workers (Lm) than what competitive industry would do (Lc). It should be noted clearly that the monopsonist exploitation is something over and above the monopolistic exploitation discussed in the previous sub-section. There we saw that monopolistic exploitation arises when the firm faces a negatively sloped demand curve for a commodity. When the firm has monopoly power in the output market, its MRP-curve (or factor demand curve) lies below VMP-curve as reproduced in figure 15.26. Under these circumstances, profit-maximization requires that the firm equates its ME with MRP (and not with VMP) at equilibrium point E. The wage rate now paid is even below the MRP of workers. The difference between competitive and monopsonist wage (wc - wm) can be divided into two parts: the part wcwn is due to the monopoly power of the firm because this would exist even if the firm did not have monopsony power in the factor market. However, the part wnwm is attributed to the monopsony power of the firm. Figure 15.26: Equilibrium of monopsonist having monopoly powerRs/unitLLm0NBwnMEmonopsonistSLVMPwcLcEMRPLnwmMonopolistic ExploitationMonopsonist Exploitation Figure 15.26: Equilibrium of monopsonist having monopoly power Rs/unit L Lm 0 N B wn MEmonopsonist SL VMP wc Lc E MRP Ln wm Monopolistic Exploitation Monopsonist Exploitation Summarizing the above two sub-sections, we can say that: In competitive markets, the workers are paid their VMP (if we assume that economic theory is correct, which in fact it is not as we show shortly) When the firm has monopoly power in the output market and no power in the input market, the workers are paid a wage equal to MRP which is less than their VMP (w = MRP < VMP)

When the firm has both monopoly as well monopsony powers, workers are paid a wage which is less than even their MRP This analysis consolidates what we concluded in the previous chapter: exploitation is built into actually existing capitalist order and the only way to assume it away is to assume that we live in a non-existing perfectly competitive capitalist world. Ironically, instead of accepting the harsh realities of capitalism, economists prefer to befool the masses by putting a veil on reality. They do this because economics is a moral, not essentially an empirical, discipline. The above analysis also justifies the existence of labor unions because, as shown, the workers will be paid less than their contribution if they behave as unorganized masses trying to compete over each other in the market against a monopsonist or monopolist buyer. Thus, while economists usually portray unions as a ‘necessary evil’ on the grounds that they reduce competition in the market, however unions may be seen as a preferred option by capitalist workers trying to avoid exploitation in monopolistic and monopsonistic markets. Monopsonist Vs Labor Union This discussion leads us to explore the more realistic situation of what happens when the monopsonist faces a trade union. If unionized workers behave like a single seller of their services, the wage rate may even rise as more workers are hired. This can be shown in figure 15.27 using the standard tools we have thus far employed. The diagram shows what happens when a monopsonist faces a non-competitive labor supply from workers. For simplicity, assume that all workers are organized under a single union which makes decisions on the part of the workers and behaves like a single monopolist seller. The situation where a single buyer of an input (monopsonist) faces a single seller of that input (monopoly) is also known as bilateral monopoly—we have monopoly agents on both sides of the input market. The market model where all workers are organized in a labor union acting as a monopolist and which faces a single buyer can be analyzed as a bilateral monopoly model. We can think of it as a single petroleum extraction company and a petroleum engineers’ union in a small town, say Soi. The basic feature of this market structure is ‘indeterminancy’. To begin with its exploration, consider figure 15.27 where the monopsonist firm is facing an upward sloping labor supply with the ME-curve lying above the SL-curve. The firm would, as earlier discussed, wish to employ Lm workers where its marginal expenditures on labor are equal to MRP at point M. However, this will not be possible for the firm because the position of workers has changed from competitive to monopolist sellers. The union, being a capitalist union, will also be solving its optimization problem of choosing the combination of employment and wage that is the best for workers—maximizes their utility. The union perceives the MRP-curve as its demand curve which is, from the union’s point of view, its average revenue curve. Therefore, we can denote this curve Du = ARu. The union’s marginal revenue curve can be derived in a similar fashion as discussed in the previous chapter: the MRu-curve will lie below its ARu-curve. Let’s now combine the four curves. In a perfectly competitive market, a firm perceives SL as the workers’ supply curve while MRP (assuming it is equal to VMP) as their labor demand curve. Hence:

the competitive equilibrium is attained at point C with a wage rate wc and an employment level Lc in a monopsonistic market, the firm perceives the ME-curve as the relevant labor supply curve, sets its employment where ME equal MRP (point M) and pays a wage wm however, the labor union perceives SL as its supply curve (or marginal cost curve) while MRPu as its marginal revenue curve. It will seek to set a contract where SL-curve intersects MRPu curve (point U) asking an employment level Lu and wage of wu (which appears on the MRPu curve at point B). Figure 15.27: Monopsonist facing a trade union—bilateral monopolyRs/unitLLm0UCwuMEmonopsonistSLMRP = Du = ARu wcLcMMRPuLuwmBA Figure 15.27: Monopsonist facing a trade union—bilateral monopoly Rs/unit L Lm 0 U C wu MEmonopsonist SL MRP = Du = ARu wc Lc M MRPu Lu wm B A Note that the wage wm offered by the monopsonist (firm’s manager) is the lower limit of the wage which would be realized if the management could somehow force the union workers to act as a competitive seller (i.e. it treats wage offered by the firm as a given parameter in its choice). On the other hand, the wage wu demanded by the union is the upper limit of wage that would be realized if the union can force the company management to behave like a competitive buyer (i.e. it treats wage desired by the union as given). Since both are trying to take their decision misperceiving the other party as price taker, their expectations are unlikely to be realized because neither of the party is actually a price taker (basically, as discussed in chapter 13, a monopolist has no supply curve because having a specific supply curve requires that the firm takes price as a given parameter and adjusts its quantity to this price). Consequently, the result is indeterminate: neither side necessarily achieving its optimal employment-wage combination. The maximum we can say is that the negotiated wage will fall between its lower (wm) and upper limits (wu). What would determine the actual outcome in this situation? The answer is: bargaining power, negotiating skills, political affiliations of the parties etc. In other words, the outcomes in actually existing capitalist orders are: inherently indeterminate or non-unique influenced and determined by factors that are governed by political power What does the power of each participant stand for? The power of each participant reflects and is determined by: his ability to inflict losses to the opposite party, and his ability to resist the losses inflicted upon him by the opposite party The strike is the main weapon available to the union while a lockout is the extreme option available to a firm—each party can threat on a strike or a lockout to get an agreement in its own favor. Sometimes, when the two parties cannot agree upon the wage or other employment conditions in a collective bargaining process, they agree to submit their disagreement to a binding arbitration—a process wherein a third party determines wages and other work related conditions on behalf of the negotiating parties. Apart from these two options (strikes and lockouts), the financial position of the union and the firm, the general attitude of the public and government towards strike, and many others play an important role in determining the bargaining powers of the two parties.

A P P L I C A T I O N B O X 15.3 Strikes and Negotiation in Pakistan Often we listen to news that workers in a specific industry or institution have gone on strike against state policies. Some recent examples include: the strike of secondary teachers in Punjab against the Education Commission for not releasing their 15% salary increment as per the announcement of federal government in its annual budget the walk out of PIA pilots from taking off passenger flights in want of high salary demands the refusal of railway drivers to drive trains until their demands for improved working conditions are satisfied The most important aspect of all these instances is the fact that none of them were resolved through the spontaneous working of market mechanisms. Rather, the issues were settled through non-market negotiations between the workers’ union and the company management. The outcome of each case reflected the bargaining power of the striking party. Railway drivers’ strike was the least successful while that of PIA pilots was the most gainful because the demand for pilots is relatively inelastic as compared to rail-drivers. Modern capitalism seeks to disorganize workers since the greater the power of capitalist unions the higher the wage the firm will have to pay. In order to achieve this end, a whole new management sub-discipline has been created–––Human Resource Management (HRM). HRM has replaced the former subject of Industrial Relations (IR) which was essentially a sub discipline of political sociology. IR recognized the functionality of collective bargaining and argued that recognizing the working class collective rights was in the long term interests of capitalist order. IR provided a basis for incorporating unions into capitalist governance structures. During the early Cold War period (1945-1979) corporatist states with strong trade union representation existed for long period in several West European countries (Britain, France, Germany, the Scandinavian countries etc) and a “high wage” policy was endorsed by most (ruling) Keynesian policy makers. Since the early 1980s IR has gone out of favor and has been replaced by HRM which rooted in Psychology (not in political psychology). HRM seeks to “de-collectivize” the working class. It advocates management practices which induce the worker to identify with the goals, organizational culture and operational strategies of the firm. HRM has been spectacularly successful––real wages have stagnated in America during 1979-2009. While workers real wages have remained constant and increase in per capita consumption is entirely debt fuelled, unemployment has been hovering around ten percent during2007-2010 in most OECD countries and unions have virtually disappeared as major players in the labor markets of the metropolitan capitalist countries. As we will argue in the final chapter of this book, this victory of the firm over the union has been made possible by practicing the ‘Science of Management’––not by the preaching of the economists because economics is a moral and not an applied science (which is what management is). It provides measures for evaluating market behavior of producers, workers, consumers and traders. It is of limited use as a means for persuading these agents to accept and behave on the basis of capitalist rationality. This is Management Science seeks to do.

Monopsony and the Minimum Wage Laws As discussed above (and in chapter 4) economists oppose interventionist state policies, such as minimum wage laws, on the ground that they create unemployment in the market. However, this policy claim is valid only if we assume that labor markets are perfectly competitive on both sides; i.e. workers’ supply as well as firms’ demand. Once we change this assumption and assume that firms have monopsonist power (as it is normally the case in real world capitalist societies), the neoclassical policy mantra of the ‘optimality of non-interventionist policy’ becomes highly vulnerable. Rather, the opposite turns out to be the case—a minimum wage law can increase both the wage as well as employment level. To see how, consider figure 15.28 which shows a monopsonistic labor market with equilibrium wage rate wm (we have drawn only the single MRP-curve as the relevant labor demand curve of the firm which can be interpreted both as MRP and VMP curve depending upon whether the firm has monopoly power or not in the output market). Suppose a minimum wage regulation is passed which requires employers to pay at least wc. This means that the monopsonist now faces a labor supply curve which is perfectly elastic (horizontal) at wc wage up to Lc level. However, to hire workers beyond this level, the monopsonist has to pay more than wc because its labor supply curve is positively sloped beyond Lc (as the regulation will affect his decision only in the region where his labor supply curve is below wc) and hence ME-curve is above wc wage after Lc level of employment. Since the wage rate wc is fixed up to the employment level Lc, the marginal expenditures will also be constant in this segment (the horizontal line at wc up to Lc). The minimum wage law makes the ME-curve discontinuous at point C. The dashed segments of labor supply and ME-curves are no longer applicable after the wage law enforcement. Profit maximization requires that the monopsonist sets its ME equal to MRP of labor which occurs at point C where he hires Lc workers at a wage of wc. We can see that the minimum wage law has made workers better off on both fronts: it has not only increased the wages paid to the workers but also the number of workers employed in the market. Figure 15.28: Minimum wage law with monopsonyCIncrease in employment due to minimum wageRs/unitLLm0AwmMEmonopsonistSLMRPwcLcMMinimum wage Figure 15.28: Minimum wage law with monopsony C Increase in employment due to minimum wage Rs/unit L Lm 0 A wm MEmonopsonist SL MRP wc Lc M Minimum wage Hence the economic argument for a non-interventionist state policy is baseless and grounded on unrealistic assumption—the argument applies to a capitalist world order that has never existed on the earth. Thus, we find that the preceding analysis is sufficient to dismiss both of the policy claims of neoclassical economics. Since wage earners normally exceed non-wage earners in capitalist societies and since their consumption is expected to have a higher welfare weight (due to the low-grade position in the pattern of income distribution) than non-wage earners, therefore policy allowing wage earners to maximize their utility increases social welfare concomitantly.

15.4.3: Perfect Competition Equals Monopsony The previous chapter exposed the fallacy behind the economic dictum that perfectly competitive markets are welfare superior to monopolies. The underlying false assumption in the standard economic comparison of the two models was to assume that competitive industry did not have a marginal revenue function. However, the assumption, as we showed, is unwarranted. A similar type of mistaken assumption is operative behind the welfare superiority claim of competitive input markets over monopsonistic ones. Figure 15.29 shows that the only difference between the two input market models is the appearance of the marginal expenditure function for the monopsonist (in the lower panel) which forces him to employ (Lm) less than the competitive level of employment (Lc). The standard model of competitive labor market makes the assumption that there is no ME-curve for competitive industry because each firm is a price taker and it can hire any amount of workers without changing the market wage rate. The market wage may be affected in response to changes in the employment decision of a number of firms, but does not change due to changes in the demand of a single firm. Figure 15.29: Valid comparison of competitive and monopsonistic labor marketsRs/unitLLm0AwmMESL = AEMRPwcLcMCLmL0RsTotal Revenue Product of labormWage Bill with positively sloped labor demand curveLcmMaximum profit employment level (ME = MRP)πmaxLess than maximum profit employment level (ME > MRP) Figure 15.29: Valid comparison of competitive and monopsonistic labor markets Rs/unit L Lm 0 A wm ME SL = AE MRP wc Lc M C Lm L 0 Rs Total Revenue Product of labor m Wage Bill with positively sloped labor demand curve Lc m Maximum profit employment level (ME = MRP) πmax Less than maximum profit employment level (ME > MRP) However, this assumption is analogous to what economic theory erroneously assumes about competitive output markets. When a single firm changes its demand for labor even by one unit, the market demand for labor must increase by one and, consequently, the market demand for labor will shift rightward leading to a rise in the market wage rate—no matter by how small a quantity, that small number can’t be zero. Again, economic theory of competitive input markets is based on the false impression that the sum of infinite (or many) small numbers equals zero! The competitive firm must also face a positively sloped labor supply curve, no matter how flat, and have a ME-function above the labor supply curve. The upper panel shows the outcome of competitive and monopsonistic decisions in terms of aggregate profit for both of them. It draws a positively sloped and convex total wage bill which is consistent with an upward sloping labor supply curve (see figure 15.24). Recall that the slope of this WB-curve is ME. The total revenue product (TRP) curve is also drawn positively sloped but it has a decreasing slope reflecting the fact that MRP (which is the slope of the TRP-curve) is decreasing as more labor is hired [TRP-curve can be obtained by multiplying the production function (of chapter 10) or output curve with price level]. The vertical difference between the two curves measures profit at each level of employment. The profit-maximizing employment level is attained when the slopes of the two curves are equal—i.e. ME = MRP. This happens at the employment level where the tangents of WB and TRP are parallel as shown in the upper panel. The monopsonist operates where ME equals MRP but the competitive firms collectively display an irrational behavior by hiring beyond profit-maximizing point. This happens to a competitive industry due to treating infinitesimal as zero which misguides it to employ some of the workers past the point where ME = MRP. You can see that by not incorporating the ME-function into its decision making, the competitive industry has hired labor up to the point where ME > MRP and, thus, its profits are not maximized as shown in figure 15.29. On the other hand, since the monopsonist correctly equates ME with MRP, his decision to employ Lm is consistent with maximum profit level. But, as argued, the labor supply curve to a single competitive firm can’t be horizontal, and must slope downward—because if it does not, then the market supply curve has to be horizontal as well. Therefore, marginal expenditures will be more than wage for the individual firm.

If we now drop the invalid economic assumption that the labor supply curve perceived by an individual competitive firm is horizontal, the wage-employment configurations of a competitive industry will be exactly the same as those for the monopsonist. Once we correct the economic theory, we find that the wage rate which a competitive firm takes as given is actually determined by the intersection of the MRP-curve and the aggregate ME-curves of all firms. This wage rate is precisely the same as any monopsonist would offer. To repeat the same from chapter 13: to argue otherwise is to argue for either individual irrational behavior at the level of the firm—so that some of workers are hired at a loss—or that individually rational behavior leads to a collective irrational behavior at the level of the market—so that profit maximizing behavior by one firm leads to the industry offering part of the employment at a loss Therefore, the wage that the competitive firm takes as given while adjusting its employment decision is not a market wage set by equating wage with MRP, but a market wage set by equating ME to MRP. If we sum up the number of workers hired by all competitive firms, the total employment at this wage will be equivalent to the employment of a monopsonist. This means that both competitive as well as monopsonist industries are in equilibrium at point M in figure 15.29. This result seriously undermines all economic arguments for more competition against less in factor markets. The corrected economic theory recognizes no intuitive difference between competitive and monopoly market structures—both produce the same welfare (employment) outcome. If this is the case, then the economic plea for free labor markets, non-interventionist labor policy and disintegration of unions stands dismissed. Capitalist labor markets—whether competitive or monopsonist—always require strong state intervention and regulatory regimes to resolve conflicts among self-interested individuals. The picture of harmonious capitalist markets as self-adjusting mechanisms spontaneously resolving and mediating individual interests is not only erroneous but also a misleading policy guide. 15.4.4: Sraffa’s Aggregation Issues We discussed the implications of Sraffa’s criticism for competitive markets in chapter 12 on perfect competition. The criticism was raised at two levels: one about a broad definition of industry and another about its narrow definition. The labor market defined as an ‘industry’ is obviously a case for revisiting Sraffa’s criticism. Recall that with a broad definition of an industry, it is not feasible to draw independent demand and supply curves. This is because any change in supply will bring about income distributional effects which in turn change the position of the demand curve. The same is also the case when we speak of labor supply referring to the entire work force. With the aggregate labor supply curve positively sloped, increase in labor supply requires increase in the wage rate. But increased wages clearly alter the income distribution in the economy and, as a result, the demand for commodities also changes. The changes in demand will change the price of the commodity produced by the workers. Since the labor demand curve is merely the aggregate MRP (= P × MP) of workers, this means that a different demand curve for labor will appear at each different point along the labor supply curve. Again, the central idea of the argument is that it is not possible to sketch independent demand and supply curves intersecting just at one point in wage-labor space because of the fact that factors that alter supply will also alter the demand for labor. The standard economic analysis ignores the repercussions of income distributional effects on labor markets. For example, as shown in figure 15.30, the standard textbooks pretend that when the labor demand curve shifts out from DLo to DL1, say due to increased MP of workers, a new and a unique equilibrium point is attained moving along the supply curve with higher wages and employment level at point B. In other words, the transition from A to B is smooth and unique.

Figure 15.30: Multiple demand curves with broad labor market definitionSL0Rs/unitLDLoDL1LbLaABwawb Figure 15.30: Multiple demand curves with broad labor market definition SL 0 Rs/unit L DLo DL1 Lb La A B wa wb But this analysis neglects the fact that increased wages along the labor supply curve will cause the distribution of income, demand for commodities and, hence, prices of goods to change in an ‘unknown direction’ until or unless we assume that there is one and only one individual in the economy (see chapter 8 if you are unable to grasp this statement). As we start moving along the labor supply curve SL from point A, the labor demand curve does not remain fixed at DL1; rather it may shift to any of the positions as shown by some of the labor demand curves drawn in the diagram. Demand curve for labor will shift with every movement along the supply curve which means they will intersect at multiple points and it is impossible to tell which wage or employment will prevail in the market. The picture shown in figure 15.30 illustrates that there is no guarantee for a unique equilibrium to exist in labor markets; rather multiple equilibrium points can exist. Thus, the economic methodology of reducing labor market contracts to simple demand-supply tools is unsuited to analyze labor market dynamics. Sraffa was right to point out that income distribution is determined in capitalist societies through power struggle and factors beyond the domain of input markets. This theme will be further developed in the next chapter on ‘market for capital’. Key Concepts Average expenditure equals the wage paid per worker. Labor supply curve measure average expenditures Backward bending labor supply curve has an initially positive sloped but becomes negatively sloped at higher wage rates, reflecting an income effect greater than substitution effect Bilateral monopoly is a market structure where a monopsonist buyer of an input faces a monopolist seller of that input Binding arbitration is a process in which a third party determines the wages and other work related conditions on behalf of the negotiating parties (usually managers and union) Competitive wage is a contract that allows an employee to adjust his time allocation between the number of hours to work and rest each day or each week Derived demand is the principle which says that inputs are valued only because they can be used to produce valuable goods and services Economic rent is the payment for an input over and above what is required to keep it in its current use; i.e. the difference between the payments actually made to an input and the minimum amount that must be paid to keep it in its current use Full income is a consumer’s maximum possible labor income (including non-labor income) assuming all of his time is sold at the market wage rate Labor refers to the amount of time an individual chooses to offer in the market at a specific wage rate Leisure is all the time spent off the market job Lock out is a firm’s refusal to operate its plant and employ its workers

Marginal expenditures represent the amount needed to purchase an extra unit of labor. Technically speaking, marginal expenditure on labor is the change in total wage bill due to hiring of one extra unit of labor Marginal revenue product also indicates the change in revenue of a firm due to the sale of output produced by one additional input, but it is less than the VMP of a competitive firm (if we do make a distinction between the two) Monopolistic exploitation is the difference between the wage offered by a monopolistic firm and that offered by a competitive market Monopsonistic exploitation is the difference between the wage offered by a monopsonistic firm and the one offered by a competitive market Monopsony is a business structure where only a single buyer faces the entire market supply Normal factor is one whose use increases with the increase in output produced Labor demand curve shows the number of workers firms are willing to hire at different wage levels Labor supply curve reflects the working hours which the workers are ready to sell at different wage levels in the market Strike refers to the refusal of a group to work under the prevailing working conditions Time allocation problem suggests that the fundamental scare resource in the economy is the availability of human time and a rational economic agent tries to allocate his time between work and leisure activities such that it results in maximum utility Value of marginal product indicates the change in revenue of a firm resulting from the sale of output produced by one additional input Chapter Summary Classical economic theory sought to explain determination of factor input prices––the price of labor, capital and land–––separately. Neoclassical economics has developed a common framework for the analysis of all factor markets In competitive labour markets supply is assumed to be unlimited and the market wage rate is given and fixed. Firms hire a worker if the cost of hiring him is below the profit his work generates Value of the marginal product of a worker is given by multiplying marginal product of that worker by the price of that marginal product. The value of marginal product reflects change in the total revenue of the firm due to change in the number of workers employed. The value of marginal product is a decreasing function of the labor employed, as is marginal productivity assumed to be in neoclassical theory A profit maximizing firm will hire a worker if the value of his marginal product exceeds his wage. A profit maximizing firm will employ workers up to the point which the value of the marginal product is equal to the (given and constant) wage rate in the labor market It labor is the only variable cost the shut down rule can be stated as operate only if average revenue product exceeds the wage The treatment of input and output markets is similar / uniform in microeconomic theory. Equilibrium in both markets occurs where marginal revenue equals marginal cost short run input demand depends on both on its own price and the price of the output as well as on the amount of the fixed factor employed.

When both factor inputs are variables the demand for a factor depends on the relative price of the two factors (the substitution effect) and change in the level of output produced by that factor (the output effect). This is similar to the effect on demand of output of change in its price The long run demand curve of an input takes account of the shift of the variable marginal product curve of the input and the induced demand for the other input caused by a change in the price of the first input. Hence the long run demand curve for an input is more elastic then it’s short run demand curve. This analysis is again quite similar to that of long run demand in competitive output markets. Thus the market input demand curve is seen to be the sum of the input demand curve of all firms in the market with the qualification that since all firms in the (input) market are price takers, a fall in input price affects not just one firm but all firms inducing a fall in the price of the (homogeneous) output they produce therefore the rise in input demand (induced by the fall in its price) is lesser than the increase in demand that would be obtained by summing up infinitesimal changes in the input demand of individual firms Labor supply is modeled by microeconomic theory along the same lines as the supply curve in product markets. The capitalist workers “trades off” work for labor and his indifference curve is convex to the origin showing that the marginal utility of an activity (work, leisure) decreases as the quantity ‘consumed’ by the capitalist worker increases. The capitalist worker like the capitalist consumer is a utility maximize. In non capitalist societies input prices are not determined on the basis of profit and utility maximization considerations. Input markets are typically small and restricted Microeconomic theory does not provide an appropriate analytical framework for understanding price and output determination in non capitalist (commodity and factor) markets The substitution and income effect of a change in the wage rate on the supply of labor have opposite effects and the overall effect of wage rate changes on labor supply remains indeterminate The labor supply curve may be backward sloping if the substitution effect of a change in wage is outweighed by the income effect––a rise in wages in these circumstances will lead to a reduction in the supply of labor. The labor supply curve is expected to become negatively sloped at relatively high wage rates Equilibrium in a competitive labor market (like in a goods market) is achieved at the point where the demand and supply of labor are equal to a unit wage rate equal to the marginal product of labor. Macroeconomic theory expects full-employment equilibrium in the labor market–––i.e. there can be no involuntary unemployment in competitive labor markets Infra marginal workers receive a “rent” equal to the wage of the marginal worker and the wage they receive in the labor market. This “rent” is the producer’s surplus. The elasticity of the labor supply curve determines the extent of the “rent’ that will accrue to infra marginal workers

Neoclassical theory justifies price structures and employment levels generated by competitive factor market mechanisms. The unequal pattern of income distribution this produces is justified by economic theory Neo Sraffian and Keynesian economists reject the view that wages are determined by labor productivity. They argue that wages are determined by bargaining among unequal partners and therefore unionization and state support of labor is necessary. Liberal economists such as Heyek deny this and argue that by artificially pushing up wages unions and governments can only create unemployment The backward bending labor supply curve is a fiction for most groups of workers. The income effects usually outweigh the substitution effect of wage change and a fall in wages leads to a rise in work hours Summing individual labor supply curves does not yield a “well behaved” market labor supply curve. The market labor supply curve can take any shape at all the relationship between the wage rate and labor supply cannot be specified by microeconomic theory. There can therefore be multiple intersections of the market supply and demand curve for labor and several equilibrium wage levels Microeconomic theory cannot prove that wages are determined by market forces. If the labor supply curve is downward sloping market mechanisms will not operate to ensure restoration of equilibrium and market intervention (minimum wages) will be justified Firms with a monopolistic position in output markets do not measure the benefit of hiring a worker by its VMP but rather by its marginal revenue product (which is lesser than VMP). In monopolistic firms workers receive the marginal revenue product which is lesser than their value of marginal product. Monopolistic firm also generate a lower level of employment than competitive firms. Similarly neoclassical theory shows that a profit maximizing firm which is a monopsonist in the input (labor) market pays a wage which is lower than the value of marginal product and employs fewer workers than a competitive firm. A monopsonist who is also a monopolist in a product market pays a wage which is lower than the wage paid by a monopsonist who does not have monopolistic power in the product market Unions emerge as monopolistic force in the labor market. They seek to force firms to pay a wage rate they would have to pay if they were not a monopsonist in the factor market. Employers seek to induce the union to accept a wage rate as if the union was not a monopolist. These are the highest and lowest limits of wages consistent with profit maximizing behavior. The actual wage is determined by relative bargaining power of the two groups between these two levels. Microeconomic cannot determine where it will settle If the unrealistic assumption that the labor supply curve of a competitive firm is horizontal is dropped, profit maximizing employment position of such a firm will be identical to that of a monopsonist. Reducing wage in the labor market does not lead to higher employment or increased welfare

Sraffa showed that it is not possible to draw independent aggregate demand and supply curves for the labor market. Since factors that alter the supply will also alter the demand for labor, therefore no unique equilibrium point in the labor market identifying equilibrium wage and employment level can be identified. Review Questions Why do capitalist firms hire a worker? Why do non-capitalist businesses hire a worker? Who is a capitalist worker? What distinguishes him from a non-capitalist laborer? Define and calculate the marginal product of labor using some numerical numbers. Evaluate the neoclassical theory of diminishing marginal productivity. Assuming that wages are the only variable cost, state the shut down rule for a capitalist firm. Demonstrate the similarity of microeconomic analysis of capitalist output and capitalist factor input markets. Was this similarity a feature of classical political economists such as Smith and Ricardo? It not, why? What is the difference in the microeconomics analysis of short run and long run labor market equilibriums? What assumption about the preferences of capitalist workers underlies the slope of the “normal” labor supply curve in microeconomic theory? “There can be no involuntary unemployment in competitive labor markets”. Asses the assumptions behind this proposition. Who are “infra marginal workers”? What determines the size of the “rent” they receive in capitalist input markets? Income distribution patterns generated by capitalist markets must necessarily be unequal. Why? What is the microeconomic theoretical justification for the necessary existence of this income distributional inequality? State and evaluate the Keynesian case for wage determination through collective bargaining between workers, firms and the capitalist state. Does Keynes accept the marginal productivity theory of wage determination? State and evaluate the Sraffian critique of neoclassical wage determination theory. “The slope of the labor supply curve is necessarily indeterminate”. Comment. Assess the impact of changes in output market structures on wage and employment determination in capitalist order. Identify the upper and lower limits within which wages are typically determined between capitalist unions and capitalist firms in input markets. Reducing wages does not always lead to higher employment. Why? How does it justify a case for wage floor? Why, according to Sraffa, is it not possible to draw independent supply and demand curves for labor markets? Chapter 16 MARKET FOR CAPITAL The previous chapter outlined the neoclassical theory of income distribution with reference to the labor market. This chapter will apply the same theoretical apparatus for an analysis of the market for “capital” to complete the argument. After developing the conventional theory, we will explain inconsistencies embedded in the conventional theory of “capital” pricing. In the previous paragraph we have put the word “capital’ in inverted commas. This is because microeconomic theory attributes a distinctive meaning which is not assumed by others economists, especially Sraffians and Marxists. We must therefore begin this chapter by explaining what microeconomists mean by “capital’. Once this meaning is clear we can remove the inverted commas around “capital” and can also use substitute words for this term.

“Capital” in capitalist-order has two forms of existence–––money and (what Smith called) ‘stock’––machinery, raw material, inventories and land. Remember these are only the firms in which “capital’ exists. It’s essence as described by Muhammad Marmaduke Pickthall is ‘takathur’–––lust and greed. In capitalist order lust and greed become universalized in the sense that every act is valued in terms of the contribution it makes to the expansion of lust and greed. Capital is the universalized form of ever expanding lust and greed. In capitalist order lust and greed endlessly flow through money and material to dominate both individual conscious and social being (i.e. civil society and the republic state). All economic schools–––classical, neoclassical, Keynesianism, Sraffian, Marxist, Intuitionalist, Behaviorist etc–––accept that it is natural and rational for lust and greed (i.e. capital) to dominate individuality and society. Societies in which lust and greed are regarded as vices and public rationality endorses values of zuhd, infaq and chastity are regarded irrational by the economists. It is in this fundamental sense that all economic schools legitimate capitalist order––an order in which value is ascribed to acts in accordance with their relative contribution to the expansion of lust and greed. Although all economic schools endorse the essence of capital they differ about the form it takes––and about the form it should take–––in capitalist society. Thus microeconomists argue that the difference in the two forms that capital takes–––money and materials–––is irrelevant, for materials which is used for producing final goods have their value expressed in money, like everything else in capitalist order. Money is the great “leveler” in capitalist order. It relates everything to everything in (exchange) value terms. When macroeconomists speck of capital they refer to essential commonality of all capitalist acts, every capitalist act has (relative) value to the extent to which it contributes to the expansion of lust and greed. Final goods, materials used for their production (including labor), knowledge, spirituality and money itself should be ascribed value on this basis and this basis alone. Sraffian economists have argued that financial markets do not perform this valuation task efficiently. The money value of machinery does not reflect the quantity of machinery used in production and the money value of machinery as determined in capitalist––specially financial—markets does not accurately represent the contribution the use of this machinery has made to capital accumulation in general–––i.e. the rate of return to specific capitals does not reflect the specific contribution to capital accumulation in general. Microeconomists have not been able to answer the question Sraffa raised. They continue to hold that “capital” in its money form is the universal equivalent accurately reflecting relative value of all capitalist acts as contributions to capital accumulation in general. This is the meaning of the word “capital’ in microeconomic analysis and since the chapter presents the microeconomic theory of valuation in capital markets, therefore we will remove the inverted commas and by “capital we will mean capital as understood by microeconomic theory throughout this chapter.

16.1: Demand for “Capital” In A Competitive Market The standard education in economics attempts to explain and justify the determination of rate of interest on lines similar to its explanation of the wage rate: the payment to capital represents its marginal productivity. This section develops the standard neoclassical model to explain the determination process of the interest rate in an idea capitalistic market economy. 16.1.1: Demand for Capital The demand side of the capital market is analogous to the demand for labor. The upper part of figure 16.1 simply substitutes capital for labor on the horizontal axis and draws the standard production function exhibiting diminishing marginal productivity of capital. Multiplying it by the price of the output we get total revenue product curve. The lower panel substitutes interest rate for wages and labor with the amount of capital. If the firm is a price taker in a competitive market, it will face a horizontal supply of capital at given market interest rate, say io. This means that its interest payment bill will be a straight positively sloped line as shown in the above panel. The value of the marginal revenue product curve is drawn negatively sloped in the bottom panel because marginal product of capital is assumed to fall as more capital is hired. Now a similar hiring rule for capital can also be defined: a profit-maximizing firm will hire capital up to the point where its contribution (marginal benefits) to the output just equals its hiring cost (marginal cost). Since the marginal cost is given by the interest rate while marginal benefits are measured by the value of marginal product of capital, the profit-maximizing point is: (16.1a) or (16.1b) Since P equals MR for a competitive firm. Summing up the individual demand curves for capital by all firms gives the market demand for capital: (16.2) Figure 16.1: Demand for capital by a competitive firmCRs/unitK0SK = AE = MEVMPKicKcK0RsProduction FunctionTRPccCompetitive Interest Payment BillKcMaximum profit capital hiringπmaxTotal Revenue ProductIPcc Figure 16.1: Demand for capital by a competitive firm C Rs/unit K 0 SK = AE = ME VMPK ic Kc K 0 Rs Production Function TRPc c Competitive Interest Payment Bill Kc Maximum profit capital hiring πmax Total Revenue Product IPc c However, the above argument is not intuitively appealing. The equilibrium condition refers to the short run period (the period in which usually production takes place), when at least one factor of production can’t be varied. This concept of ‘short-run production’ is arguably justified when we keep capital fixed and allow labor to change. But it makes very little sense to suppose that machinery can be variable keeping labor constant. In fact, capital is the least flexible factor of production—if this could be changed, then everything else can be varied too. 16.1.2: Supply of Capital Again, the neoclassical economic theory maintains that the supply of capital is also made by the households or consumers (we discuss the implications of this assumption later). As we learnt in the last chapter the supply of labor input results from the potential employee’s choice between work and leisure, similarly the supply of capital originates from a capitalist individual’s decision about consuming today or tomorrow—called the inter-temporal choice problem. The basic idea is that a consumer has a horizon of full life-time spending involving the choice of how much to consume and how much to save. The more he consumes today, the less he will be able to save for tomorrow. While making this trade-off, the consumer must look ahead to his expected future income as well as his future consumption plan. Irving Fisher developed the model wherein economists analyze the choices of rational and forward-looking consumers.

Intertemporal Budget Set When people decide about how much to consume today and how much to save for tomorrow, they face an intertemporal budget constraint. Understanding the capitalist consumer’s choices about current and future consumption requires an understanding of this budget constraint. For simplicity, consider a capitalist consumer who is planning his consumption over two time periods: period 1 is his youth (today or current period) and period 2 is his old age (future period). Let’s denote his current consumption or consumption in period 1 by C1 and that of in period 2 by C2. Further, he earns income M1 today and expects M2 income in future. Suppose initially that the only way the consumer can transfer money from period 1 to period 2 is by saving it without interest. Also assume for the moment that he has no possibility of borrowing money. This means that the most he can spend today is M1—i.e. his current consumption equals current income due to the assumed borrowing constraint. His budget set will look like the one shown in figure 16.2. Facing the borrowing constraint, the consumer has two choices: either to consume M1 today and M2 tomorrow and make no savings, in this case he will be at point E (his endowment point) where he just consumes his income of each period; or he can choose to consume less than his current income and save some for period 2. This allows the consumer to move along segment FE where his current consumption is less than his current income. The difference between the two equals his saving in the first period: (16.3) In the second period, his consumption will equal his income in period 2 plus the accumulated savings; i.e. Since the consumer cannot earn interest on his savings, the opportunity cost of consuming today is the forgone amount he can consume in future. Here, his opportunity cost will be one; i.e. by consuming one rupee today he sacrifices the opportunity to consume it tomorrow. The slope of the budget line is -1—one rupee today equals one rupee tomorrow. Figure 16.2: Intertemporal budget set with borrowing constraintsC1M10C2(Endowment point)FM2Slope = -1C1C2 =M2 +SSavingsbE Figure 16.2: Intertemporal budget set with borrowing constraints C1 M1 0 C2 (Endowment point) F M2 Slope = -1 C1 C2 =M2 +S Savings b E Think now of a capitalist society where each and every resource is treated as capital—originally dedicated to the accumulation of more capital. There will be money markets which offer some io percent interest tomorrow on each rupee saved today. This means that the consumer can convert one rupee of today into one rupee plus interest accrued tomorrow. Therefore, the one rupee saved today will not be equal to one rupee tomorrow. If the market offers interest rate i on each rupee saved, then the future value of current 100 rupees can be calculated as: or With interest rate 10% (= 0.1), the 100 rupee will equal 110 [= 100 (1 + 0.1) = 100 + 10]. In general, the future value of current P rupees will amount to following after one year: (16.4)

Conversely, it means that the one rupee tomorrow will be less than a rupee today. This can be seen by simply converting the relation (16.4) as: (16.5) Thus if you expect to earn rupees 100 tomorrow and the interest rate is 0.1, its present value will be rupee 91 [= 100/1.1]. Equipped with the ideas of compounding and discounting, if the consumer now consumes less than his income in the current time period, he will save amount M1 – C1 today on which he can earn an interest rate of i tomorrow. This means that his current savings will be worth the following in period 2: The amount that he can now consume in period 2 by is given by: (16.6) This says that his consumption tomorrow will equal his future income (M2) plus the amount saved today including the interest earned on that saving. Let us now allow the consumer to borrow any amount he wants at the given interest rate io. If the consumer is a net borrower today, this means that his consumption today is greater than his current income (i.e. C1 > M1). The consumer will now have to pay interest amount i(C1 - M1) in period 2 on whatever he borrows today. Of course he will also return the borrowed amount (C1 - M1). His budget constraint is now given by: or which is exactly what we had in (16.6). We are now in a position to draw the feasible set of consumption points for the consumer in figure 16.3. At point E, the consumer is on his endowment point. If he consumes nothing today and saves all of his income, the future value of his income (and his consumption in period 2) at interest io will equal: (16.7) Figure 16.3: Intertemporal budget set without borrowing constraintsEC1M10C2(Endowment point)M2Slope = -(1 + i)M2 + M1(1 + io)PF Figure 16.3: Intertemporal budget set without borrowing constraints E C1 M1 0 C2 (Endowment point) M2 Slope = -(1 + i) M2 + M1(1 + io) P F This gives the vertical intercept F of the intertemporal budget line FP which measures the maximum amount of second period consumption when C1 = 0. Similarly, the present value of all his income is measured by: (16.8) which gives us the horizontal axis P. At this point, the consumer plans to consume nothing in period 2 and borrows as much as possible against his future income. Joining the three possibilities for the consumer, we get FEP budget line. All the points on this budget line are feasible for the consumer in the sense that they are all available to him. Any point along the line segment FE implies that the consumer is a net saver while a point along segment EP means he is a net borrower. The slope of this budget line equals– (1 + i)— the opportunity cost of present consumption. The consumer can transfer each rupee of present consumption into (1 + i) by not consuming it today. The negative sign indicates the trade-off facing the consumer between present and future consumption; i.e. both can’t be increased with income being fixed in both the periods. Intertemporal Preferences The intertemporal preferences of the forward looking capitalist consumer are represented by indifference curves. This indifference curve shows the combinations of consumption today and tomorrow that make the consumer indifferent. If the consumer’s first period consumption is reduced, his second period consumption must increase to keep him equally happy. The shape of the indifference curve indicates the consumer’s taste for consumption at different time periods—how much extra amount of consumption he requires in period 2 in order to be compensated for a one unit reduction in period 1 consumption. If, for example, we draw an indifference curve with a constant slope of -1 in (the dotted line) figure 16.4, it would represent the taste of a consumer who does not care about consuming today or tomorrow. Technically speaking, his marginal rate of substitution between today and tomorrow is -1. Such a consumer cannot be called a capitalist consumer because he is not concerned about accumulation. The typical capitalist consumer is one who has a relatively high preference for future consumption made possible by accumulations. This point has been stressed by major economic historians (Weber, Tawney, Schmoller, Phyllis Deane) seeking to explain the transition from feudalism to capitalism in Western Europe. Modern economic history, particularly Foster and Arrghiri, have taken note of the consumption explosion in the United States and the virtual disappearance of non-corporate private sector saving (erroneously called household saving for the household itself is disappearing in America).

The intertemporal marginal rate of substitution is termed the rate of time preference—the rate at which the consumer is willing to substitute second period consumption for first period consumption. Figure 16.4 draws two usual shaped convex indifference curves. To understand what they mean, consider two choice points A and B which are mirror images of each other: Though the two bundles offer equal total consumption, but A has more of consumption today as compared to bundle B which offers more in the future. Since future events are uncertain and can change, this means that the consumption of one-rupee today will be worth more than the same amount of consumption in future. Figure 16.4: Modeling intertemporal preferencesCC1200C220Slope = -130103010AB Figure 16.4: Modeling intertemporal preferences C C1 20 0 C2 20 Slope = -1 30 10 30 10 A B Alternatively, the capitalist consumer will require more than one rupee of future consumption if his current consumption is reduced by one rupee. This means that a consumer who discounts future consumption will prefer B to A. The two indifference curves reflect this behavior of the consumer. Since he prefers more consumption to less, points on the higher indifference curves (such as point C) are preferred to lower ones (such as point A). The consumer’s rate of time preference along such indifference curves depends upon the level of consumption in the two time periods. The marginal rate of substitution keeps on decreasing as he gets more and more of present consumption—i.e. when current consumption is very low, the consumer requires much extra future consumption to give up a unit of current consumption. Optimization: Choice about Saving and Borrowing Given the standard apparatus, economists model the choice about how much to consume today and tomorrow. The capitalist consumer would like to end up at the highest possible indifference curve in his effort to maximize utility. The right hand side of figure 16.5 shows the optimal choice of consumption at point D where the consumer consumes D1 today and D2 in time period 2. At equilibrium, the slopes of the budget line and indifference curve are equal: (16.9) Since current consumption is less than current income at point D, the consumer is a net saver at market interest rate ro. His savings equal: on which he earns S(1 + io) amount in future. Figure 16.5: Intertemporal choice with borrowing or saving possibilitiesEC1M1C2M2Debt repayment =B(1 + io)PFG2G1GB = Borrowings00EC1M1C2M2Interest earnings =S(1 + io)PFD2D1S = SavingsD Figure 16.5: Intertemporal choice with borrowing or saving possibilities E C1 M1 C2 M2 Debt repayment = B(1 + io) P F G2 G1 G B = Borrowings 0 0 E C1 M1 C2 M2 Interest earnings = S(1 + io) P F D2 D1 S = Savings D But suppose Nomi is another capitalist consumer having a strong time preference for current consumption. His equilibrium may be at point G in the left hand panel where he ends up as a net borrower because he consumes today more than what he earns today. His borrowings will be equal to: and he will repay this amount plus interest accrued on this borrowing in future: B(1 + io).

Effects of Changes in Interest Rate Let us now see what happens to the decision of capitalist consumer to lend or borrow when the interest rate changes. Assume that the interest rate rises from io to i1. What happens to the budget line? To see this, consider expressions (16.7) first: (16.7) We can see that the increase in the rate of interest from io to i1 increases the future value of consumer’s income: < for io < i1 This means that the vertical intercept of the budget constraint will increase. Similarly, expression (16.8) shows that the horizontal axis of the budget line will decrease as the increase in the rate of interest will reduce the present value of consumer’s income. The budget line tilts to a steeper position QR in figure 16.6 having a slope –(1 + i1): for a given reduction in current consumption, the consumer will get more consumption in the future when the interest rate is higher. Note that the budget line has rotated around the endowment point of consumer because this point always remains affordable for the consumer, no matter what the interest rate is—he will always have the possibility to consume what he earns today. This change in the interest rate will bring about changes in his consumption plans in the two time periods. Here we can have two cases depending on whether the capitalist consumer is a net lender or a borrower. Effects on a borrower Suppose that he is a borrower initially (point G). It can be seen in figure 16.6 that his current consumption will decrease and that of the second period will increase while moving from point G to H. The model predicts that the consumer’s borrowings will fall in response to a rise in the rate of interest (because the current consumption has decreased). Again, the total effect of interest rate changes can be decomposed into two effects: the substitution effect and income effect. The substitution effect is the change in consumption plan that results from changes in the relative prices of consumption in the two time periods. When interest rate increases, the current consumption becomes more expensive in the sense that each rupee spent today means giving up more interest earnings by not consuming it. The substitution effect, therefore, tends to make the consumer choose less today and more in period 2. Figure 16.6: Effect of interest rate increase on a borrowerEC1M1C2M2PFG2G1GReduction in Borrowings0RQHH1New budget lineSlope = -(1 + i1)Old budget line Slope = -(1 + io) Figure 16.6: Effect of interest rate increase on a borrower E C1 M1 C2 M2 P F G2 G1 G Reduction in Borrowings 0 R Q H H1 New budget line Slope = -(1 + i1) Old budget line Slope = -(1 + io) The income effect also works in the similar direction. Since the consumer is initially a borrower (this is true of present day American capitalist consumers but not of Chinese capitalist consumers), increase in interest rate makes him worse off because now he has to pay more in debt repayment [B(1 + i1) > B(1 + io) if i1 > io]. If consumption in both time periods is a normal good, then income effect will reduce both of them. Since the current consumption has decreased due to both effects, we can conclude that an increase in interest rate reduces the borrower’s amount of borrowing.

The reduction in interest rate will work in the opposite direction and hence we leave its drawing to the students as a practice. The first two rows of table 16.1 summarize the effects of interest rate changes on the borrowing decision of a capitalist consumer. Table 16.1: Summary of the effects of interest rate changes Type of Consumer Direction of Interest Rate Change Effects Borrower Increase borrowing reduces: both substitution and income effects reduce the current consumption Decrease borrowing increases: both substitution and income effects increase the current consumption Saver Increase indeterminancy in savings: substitution effect reduces but income effect increases the current consumption Decrease indeterminancy in savings: substitution effect increases but income effect reduces the current consumption Source: Adapted from Microeconomic Analysis by Denzau T. Arthur Effects on a saver Now consider a capitalist consumer who is initially a saver in figure 16.7. The substitution effect carries the same sign; i.e. negative—reduces the current consumption. But the income effect changes its sign and becomes positive. This is so because increase in the interest rate makes a lender better off as he can now earn a higher return on each rupee lent. Given that consumption in both periods is a normal good, the consumer would spread this improved income over both periods and current consumption increases. Since the total effect is the sum of a negative substitution effect and a positive income effect for a saver, the result is ambiguous and indeterminate. Hence, it is not possible to determine the net effect of increase in interest rate on current consumption as well as lending decision of this type of capitalist consumer. The summary of these results is presented in table 16.1. Figure 16.7 shows the case of a net lender who has decreased the supply of savings following an increase in interest rate as his equilibrium point moved from D to J—hence implying the possibility of a negative relationship between the supply of savings and interest rates. The diagram is drawn with a negative substitution effect greater than the positive income effect. We can also draw the opposite case with income effect larger than the substitution term and hence resulting in a positive relation between interest rate and supply of savings (the diagram is left for the students as a practice). Remember that standard economic theory cannot guarantee a smooth positive relation between savings and rate of interest in capitalist society. It can place only a loose restriction on the outcome of interest rate changes on the decision of a net lender: a lender must remain a lender after increase in the interest rate. This is illustrated in figure 16.7 where the consumer is initially at point D with a consumption bundle to the left of his endowment point E. If the interest rate increases, his new equilibrium cannot move to the right of the endowment point in the segment ER because choices to the right of point E at segment EP were available to the consumer when he faced the original budget line FP but they were all rejected in favor of point D (the choice point at FP).

Figure 16.7: Effect of interest rate increase on a lender or saverEC1M1C2M2PFD2D1D0RQJJ1New budget line Slope = -(1 + i1)Old budget line Slope = -(1 + io) Figure 16.7: Effect of interest rate increase on a lender or saver E C1 M1 C2 M2 P F D2 D1 D 0 R Q J J1 New budget line Slope = -(1 + i1) Old budget line Slope = -(1 + io) Since the original optimal bundle D is still available at the new budget line QR, the new equilibrium point must be a point outside the old budget line FP. This means that the new optimal choice point must be to the left of the endowment point after the increase in the interest rate implying that a net lender must remain a lender if the interest rate goes up. Apart from this loose restriction that an interest rate increase cannot induce a lender to become a borrower, microeconomic theory can give no definite prediction about the direction of the relationship between interest rate changes and the saving decision of a capitalist consumer. With several consumers in capitalist society having different rates of time preferences, it is possible to derive any shape of the supply curve of savings by aggregating their individual supply decisions. However, the economists insist that the saving supply curve is normally of the ‘right shape’ (positively sloped), as in figure 16.8, and the rest of the shapes are either ‘anomalies’ or merely a matter of some ‘intellectual discussions’. Standard textbooks draw a positively sloped supply of savings against interest rate rarely mentioning the facts that: the standard theory provides no definite justification for this ‘right shape’, and the ‘right shape’ of the market supply of savings requires that there is one and only one capitalist consumer in society who never changes his taste with changes in his income Even by assuming the only capitalist consumer the theory remains indeterminate. For a single consumer can neither be a net-lender nor a net-borrower–––there is no one to lend to or borrow from in a case of a single consumer. Assuming the existence of a single capitalist consumer illustrates the absurdity and essential incoherence of Economics. For if there is only one (representative) consumer there is no possibility of exchange and no possibility of the realization of exchange value in commodity or factor markets–––macroeconomic has no credible microeconomic roots (there are no markets in Robinson Crusoe’s island and none in the island of the Swiss family Robinson either). Figure 16.8: Typical upward sloping supply curve of savingsS (savings)0i (interest rate)SS Figure 16.8: Typical upward sloping supply curve of savings S (savings) 0 i (interest rate) SS 16.1.3: Equilibrium in the Capital Market Joining the demand and supply sides, economists jump to the conclusion that the equilibrium interest rate is determined at the intersection of demand for and supply of capital in the capital market, as shown in figure 16.9. Since the demand curve for capital represents its MRP, the equilibrium level of capital hiring reflect the fact that capital is also paid its fair contribution in the total output. This conclusion makes three specific claims:

the reward for capital (interest rate) is determined by the quantity demanded and quantity supplied of capital the market rate of interest reflects the marginal productivity of capital the market mechanism always determines a unique equilibrium rate of interest Having completed this basic model, we now move on to explain the political assumptions underlying the microeconomics. Figure 16.9: Equilibrium in capital marketK (Capital)0i (interest rate)SkDkioKoE Figure 16.9: Equilibrium in capital market K (Capital) 0 i (interest rate) Sk Dk io Ko E 16.2: Euler’s Exhaustion Theorem: Solution to Class Conflict The neoclassical model of income distribution developed in this and the previous chapter seeks to show that the returns to the factors of production are determined by marginal productivity theory (also termed as functional distribution of income). According to this theory: when each factor of production is paid in line with its marginal productivity, it is getting its fair and just reward since this reward equals to what it contributes to the welfare / accumulation of the society as a whole, and the configuration of factor prices (wages and interest) that are generated by the competitive markets actually reflect the marginal productivities of factor inputs. Hence, the factor rewards determined in a market economy are fair and just ones when economic agents, say workers, unite and ask for more than what the market offers, they are actually trying to violate the rules of marginal productivity theory (i.e. they are working against the rules of justice and hence against their own self-interest). Such deviance should be met with force by capitalist state However, this description is merely the first half of the neoclassical theory of income distribution. A complete theory of income distribution should answer two questions: One the one hand, it should explain exactly how much each factor of production will receive out of the total value of goods produced in a capitalist society On the other hand, the theory should also show that the sum of the payments made to all factors of production fully account for the value of goods produced in an economy—all the value is ‘exhausted’ in factor payments and nothing is left over. Technically, speaking it should show that Value of Output = Sum of Payments to Factors of Production With labor and capital being the only two inputs, we should have the identity: Value of Output = Wage Payments + Capital Payments or Y = wL +iK (16.10) where w = wage rate and i = interest per unit of capital both expressed in terms of the physical output. The neoclassical response to the first question has been developed above. The theory treats the national product (or national income) (Y) as a function of capital (K) and labor (L): Y = f (L, K) (16.11a) where all the quantities are expressed in physical terms. Multiplying Y by price we can obtain the value of output in monetary units. This output is distributed between the capital-owners and the workers, in accordance with the accounting relationship (16.10). If the markets are left free without any intervention, each factor will receive a return which equals its marginal product:

(16.11c) and (16.11d) Using (16.11c) and (16.11d), the shares of labor and capital are given by: (16.11e) (16.11f) That is all as far the first question is concerned. But obviously it is not clear from this part of the story whether the theory answers the second question as well—i.e. whether the sum of (16.11e) and (16.11f) will exhaust the total output produced. Even if we assume that the marginal productivity theory is valid in explaining the determination of factor shares, it does not ensure that when all factors are paid their marginal products no surplus is left over for either of the factors to appropriate to itself. Similarly, the theory also does not rule out the possibility that the sum of the competitive payments may even exceed the total output. In this case, the claims will be inconsistent since the sum of the factor shares will be greater than total output produced. Importance of the answer to the second question can be appreciated by noting the fact that one of the major objectives of marginal productivity theory of income distribution is to show that the market mechanism organizes production and its distribution in a fair and harmonious manner. To see what this means, note that the above formulated neoclassical theory is quite consistent with the interpretation that the distribution of income / output depends upon who initiates and conducts the production process. For example, if the production process is controlled by the capital-managers, then the maximum that the marginal productivity principle says is that the wage rate cannot exceed the marginal product of labor; i.e. w ≤ MPL while the rest of the output flows to the managers of capital. Similarly, if the workers take control of the production process, then the reward for capital could not exceed the marginal product of capital; i.e. i ≤ MPK and the remaining output is taken away by the workers. However, the theory does not guarantee that once the ‘hired factor’ as well as the controlling class has been paid out their marginal product shares, no surplus output will remain with the controlling class to be appropriated to itself. The theory also does not recognize that if the workers take control of capital, they will themselves become capital controllers and the decision to distribute the product value between wage and non-wage payments will become subject to planning––it will move out of the market. If the ‘remaining part of the output flowing to the controlling class of production process after paying the marginal product of subordinate factor’ is greater than its own marginal productivity, this means that the control over the production process pays dividends to the controlling class in addition to their contribution in output. However, this interpretation of marginal productivity theory is not endorsed by economists since it indicates the existence of class-conflict in a market economy—after all, if the control of the ‘production process’ is the ultimate determinant of income shares, why should a factor input be content with its marginal product and not look for taking over the production process itself? The idea of class-conflict was at the center of classical economists’ (such as Smith, Malthus and Ricardo’s) theories of income distribution. These economists maintained that capitalist economies are structured by classes (such as workers, landlords and holders of ‘stocks’) and the share of each group is determined largely by social and political conditions. For example, Malthus and Ricardo conceived that the wage share of workers is determined not in accordance with their contribution to output, but by the principle of ‘subsistence wages’—i.e. workers receive out of the total output only what is required to reproduce their labor services and their family. The exact amount of this ‘subsistence wage’ may differ as it is dictated by the level of development that has taken place in any society at any specific time (e.g. subsistence wage in Pakistan will be far lower than that in the US). Marx took this ‘class-based’ analysis to its logical conclusion by showing that capitalism is a system of production where workers are exploited by the capitalist class.

The marginal productivity theory of income distribution was developed to refute the ‘class-based’ theoretical analysis put forward by the Classical economists in the early and middle parts of the 19th century. Neoclassical economics set itself the task to prove that the fundamental characteristic of the market economy is ‘harmony’ and not ‘class-conflict’; and that the market is not a source of exploitation but of welfare maximization. The response to the Classical heritage came in the form of ‘equilibrium based analysis’ which asserted that competitive markets generate prices which leave all market participants in a state which cannot be improved upon by any other means—no one can be made better off by means other than participating in the market. Hence, ‘market equilibrium’ is not only efficient but also welfare maximizing for all agents. The marginal productivity theory (an off-shoot of marginalist framework of analysis) contended that the shares of all factors of production are determined by ‘objective and technical’ conditions (such as their marginal productivities). However, as shown above, this ‘marginal productivity principle’ is not enough to dismiss the existence of class-conflict in capitalist societies. If neoclassical economists had to prove that the fundamental characteristic of market economy is ‘harmony’ and not ‘class-conflict’, they must show that their income distribution theory also answers the second question—the factor prices generated by the marginal productivity theory are such that the total factor shares are equal to the total output. Fortunately, the rescue to the problem came, but neither from some rigorous economic theory nor from some ‘new empirical observations’, rather it came out of a mathematical relation suggested by the mathematician Leonhard Euler. According to him, if the production function (16.11a) displays constant returns to scale, then the marginal productivity theory satisfies the ‘adding up’ identity (16.10) as: Y = MPL×L + MPK×K (16.12a) To obtain its monetary version, simply multiply by price: PY = PMPL×L + PMPK×K (16.12b) The Euler’s theorem simply says that the factor prices generated by the competitive input markets: reflect the marginal productivities of those factor—hence they are just and fair are efficient because they maximize the social welfare of all, and also rule out any possibility of ‘surplus value’ to be appropriated by one class or another—whether the dominant or dominated. Thus, the theorem rendered ‘control over the production processes’ as irrelevant in capitalist societies since the reward of each factor depends upon what it contributes to the production process, nothing more and nothing less. Since this mathematically elegant proposition solved the missing element of marginal productivity theory, it tempted economists to assume that the production function (16.11a) is precisely a function of this type. Thus, if we assume that capitalist production process takes place under the conditions of:

infinite possibilities of substitution between inputs (so that the iso-quants are continuous and smooth), and constant returns to scale then market economies will uproot class-conflict as a fundamental expression of capitalist societies. If we reject these assumptions, then marginal productivity theory cannot demonstrate the non-existence of surplus product and its appropriation by dominant classes. There is irrefutable evidence to shows that in both product and factor markets there exist increasing return to scale and relatively low elasticities of factor substitution. 16.3: Complexities Creep in: Some Untold Problems with Capital Market Analysis All of the strong theoretical and policy claims of neoclassical economics rest on a number of inconsistent assumptions. This section will develop some of the devastating criticisms leveled against neoclassical theory of income distribution in general and the theory of capital remuneration in particular. However, it should be kept in mind that the criticisms developed in the last chapter (such as ‘perfect competition equals monopsony’) are also applicable to the theory of capital. 16.3.1: Sraffa on Diminishing MP and Return on Capital Recall Sraffa’s criticism of marginal productivity from chapter 10 and 11. That criticism can be applied here with its full force (it was first put forward by Bhaduri in 1969). The physical capital market must also be defined in a broad sense which means that there are in fact thousands of different machines that are lumped together to call them ‘capital as a factor of production’. This means that a change in the price of such an input would bring changes in numerous industries and therefore it would change the distribution of income. This point can now be developed in a more explicit form. Consider a capitalist economy composed of workers and capital-controllers. At the level of a firm, the following equality holds: Y = w × L + i × K (16.10) In order to derive the marginal product of capital, we need to change output. Of course, the change in output equals the sum of changes in wages and interest payments: (16.12a) Decomposing the second term in this expression (leaving the first one aggregated because we are interested in the MP of capital): (16.12b) This says that the change is the sum of the two parts: interest rate times the changes in capital and capital times the change in the rate of interest. Dividing through by change in capital (ΔK) we have this expression for the marginal product of capital: or (16.12c) The standard economic theory assumes that the first and the last terms of (16.12c) on the right hand side are zero for a competitive firm—i.e. increase in output due to more hiring of capital by a single firm has no impact on the wage rate (Δw = 0) and interest rate (Δi = 0). So cancelling out the zero terms we have the desired result of those who advocate marginal productivity theory: (16.12d) Though this ‘desired result’ may make sense at the level of the firm, it is definitely not a good approximation at the level of the industry. At this level, changes in capital will cause changes in wages as well as rate of interest. Therefore, the full relationship is given by (16.12c) which means that the interest rate does not equal marginal product of capital unless the terms are zero. This was the essence of Sraffa’a concern also raised in the previous chapter: with broadly defined industry, changes in the demand or supply will affect the distribution of income in society. We can conclude, in the words of Keen, from this discussion that ‘distribution of income is neither meritocratic nor determined by the market. The distribution of income is to some significant degree determined independently of marginal productivity and the impartial blades of supply and demand’.

16.3.2: The Problematic ‘Circular Flow’ of Economics One of the problematic assumptions underlying the neoclassical theory of income distribution is its ‘dual treatment of capital as one’. To understand this, consider the standard flow of economic activities which says that all commodities—ranging from bread to a steel mill—are produced by ‘factors of production’ which are reduced to labor and capital. Figure 16.10 shows the standard circular flow diagram. The outer flow tells us that the factors of production move from ‘households’ to the business sector while goods flow from firms to the households. The inner circle shows the monetary flow of funds—firms make payments against the supply of inputs to the ‘households’ while the latter purchase the goods and services produced by the business sector. This circular flow can be valid if the firms transform inputs into output while households convert output / income into factors of production. The first part of the circular flow seems quite reasonable because factories do convert labor and capital into output. However, for the circle to be complete, consumers must transform goods they receive from firms into labor and capital. Of course it seems correct to say that households convert goods into labor services they supply to the firm. But the most problematic proposition is to say that the household sector also supplies capital by converting goods into capital. If by ‘capital’ we mean ‘physical capital’ (machines etc.), this begs the question ‘where these machines are produced’. As far as physical capital is concerned, the argument runs as follows: the households receive goods produced by the firms, internally convert them into machines and then sell them to the firms. Clearly, this is nonsensical because if households transform goods into machines, this implies that they must also be ‘firms’. Thus we find that the flow of capital from households to firms cannot be in physical terms. Figure 16.10: The standard economic circular flowFirmsHouseholdsPurchase of Output (Goods and Services)Supply of Output (Goods and Services)Supply of Inputs (Labor and Capital)Input Payments (Wages & Interest) Figure 16.10: The standard economic circular flow Firms Households Purchase of Output (Goods and Services) Supply of Output (Goods and Services) Supply of Inputs (Labor and Capital) Input Payments (Wages & Interest) Capital transformed from households to firms must be financial capital (deposits, bonds etc.). But this raises another problem with the concept of the circular flow diagram as economic theory treats this financial flow of capital as directly contributing to the production process of the firms. The circular flow says that the flow of capital from capitalist consumers to the firms generates an earning-flow back to the consumers and this interest earning reflects the marginal productivity of capital. This could be the case only if the financial capital directly adds to the production process after combining with the labor input. Clearly, this is not the case. The standard circular flow model is not complete and the only way to complete it is to appreciate the fact that firms also produce ‘physical capital’ which in turn also requires the employment of labor and capital produced earlier. Sraffa’s book The Production of Commodities by Means of Commodities successfully challenged the neoclassical vision of the production process of a capitalist economy and provided an alternative framework to analyze the capitalist production process where the firms produce not only the consumption goods but also the capital goods (the details of his ingenious method are beyond the scope of this text).

How could the standard economic circular flow be rescued from this dual treatment problem? It could be rescued only if one can demonstrate that there is a direct and unique relationship between the financial measurement of capital and its physical productivity—which is not the case as shown in the next sub-section. The standard textbooks never mention these complexities and directly jump to the conclusion that the reward of capital reflects its marginal productivity, just as is the case for labor. 16.3.3: The Capital Controversy Thus far, you should be familiar with the four diagrams drawn in figure 16.11. Make sure you read them properly: all of them are drawn with quantity of capital on one of the axis. In brief: part (a) says that it is possible to insert quantity of capital into the production function of a firm to obtain the standard well-behaved production function exhibiting diminishing marginal product of capital Part (b) says that it is logical to draw iso-quant curves in a labor-quantity of capital space (representing numerous possibilities of substitution between labor and capital) independent of the price of capital (that is why changes in interest rates are assumed to affect only the iso-cost line and not the iso-quant curve) part (c) asserts that there is a unique relationship between the demand for the quantity of capital and the interest rate—changes in the interest rate will cause changes in the demand for the quantity of capital in an opposite direction part (d) tells us that the price of the quantity of capital depends upon the demand for and supply of the quantity of capital. Further, the income earned by controllers of capital equals the marginal product of physical capital The repetition of the word the ‘quantity of capital’ might sound a bit annoying, but we want you to make sure that it is ‘quantity of capital’. That is at the heart of neoclassical analysis. Pick up any good textbook on microeconomics and you will see that it is ‘quantity of capital’. This ties in with the standard assumption of neoclassical analysis that money is neutral and plays no independent role in the determination of value and prices. But rarely would the textbooks (or your teachers) give you even a clue that there is some fundamental problem with the concept of the ‘quantity of capital’. Microeconomics texts still remain silent about the debate (or the ‘intellectual war’) that was fought on the concept of the ‘quantity of capital’ some 50 years ago between the two Cambridges—Cambrdige, England and Cambridge, Mass in USA. On the US Cambridge side, there were apostles of neoclassical economics (such as Samuelson and Solow) while the England Cambridge party consisted of the critics of neoclassical economics (such as Joan Robinson, Kaldor, Sraffa, Steedman and Pasinetti). Their debate is referred to as the Capital Controversy because it focused on the nature and role of capital as a means of production. Since the debate was largely fought between the two Cambridges, it is sometimes also called Cambridge Capital Controversy (CCC). Though most of the debate was polemic and highly mathematical in nature, there are some many issues that can be explained in relatively plain language. It is important to note that the reason why this debate is not a part of ‘standard economic education’ is not due to the fact that it was something unimportant or misconceived; it is ignored and sidelined by economists because of the simple fact that they lost this debate! Let’s develop an insight into the nature of the issues involved in this debate.

Figure 16.11: Four hey diagrams of neoclassical economics involving capital as an argument(a) Production function0K (Capital)Y0LKYoKcLcABC(b) Optimal Choice of CapitalK (Capital)0i (interest rate)SkDkieKeE(d) Market Return of Capitali (interest rateK (Capital)0VMPK = DK(c) Demand for Capital & Interest RateKbKaibiaBA Figure 16.11: Four hey diagrams of neoclassical economics involving capital as an argument (a) Production function 0 K (Capital) Y 0 L K Yo Kc Lc A B C (b) Optimal Choice of Capital K (Capital) 0 i (interest rate) Sk Dk ie Ke E (d) Market Return of Capital i (interest rate K (Capital) 0 VMPK = DK (c) Demand for Capital & Interest Rate Kb Ka ib ia B A To begin a survey of this controversy, first you should appreciate the need to focus on the word quantity of capital. It should be clear to you from the above diagrams that whatever results economists derive regarding the distribution of income from marginal productivity theory crucially depend upon this ‘physical’ concept of ‘capital’. If economists really want to make people believe that the distribution of income between workers and capital-controllers follows the marginal principle in a market economy, they must prove that ‘there is a unit in which aggregate physical capital can be measured and that unit of measurement is itself independent of income distribution and output prices’. If (and this is a very big ‘if’) we can find such a number in which the quantity of capital can be measured, only then we can insert ‘physical capital’ in the production function along with labor. This will then allow us to analyze a system of production wherein capital goods play a role in the production process along with labor on the one hand, and at the same time analyze the distribution of income in a market economy on the other hand. The introduction of ‘physical capital’ as a separate factor input plays multiple roles in neoclassical theory; i.e. as a collection of machines it leads towards growth theory—a topic discussed in macroeconomics as technical knowledge and natural resources it leads towards international trade theory as an expression of unequal endowments—a topic usually discussed in international economics as a source of a form of reward, called interest, it leads to income distribution theory—discussed above Thus, the concept of physical capital is of utmost importance for the survival of neoclassical theories of growth, trade and income distribution. An Impossibility Theorem The critics of neoclassical economics successfully established that it is impossible to construct a measure of ‘capital’ the value of which is independent of the rate of interest and wages in the economy. The reason for this ‘negative theorem’ is straight forward. The measurement of the ‘quantity of capital’ involves a major hurdle: how can we add heterogeneous capital goods? Basically, the concept of ‘physical capital’ includes too many things to be reduced to one homogenous substance called ‘capital’. For example, it covers machines, factories and buildings; trucks, ships and planes; steel mills, oil wells and power stations. Interestingly, each of these items consist of a number of other types of capital inputs (think of different parts of a truck). The problem is that the way we cannot add ‘apples’ in ‘oranges’, similarly we cannot simply add up incompatible units of ‘capital’. The only thing that such heterogeneous commodities have in common is a ‘monetary price’. This implies that capital is irretrievably a value, and not a physical, quantity.

The neoclassical economists argued that there is no problem in adding up the money value of all these different capital items to get an aggregate measure of physical capital. Traditionally, their idea was that capital could be measured by multiplying the amount of each type of capital good by its price and then adding up these multiples. The neoclassical economists assumed that their theories of production and income distribution would remain unaffected, no matter whether one uses ‘value of capital’ or ‘physical capital’ as an argument in the production function. But this is not the case because ‘the financial aggregate stock of capital’ depends upon the rate of interest paid out as part of the cost of goods included in this very ‘capital stock’. This creates circularity in the argument: the price of a piece of capital depends upon the rate of interest (as it is one of its cost components) and the rate of interest will change as prices of physical capital change. In order to determine the value of capital, it is necessary to know the rate of interest (and hence the distribution of income) first, but the rate of interest cannot be worked out without having the ‘price of capital’ first (because the rate of interest equals the ratio of interest to price)! Figure 16.11: The circularity involved in the financial measure of physical capital(1)Changes in i (corresponding to an opposite one in w)(2)Change in the distribution of income(3)Changes in the distribution of demand(5)Changes in the prices of capital goods(4)Changes in the prices of outputs (6)Changes in the value of capital Figure 16.11: The circularity involved in the financial measure of physical capital (1) Changes in i (corresponding to an opposite one in w) (2) Change in the distribution of income (3) Changes in the distribution of demand (5) Changes in the prices of capital goods (4) Changes in the prices of outputs (6) Changes in the value of capital To further consolidate your understanding of the relationship between the ‘monetary measure of capital’ and the distribution of income, note that as the distribution of demand between different sectors of an economy changes, not only does the price of the product change, but the price of capital goods used in producing those goods also changes. For example, if the share of property income rises at the expense of wages in the economy, this will decrease the demand for basic consumer goods and increase that of the, say means of production. This means that the price of the capital goods used in producing means of production would rise and that of the capital goods used in producing basic consumption goods would fall. This in turn would change the sum of the prices of the two types of capital goods. Thus, changes in the distribution of income lead to changes in the distribution of demand between sectors; which in turn means that the total value of capital stock changes with the distribution of income. Figure 16.11 summarizes the nature of circularity involved in the economic measure of capital. It is clear to see that any change arising from box (1) affects the value of capital in box (6). But the process does not end here, changes in the prices of capital then also affect the changes in interest rate i in box (1). The simple logic presented by Sraffa and party shows that the ‘monetary measurement of the stock capital’ is not independent of the distribution of income between wages and interest rate itself. The economic argument suffers from the logical fallacy of ‘begging the question’.

Implications of the ‘Impossibility Theorem’ Why bother so much about the above measurement problem? Actually, the above result falsifies economic theory right at its root which claims that the distribution of income is uniquely determined by the markets and there is nothing that policy-makers can or should do to improve the situation of someone in society. The Cambridge Capital Controversy had serious negative implications both for the theoretical foundations and the associated policy claims of the economists. This controversy showed that it is impossible to deduce unambiguous predictions from aggregate capital models, where physical capital is measured by using prices to add up all types of capital inputs. Here we discuss some of its implications leaving aside the technical issues. Badly behaved capital: Look at part (c) of figure 16.10 which draws demand for capital as a function of the ‘quantity of capital’. It says that if the interest rates fall, the firm will smoothly choose a higher ‘quantity of capital’ and hence we have a negatively sloped demand curve. However, the curve is drawn on the assumptions that an ‘income distribution free measure of capital’ is available and that changes in the interest rate do not bear any effects on this measured ‘quantity of capital’ leaving it the same in value. But as we know that capital is necessarily a value, and not a physical, quantity and its value does change after changes in the interest rate. Given this, if we assume that there is a negative relation between interest rate and the quantity of capital, when the interest rate rises the demand for physical capital will decrease, however, the value of capital stock might rise or fall depending upon the demanders’ intensity for capital—whether the value will decrease or increase depends upon how the distribution of income and pattern of demand has changed in the economy. Figure 16.12: Demand curve for capital in a multi-commodity economyK (Capital)0i (interest rate)SkDk Figure 16.12: Demand curve for capital in a multi-commodity economy K (Capital) 0 i (interest rate) Sk Dk In a nutshell, there is no way to tell in which direction the value of capital will change after changes in the interest rate, and hence there is no justification for drawing a negatively sloped demand for capital. In fact, we can have any shape of the demand curve for capital in an economy where more than one units of capital are used as a factor of production. Figure 16.12 shows a possible shape of the demand curve for capital that can result in a multi-commodity economy. Thus, we find that it is the fallacious methodology of economists that allows them to reach at strong and apparently rigorous conclusions: they mistreat capital when they put its quantity on one axis and its price on another in the textbooks, and that too without discussing the ‘citrus paribus’ conditionalities. Refutation of marginal productivity theory of income distribution: The neoclassical theory of income distribution, as outlined above, maintains that under competitive conditions the rate of return on capital (i) equals the MP of capital, while the wage rate (w) equals the MP of labor. The Capital Controversy showed that there was an inherent problem in applying this model of income distribution to capital. It is evident from figure 16.12 that we can have multiple equilibria since the demand and supply curves are intersecting at more than one point. The interest rates actually prevailing at any moment in time in markets depend less upon the demand-supply forces and more on factors beyond market control. If we complement this diagram with the fact that the saving supply curve can also take any shape in a heterogeneous capitalist society, the result becomes even more shattering for the standard theory. The Capital Controversy concludes that instead of prices determining the distribution of income in a market economy, the causation works the other way round—distribution of income determines relative prices.

Dichotomy between financial and physical capital: Capital Controversy also dealt a telling blow to the assumption that financial capital can stand for the physical capital of a firm or of an economy. As discussed above, in order for the neoclassical vision of the circular flow to be valid, the assumption that there is a unit of measurement in which capital can be added independent of the distribution of income must be valid. Since this is impossible in a multi-commodity economic model, hence the financial side of capital cannot represent its physical side. Joan Robinson described this dichotomy in the following passage: “we are accustomed to talk of the rate of profits on capital earned by a business as though profits and capital were both sums of money. Capital when it consists of as yet uninvested finance (i.e. when it is financial capital, it) is a sum of money, and the net receipts (i.e. profits) of a business (on this financial capital) are sums of money (as well). But the two never co-exist in time. When the capital is a sum of money, the profits are not yet being earned. When the profits are being earned, capital has ceased to be money and becomes plant. All sorts of things may happen which cause the value of the plant to diverge from its original cost (i.e. financial value). When an event has occurred, say a fall in prices, which was not foreseen when investment in the plant was made, how can we regard the (financial) capital as representing the plant?” [Robinson (1953): p. 84, quoted from Harcourt (1972): p. 19]. Political Agendas of the Two Cambridges Underneath the apparently technical debate of the Capital Controversy lies the clash of ideological and political views of the two combating groups regarding the functioning of market capitalist system. The Cambridge-England critics of neoclassical economics (who may be termed as post and neo-Keynesians) regard market capitalism as an inherently antagonistic social order where different classes (such as workers and managers of capital) are trying to dominate each other. They argue that the distribution of surplus value cannot be understood independent of the political institutional structures of the market capitalist system. These critics, having rejected the marginal productivity theory of income distribution, argue ‘for a return to the Classical method of analysis in which pricing is an aspect of distribution’ instead of ‘distribution being but an aspect of pricing’ (Harcourt: 1972). The Cambridge critics, following Mill, distinguished between the analysis of production and that of distribution. They reinforced Mill’s view that: ‘the laws and conditions of the production of wealth partake of the character of physical truths. There is nothing optional or arbitrary in them’, whereas, ‘It is not so with the Distribution of wealth. That is a matter of human institution(s) solely’. Neoclassical economists, on the other hand, have some other beliefs. They struggle to show that capitalism is fundamentally characterized by harmony where each individual makes voluntary choices as a market participant—this is the reason they employ the ‘equilibrium methodology’ to analyze the market system. To them, the basic unit of a market capitalist system is ‘a self-interested individual’ and not ‘social classes’. Hence, in the neoclassical theory of income distribution there is no room for the analysis of ‘class-struggle’. Their theory pretends to show that the supply of inputs is determined by a great mass of self-interested individuals and both production as well as distribution is dictated by the ‘laws of nature’ (such as the laws of demand and supply). The symmetric incorporation of ‘capital’ as a factor of production alongside ‘labor’ in the neoclassical production function is actually intended to incorporate the idea of ‘social and political equality’ of labor and capital in market capitalism.

In another sense, the neoclassical theory of income distribution was also developed to justify the idea that capital is a factor of production whose return is determined by its marginal productivity as is the case for labor. Interpreted this way, the neoclassical income distribution theory was a theoretical response to the challenge of Marxism which questioned the fairness of the reward flowing to capital as well as the political institutional arrangements of market capitalist order. 16.4: Why Economics? Having gone through the book this far, you might be wondering why economics has not ceased to exist as an academic discipline if it abounds with so many contradictions and inherent problems. The answer to this question lies neither in the fact that there is ‘some deeper truth’ hidden behind microeconomic theories nor that these theories have been shown to explain the empirical realties of capitalist order, rather a major reason for the sustainability of neoclassical economics rests on the fact that it continues to provide a justification for the agenda of liberal capitalism against religious social order. Economics as a distinct academic discipline arose at a time when Europe was undergoing a social transformation—a transformation from Christianity to capitalism. The new capitalist class was asking for the removal of political and social controls on individual and society which were justified on the grounds of religious doctrine. Since a religious social order seeks to structure all social institutions so as to maximize the opportunities for the fulfillment of the Will of God, it necessarily imposes restrictions to discourage the immoral impulses of ‘accumulation and competition’ (i.e. greed and envy)—the impulses which ultimately commit an individual to ‘rivalry in worldly goods’ as an end in itself. In the social environment of Europe during the 18th century, economic theory provided a counter to the religious way of thinking about individual, society and state. The emerging capitalist class faced social and political barriers and restrictions and whenever they objected to these barriers, they were reminded that these controls were needed to maintain the social order. At this critical juncture, economic theory armed the capitalist class with an effective rejoinder against the priests: it brought forth the idea that a system of government was not needed to maintain social order, instead social order and harmony arise spontaneously and naturally in a market economy where each individual is guided by only his or her self-interestedness. The echo of this idea was also found in Smith’s famous ‘invisible hand’ doctrine which played a key role in the transformation taking place during the 18th century in Europe. Economists, since that time, proposed that the essential feature of a market social order was ‘equilibrium’—reflecting a state of social harmony. They preached the assumption that a market system necessarily and inherently tends towards equilibrium. If markets automatically attain equilibrium, then everything happens in equilibrium, hence in harmony, in a market system. This impersonal, spontaneous, natural and automatic ‘market equilibrium’ was presented to replace the legislative order of the European Christendom. Keen has rightly pointed out that ‘if, instead of equilibrium, economists had promised that capitalism would deliver chaos; if, instead of meritocracy, economists had said that capitalism could concentrate inequality, then economists could have hindered rather than helped the transition to capitalism’ [Keen (2004): p. 162]. It is specifically due to the service of this ‘economic vision’ that economics has been able to resist all its critics—though, over the last century, it has been proved that economic theory is fundamentally flawed, but over the years the commitment to the ‘economic vision’ has become stronger. Thus, the resistance to stick with economic theory is deeply embedded in ideological reasons. By using economics doctrines, they try to rationalize the (false) belief that capitalism is a rational system—in the sense that maximizing utility / self-interest / freedom maximizes social welfare. In this sense, economics is the religion of modern or enlightened man who treats its ‘belief system’ as unshakable dogmatic truths.

Another way in which this ‘unsmart economics’ has been preserved is by keeping the masses ‘ignorant’ of its unsmartness. Most of the students of economics, and even a great majority of its teachers and practitioners, do not know that the foundations of economics have been refuted long ago. Most economics textbooks present an uncritical exposition of neoclassical economic theory. Students are exposed to the ideas such as that ‘monopolistic power’ reduces the efficiency of market system; but they are never told that the ‘proof of the proposition that markets are efficient’ is itself fallacious! A third reason why neoclassical economics has managed to survive despite its logical fallacies is the absence of any grand alternative competing theory to microeconomics. The survey of alternative schools of thought in the next chapter will show that though there are a number of emerging trends against neoclassical economics, their work is mostly restricted to the critical evaluation of microeconomics and they largely fail to provide any rigorous alternative framework to analyze capitalist social order. Economics will continue to celebrate its triumph, thanks to missing alternatives. Is Economics Free of Ideology? Most economists dismiss the idea that ideology plays any role in the development of economic theory and they boast of the notion that economics is fundamentally a value-neutral science based upon some ‘objective natural laws’ easily distinguishable from value-judgments. This is the reason why you would see terms ‘positive and normative economics’ in all text books of economics to signify that as if there were some ‘descriptive’ and ‘natural’ aspects of economic theory which are purely independent of value judgments. However this is one of the major misconceptions economic practitioners have popularized. As discussed above, the very concept of ‘equilibrium’ presented as some ‘positive fact’ by economists is actually based upon a ‘normative ideology’—i.e. self interestedness leads to social harmony. Contrary to what economists boast of, it is the defense of this core economic ideology that has made economic theory so resistant to change because, as shown above, the critics of economic theory have asked it to abandon the core belief of ‘equilibrium’. Today, any policy maker who has the beliefs that: free markets automatically and naturally gravitate towards equilibrium positions, market equilibrium reflects maximum attainable efficiency and achievement of economic efficiency is the most prioritized individual and social end in itself will assert that any other system than market mechanism will produce disequilibrium and hence will reduce efficiency. Based upon this ‘ideology’ such a practitioner will, for example: oppose minimum wage laws—as they lead to labor market disequilibrium and unemployment oppose state controls on market prices—on the grounds that they create mismatch in product markets oppose quantitative restrictions on imports—assuming that more trade is better than less

On the other hand, this policy maker will support only those policies which can the make real world conform as much as possible to the idealized fiction of capitalist ideology—i.e. perfect competition. The believer in economic theory will: ask for private business enterprise in the provision of all goods and services—assuming that private enterprise is superior to public ownership of resources ask for minimum government intervention with private businesses—because governments, not being subject to the discipline of demand and supply, frustrate the market mechanism either by over or under production ask for more liberalization, privatization and deregulation ask for anti-monopoly and anti-union laws ask for more openness towards multinational companies ; so on and so forth. Ironically enough, economic practitioners impose on all this proclaim that they are not ‘being ideological’! This analysis has once again reinforced one of the major themes of this book: ‘economics is by no means a positive science—it does not deal with how societies actually work—rather it is a normative science—deals with how they ought to function’. The very fact that economic analysis leads to specific ‘social policy’ which has to be put in use to manoeuvre societies is more than enough to expose the reality of economics. The control of capitalist policy making institutions in the hands of economic practitioners is in fact another reason for the perpetuation of economic theory and ideology. 16.5: Economic Theory of Profit This section will briefly outline the standard theory of profit. Mainstream economic theory of profit begins by distinguishing between an “accounting” and “economic” conceptions of profit. “Accounting profit” is the difference between total revenues and total costs incurred by a firm. “Economic’ profit deducts from the excess of revenue over cost the implicit return on capital owned by the shareholders. Sometimes “unpaid management time” is also subtracted from accounting profit. So we write: and (16.13) where SCC is shareholders cost of capital while UCM is the unpaid cost of management. The “implicit” cost of capital is calculated by multiplying a representative rate of interest (say six month Treasury Bill’s rate) with shareholders equity: Where r = representative interest rate and SE= Shareholders Equity. So we have: (16.14) It is difficult to derive some agreed upon measure of unpaid managers time mainly because most managers salaries in advanced markets (and also in the case of market leader firms in Pakistan) typically include stock returns and it has become almost impossible to decompose managers salaries. Types of Risks Microeconomic theory treats profits as a reward for risk-taking behavior. Though many risks are insurable in modern capitalist order but ultimately it is in the very nature of risks that they cannot be insured against–––there is always a possibility that the whole system of claims and obligations which constitute a financial system may collapse at a moment and all insurers may go bankrupt. In the 2007-2009 global financial crises, there was a likelihood that this would happen in America and the government of George Bush and Barak Obama had to spend about $5 trillion (nearly 40 percent of US GDP) of tax payers money to bail out the banks and other financial intermediaries.

Uninsurable risks are sometimes called systemic risks. Systemic risks increase exponentially for all capitalist businesses during the downturn of a typical business cycle ––but the impact of a typical business cycle downturn depends upon: the exposure of that business to financial markets–––the higher the leverage ratio and the greater the share of speculative investments in its assets portfolio, the greater the systemic risk of a given capitalist business, and the nature of the products it is bringing to the market–––thus producers of goods and services with high income elasticity of demand (say yachts, tourist services, financial derivatives) will be much more “systemic” risk prone than producers of essentials such as atta It is also important to stress that for non-capitalist businesses capitalist crises provide an opportunity for growth and consolidation. Thus, most small scale businesses in Pakistan are non-capitalist––they have no dealings with financial markets. There is thus comparatively little impact of the cyclical downturn on Sabzi Mandi, Anarkali, Raja Bazzar or Bara Market. Indeed as heavily leveraged wholesalers and super-markets and agri-businesses collapse, there are opportunities for the small non-capitalist businesses to expand their businesses. Crisis creates opportunities and rewards for non-capitalist businessmen. Capitalist businesses remain exposed both to such systemic risks and also to what is called sovereign risk. “Sovereign” risk is the risk associated with lending to a capitalist government which defaults on its debt obligations–––Mexico in 1994, Russia in 1998, Argentina in 2001, the UAE in 2009 and Greece in 2010 experienced this (Italy and Portugal may soon follow). There is no global bankruptcy law and court and no international lender of the last resort–––thus, when Pakistan defaulted in 1972-3, no punitive action could be taken against Pakistan by American, the IMF or the International Court of Justice. Capitalist firms dealing with a capitalist government that may default thus face an uninsurable “sovereign” risk. Table 16.2 summarizes the four types of risks recognized by microeconomic theory. Table 16.2: For types of business risks Types Example Risk of default Loans to sick enterprises in the textile sector Insurable risk Fire, accident, natural disaster Systemic Inflation, changes in interest rates, stock market collapse Sovereign Pakistan 1972-73, Greece 2010 Such risks entail high volatility of profits. In capitalist order profit rates are usually higher than interest, wages and rent. They include what is called an “equity premium” over and above the “cost of capital” (i.e. interest / rent) and the cost of labor (the managers’ wage). Typically the “equity premium” rises during a stock market boom and declines sharply when the downturn begins and during the downturn. Indeed, during most recessions the interest rate is in real terms higher than the profit rate implying a negative equity premium. An upturn in economic activity is typically associated with an upsurge in what are called “Schumpeterian profits”. Joseph Schumpeter, an Austrian economist, saw capitalism as a dynamic system in a permanent state of disequilibrium. A typical capitalist business cycle is presented in figure 16.13. The typical capitalist business cycle is divided into four phases:

Trough (1999-2002): A decline in economic activity Boom (2002-2006): A recovery and continuing growth Peak (2006-2007): Near full employment and “potential” output produced Trough (2008-2010) The American economy boomed during most of the 1990s. But in the late 1990s there was a “dotcom” crash. This was accentuated by the counter attack on America in 2001 and the decline in the financial markets deepened. The government responded by a drastic reduction in interest rates and there was a major revival of consumer demand in America. During 2002-2006, America experienced boom conditions and peak conditions were achieved somewhere in early 2007. Then the “sub-prime mortgage” bubble burst and there was another crash during 2008-2010. It is not clear whether this trough has ended and a new sustainable upturn has begun as yet, although positive growth has been recorded in America during the first two quarters of 2010. Figure 16.13: Typical capitalist business cycleTime0Output IndexTroughBoomPeakRecession Figure 16.13: Typical capitalist business cycle Time 0 Output Index Trough Boom Peak Recession Schumpeter’s Account of Business Cycles and Profits Schumpeter argued that cyclical upturn begins when there is an innovational breakthrough. Schumpeter saw these “breakthroughs” as originating in production technology–––steam, electricity, the rail road, the radio. The 1992 boom was also trigged by a breakthrough in physical technology–––the ITC “revolution”. He argues that those who invest in the production and commercialization of this new technology bear considerable risk and the technological leap they make enables them to make “monopoly profits”. But these “monopoly profits” are temporary and they are soon “competed away” by rivals and imitators. However, according to Schumpeter, monopoly profits and disequilibria always characterize capitalist order (Hayek also emphasizes this but in a different context). This is because, Schumpeter believed, that technological innovations are a permanent feature of capitalist order. Monopoly profits are transferred from one capitalist market to another for one technological breakthrough follows fast on the heels of another. As profits become normal in one industry (airlines), they become monopolistic in another (computer software). Innovations, however, need not necessarily be related to changes in production technology. For example, there has been no major production technology breakthrough following 2002 but American economy still had an upturn––the main cause of the 2002-2006 upturn was financial sector deregulation and the explosive growth of financial products and derivates. Similarly the upturn after 1935 was sustained not by production technological innovations but by a massive upsurge in military expenditure by America, Britain, Germany and Japan. Keynes on Profit What determines the rate of profit? Microeconomic theory has no answer to this question. The often repeated rhetoric that “profit is a residual” is of course meaningless––i.e. no answer at all. For the question that is being asked is “given that profit is the difference between the cost of capital (rent plus interest) and the return on capital”, what determines this difference? What makes this difference to increase or decrease? What induces people to take more or less risks? When does the price of taking risk rise or fall?

The American economist Knight provided no answer to this question––he repeated the “residual” buzzword––nor did Schumpeter. Two economists have taken the bull by the horns and directly addressed this question. The first was Keynes. He said that risk taking and its price (i.e. the rate of profit) were determined by “animal spirits”. It is these “animal spirits” which drive expectations and expectations, said Keynes, were not rational. Fluctuations in stock and bond prices are driven by speculation which reflects expectations and hunches based on “animal spirits”. Variations in stock price indexes are reflected by “random walks”. There is no rational basis for estimating what return on a specific stock will be–––except that in the “long run” it will converge to the stock market average index price. But one can’t say what this average index price will term out to be in “the long run”. Empirical analysis seems to strongly confirm this view that there are no rational explanations for variations in the price of risk taking in capitalist markets. Thus, nobody could predict the stock market crash of 1929-33 or of 2007-2009. Nor could the mathematically sophisticated models for risk evaluation prevent major banking sector bankruptcies in America. International regulatory regimes based on the assumption that banks could themselves adequately identify and manage risk exposure are clearly seen to have failed. The most conspicuous failure is that of Basel Accord bank supervision regime. Sraffian Position on Profit As we argued in this chapter, Pierro Sraffa saw the share of gross profit in total value added being determined by class struggle. By “gross profits” Sraffa meant rent plus interest plus net profits (surplus). Total value added (GDP) is divided between wages (the share of the labor class) and gross profits (the share of capitalist class). Each of these two classes seeks to maximize their share of total value added. The greater the relative bargaining power and political strength––reflected particularly in the control of state mechanisms and policy making processes–––of the capitalist class the higher their share of gross domestic output (total value added). Gross profits is, then, divided among the three major segments of the capitalist class; i.e. owners of physical assets (who receive rent) owners of loanable funds (who are paid interest) and risk takers (who capture net-profit). Again it is the relative bargaining power and political strength of the three capitalist subclasses which determine the distribution of gross profits between rent, interest and net profit. Sraffa argued that: Gross profits rises in capitalist booms and declines more than proportionally in slumps and troughs. Most Sraffians (e.g. Ian Stedman and Frances Cripps) argue that wages are relatively inflexible both downwards and upwards. Real wages cannot fall below a fairly stable “floor” in depression or rise very much in booms periods. Profits are much more volatile and display much greater flexibility than wages. A wealth of empirical evidence exists to substantiate this view

The share of interest and rent in gross profits rises in capitalist slumps and recessions and falls in relative terms in boom periods. Interest and rent are “sticky downwards” as Keynes argued over eighty years ago. Risk taking drives the capitalist system but risk takers are heavily punished when they take “undue” and “excessive” risks. It is the capitalist state which bails them out by shifting the burden of failure from the risk takers to the tax payers. The American government spent about $ 5trillion of tax-payers money bailing out failed banks and financial intermediaries during 2007-2009. The burden is also shifted by throwing “surplus” workers out of the jobs. Once again the capitalist state picks up the pieces by income support payments funded once again out of tax-payers money. Key Concepts Intertemporal choice is the choice involving different periods of time Intertemporal budget constraint is the budget constraint applicable to income and expenditures involving more than single time period Rate of time preference measures the rate at which the consumer is willing to substitute second period consumption for first period consumption Saving is the residual amount of income left out of consumption expenditures Discounting is the practice of reducing the value of a future payment to calculate its value today Compounding is the process of calculating the amount to which a payment will grow at some time in future (by accumulating interest on interest) Euler’s Theorem says that when the production function displays constant returns to scale, it satisfies the adding up property: output equals sum of the marginal products of inputs times their level of use Capital controversy refers to the theoretical debate fought between two Cambridges on the nature and role of capital as a means of production Marginal productivity theory of income distribution asserts that the income share of a factor of production is determined by its contribution in output produced Supply of saving reflects the amount of savings supplied by an economic agent at different rates of interest Chapter Summary The theory of the demand for capital in standard microeconomics text is similar to the theory of the demand for labor. The capital demand curve is negatively sloped for the competitive firm which faces a horizontal capital supply curve. Equilibrium is achieved where the value of marginal product of capital equals its cost / price –– the rate of interest. This maximizes the profitability of the competitive firm. Short run equilibrium analysis seems intuitively misleading since capital in the form of machinery is not as flexible as labor Supply of capital is supposed to reflect the inter-temporal choices of capitalist consumers subject to their inter-temporal budget constraint The capitalist consumer’s inter temporal choice of consumption is determined by the interest he can earn on his saving and the value of his present consumption discounted by this interest rate The intertemporal consumption choice is also determined by his ability to borrow and the interest he has to pay on this borrowing. This has to be offset against the interest he earns on his saving, and the total amount available to the capitalist consumer depends upon his income the amount he can borrow and the interest he earns on his savings and pays on his borrowings

The intertemporal marginal rate of substitution in known as the rate of time preferences. It measures the rate at which the capitalist consumer is willing to substitute future for present consumption. The typical capitalist consumer is an accumulator. Therefore he has a preference for future over present consumption but the future is risky and future anticipated consumption may or may not materialize. Therefore future consumption has to be augmented by interest earnings required to offset this riskiness and microeconomics analysis typically models indifference curves showing time preferences of capitalist consumers to reflect this expected riskiness of future consumption flows. These indifference curves are normal and “well behaved”–––sloping downwards and convex to the origin. The marginal rate of substitution between future and present consumption keeps on decreasing as the level of consumption rises The capitalist consumer’s borrowings fall when the interest rate rises. When interest rates rise the capitalist consumer substitutes future consumption for present consumption which becomes more expensive–––hence his present consumption falls. If we assume that the typical capitalist consumer is a net borrower a rise in the interest rate will reduce his income (and therefore his present consumption) The microeconomic theory of saving behavior cannot identify a uniquely rational relationship between saving and interest rate at the level of the market. This is because capitalist consumers with different time preferences (net lenders and net borrowers) rationally respond differently to changes in the interest rate. The market supply function can take any shape although microeconomic theory presents it as “well behaved” (upward sloping). Equilibrium in the capital market is determined by the intersection of the market demand and market supply curve at a price (the interest rate) which equals its marginal revenue product. Since interest equals marginal revenue productivity interest is a fair recompense for the factor of production capital. Marginal productivity theory holds that both labor and capital are recomposed by the market in accordance with their marginal product ––– i.e. contribution to profit / welfare maximization. This recompense represents capitalist justice and attempts to seek a higher wage / interest should be resisted by the capitalist state since it violates the norms capitalist justice. Marginal productivity theory cannot demonstrate that the value of output produced in capital markets will necessarily equal the value of the recompense to capitalist factors of production (i.e. labor and capital) If value of output is not equal to value of income the controllers of the production process have the opportunely to appropriate the surplus product. Classical economists –––especially Ricardo and Marx–––recognized that appropriation of surplus product was a central feature of capitalist distribution Euler shows that assuming constant return to scale and infinite factor substitutability, the aggregate value of income shares of factors of production determined by their marginal productivity will equal the value of aggregate output. Hence there is no surplus product available for appropriation

The Sraffan criticism of marginal productivity theory holds that a change in the price of capital brings about a change in the distribution of income since it affects prices of a large range of product markets. Hence the pattern of the distribution of income becomes a determinant of changes in factor prices, which therefore do not reflect solely the changes in their marginal productivity. The Cambridge Capital Controversy (CCC) of the 1960s showed that the results regarding the justice and equity of the pattern of income distribution generated in capitalist factor markets where factor prices are determined by marginal productivity depended upon a particular conception of capital by this theory. Capital was regarded as something physical such as machines, buildings and raw material But physical capital can only be measured in value (money) terms and the value assigned to physical capital is not independent of the prices of output (produced by that physical capital) and of the pattern of income distribution. This shows that capital is necessarily a value and can only be measured in terms of money. When the aggregate capital stock is measured in value terms it includes the interest paid on this capital stock and included in its price. The price of a piece of physical capital (machinery) depends on the interest rate (one of its costs of production). But the rate of interest changes as the price of physical capital changes. As Sraffa has shown the monetary value of physical capital goods changes with the distribution of income. The monetary measurement of physical stock is not independent of the distribution of income between wage earners and non wage earners. There is no income distribution invariant measure of physical capital stock. The value of capital stock will depend upon (a) the pattern of income distribution and (b) the demand for physical capital. Since changes in the interest rate necessarily change the pattern of income distribution the impact of changes of the interest rate on the value of physical capital remains uncertain The capital controversy debate showed that marginal productivity theory cannot provide an explanation of the determination of the rate of interest–––which is set by the State Bank and is not an outcome of market forces. The pattern of income distributions determines relative factor prices in a capitalist earning Recognizing that it is the distribution of income which determines prices means that it is the institutional and political arrangements of a specific capitalist society which determine the distribution of surplus product between waged and non waged income. It is the pre determined pattern of income distribution which generates price structures in both commodity and factor markets The neoclassical theory of income distribution presents capitalism as a harmonious order in which self interested individuals achieve their ends in a mutually beneficial manner–––the market permits positive sum games. Sraffian and classical economists see capitalist order as conflictive where unending class struggle determines the pattern of income distribution

Modern economics continues to ignore the criticisms leveled against mainstream neoclassical analysis because this analysis justifies capitalist order. Economics presents capitalist order as harmonious and just but Sraffian and Marxist analysis describes capitalist order as conflictive, chaotic and exploitative Economics survives because it (a) continues to serve as an ideology justifying capitalist order and providing a a tool box for rendering it functional and (b) its major critics–––Sraffians and Marxists–––remains committed to capitalism and their criticisms of orthodox economic theory do not reject fundamental capitalist values Review Questions Compare and contrast the microeconomic theory of the demand for labor and the demand for capital. What is the price of capital in microeconomics theory, and why? Distinguish between physical and financial capital. What is the relationship between the price of physical and financial capital? What are the determinants of the supply of capital according to standard microeconomics theory? Who according to this theory supplies capital? What does the ‘inter temporal marginal rate of substitution’ measure? What is the weakness in the microeconomic theoretical prediction that the market capital supply curve is “well behaved”–––sloping upward from left to right and showing a positive relationship between changes in the interest rate and in the supply of capital by capitalist consumers? Show how equilibrium is achieved in the market for capital according to microeconomics theory. State and evaluate the microeconomics case for regarding interest as a fair reward for capital. What is the just theory of input price determination according to economic theory? If interest is the “fair recompense” to capital, what determines profit in capitalist markets? What assumptions are required in the Euler theorem to refute the Marxist / Ricardian assertion that profits are necessarily appropriated from labor shares? State and evaluate the Sraffian critique of marginal productivity theory. What was the Cambridge Capital Controversy of the 1960s? Who won the argument –––Cambridge England or Cambridge Mass–––and what was the main argument of the winning side? “Capital is necessarily a value and can only be measured in monetry terms.” Explain. What is the relationship between the pattern of income distribution and the monetary valuation of the physical capital stock? What is the relationship between changes in the value of physical capital and changes in the interest rate? Who sets the rate of interest in Pakistan and on what basis? What is the relationship between the income distribution pattern and the structure of output and input prices in capitalist markets? Rejecting marginal productivity theory as the underlying principle determining income distribution amounts to rejecting the view that capitalism is a harmonious, non-conflictive system in which everyone gains from the functioning of efficient markets.” Discuss. Why does modern microeconomics continue to ignore the criticism of the theory of distribution by Sraffa, and several leading economists from Cambridge England, more than fifty year ago?

Why do the Marxist and Sraffian critiques of microeconomic theory continue to remain ineffective? Chapter 17 ALTERNATIVES TO MICROECONOMICS As pointed out in the last chapter that one of the reasons for the survival of microeconomic theory, despite its incoherence, is the absence of any grand alternative competing theory. This chapter provides a brief survey of alternative schools of thought in order to substantiate the claim that though there are a number of emerging trends against neoclassical economics, their work is mostly restricted to the critical evaluation of microeconomics and they largely fail to provide any rigorous alternative framework to analyze capitalist social order. Note that we will not provide a summary of this chapter, rather leave it for students to develop one for themselves as practice. 17.1: Macroeconomics, Keynesianism and Post-Keynesianism It has become fashionable to speak of “classical macroeconomics” because Smith and Ricardo analyzed variations in aggregate output and its distribution. Moreover the basic unit of analysis in their work was not the a-social self determined individual but social classes. Smith and Ricardo were pre-eminently political economists and it is torturous and unnecessary to separate the ‘micro’ and ‘macro’ elements in their theories of price, distribution and growth. In any case most of their “macro” insights have been incorporated in the work of Sraffa, his followers and Marxist economics—and to a lesser extent in Post-Keynesian theories. We will therefore pan over ‘classical macroeconomics’. Modern macroeconomics was a response to the capitalist crises of the interwar period (1919 – 1945). It blossomed in what is described as capitalism’s “golden age” (1950 – 1970). It has found to be seriously wanting in the stagflationary decade of the 1970s and has been in a process of decline and deconstruction since the 1980s when the NeoClassical—actually new neoclassical—heartlands came under the Ronald Reagan and Margaret Thatcher regimes. Today macroeconomics theory has been almost totally subsumed by microeconomics. Currently they teach ‘representative agent macroeconomics’—the national / global capitalist economy is regarded as containing only one ‘representative’ consumer producer financer in the IVY League universities and even at Oxbridge and the LSE. This absurd model of capitalist order reflects both The essentially moral and normative character of economics. Economics requires everyman to accept capital accumulation as an end in itself, as the sole purpose of existence. The ‘representative’ consumer-producer financer is a representative of capital—he is not a representative of everyman. If Abdullah Zhaghazai rejects accumulation as an end in itself he is irrational and economics can say nothing to him or about him. Representative agent macroeconomics analyses how all rational (i.e. profit / utility maximizing) producers-consumers-financers ought to behave. It provides (neo-Kantian) maxims for ordering / evaluating empirically observed behavior on the basis of the moral criterion of efficient capital accumulation

However even if everyman is a compulsive, eternal utility / profit maximizer, the maximization of individual utility and profit cannot lead to the maximization of total (social) utility and profit. This is because capitalist order is dominated by the vices of greed (accumulation) and jealousy (competition). Capitalist individuals maximize utility and profits at each other’s expense. Capitalist order is vicious, filthy, rapacious and conflictive. It is not harmonious as the representative agent macroeconomists pretend by postulating their absurd model of the national / global capitalist economy. Capitalism is an irrational order even on its own terms. Aggregate profit / utility (welfare) cannot be maximized. It ought not to be maximized. Keynesian macroeconomics was a partial and qualified recognition of the essential irrationality of capitalist markets. Keynes demonstrated that supply does not create its own demand and under consumption and over production were systemic tendencies nurturing capitalist crises. Keynes stressed the non-neutral character of capitalist money, the role of expectations in investment decision making under uncertainty of outcomes and the cyclical behavior of aggregate demand and supply. Keynes therefore asserted that the capitalist state had a crucially important role to play in sustaining full employment, equilibrium and steady state growth. The capitalist state should use countercyclical fiscal and monetary policy to influence expectations and expenditures and correct market failures. Keynes advocated that the state should play a major directional role in the labour market and in the financial market. It should ensure the existence of high and rising wages, near full employment, low interest rates, stable exchange rates and restrict capital mobility. Keynes’ followers such as Clover and above all Hicks developed a methodological framework for reconciling Keynes and Walras—the leading inspiration behind the neoclassical school. Clover and Leijonhufrud argued that Walras recognized the possibility that the sum of effective (as against notional) excess demand could be negative and hence there could be voluntary unemployment. The argument was that Keynesian analysis applied when there was disequilibrium while Walras had described capitalism in equilibrium. But the capitalist market system is constantly—and normally in a state of disequilibrium for without disequilibrium there can be no accumulation (no “super normal” profit, no surplus). Capitalist markets are mechanism for realizing / distributing surplus produced outside the market (remember the market is an arena of exchange, neither of production nor of regulation). It is this necessary disequilibrium between aggregate supply and demand which requires the existence of debt and credit and assigns a crucial valuation role to financial markets within capitalist order. The mainstream Keynesians therefore argued that Keynes was right in seeing the capitalist market system as having no inherent equilibrating tendency and recognizing the non neutral character of capitalist money, credit and finance. He was right in emphasizing the necessary destabilizing role of investment and in seeing values generated in financial markets as vulnerable to expectation shocks. Hicks cleansed Keynesian analysis of all those elements which showed that individual capitalist agents when they behaved rationally (i.e. sought their particular utility / profit maximization) necessarily made the market behave irrationally (i.e. it could not be an instrument for maximizing aggregate utility / profit). Hicks forgot about Keynes’ concern about uncertainty, expectations, liquidity preferences and arbitrary determination of asset values by financial markets in capitalist order. Hicks developed his IS-LM model on the assumption that expectation, uncertainty and speculative determination of asset values would never affect the relationship between savings and investment on the one hand and the interest rate and the income level on the other. Moreover the IS and LM curves were smooth, well behaved (the IS curve sloping downwards like the aggregate demand curve and the LM curve sloping upwards like the aggregate supply curve of orthodox economic theory) loci of product and money market equilibrium points—the problem of aggregating individual consumption, saving and investment preferences were thus ignored, jus as the problem of aggregating individual tastes and individual production response to changes in prices and incomes have been ignored in standard microeconomic theory. However Hicks argued that because of the existence what he called “a liquidity trap” the LM curve was likely to be near horizontal at origin and almost vertical at its apex—increasing money supply would not reduce interest rates and stimulate investment beyond a floor interest level nor would increase in money supply increase output beyond a ceiling output level—Keynesian economics was the economics of depression and orthodox economics was relevant when the capitalist economy was functioning at near full employment levels. Most orthodox Keynesians believed that normally the capitalist economy reflected a phase where the LM curve was sloping upwards smoothly and hence a combination of conventional and Keynesian policies was needed.

During the ‘Golden Age’ (1950–1970) most metropolitan capitalist policy makers accepted Hick’s view that the money supply and government expenditure were exogenous variables—not determined by capitalist market forces but under the control of the capitalist states. The capitalist government was therefore the agency which concatenated individual producer-consumer-financier rationalities in such a manner that conflict within the capitalist market system was mitigated and a maximization of aggregate welfare (utility / profit) was achieved. Representative agents economics rejects the notion of the capitalist state’s over arching rationality and by re-establishing the microeconomic foundations of macroeconomics insists that the existence of uncertainty and the arbitrary speculative determination of asset values does not negate the inherent and essential rationality of capitalist individuality. Economists hold that capitalist individuals form expectations rationally. These expectations confirm the prediction of the Hicksian IS-LM model. Thus if the government raised money supply there would not be a time lag between output and price rise, inflation would occur intensively because of “rational expectations”. The output level would not rise and state policies would necessarily be totally ineffective. Everything done by the government would instantly lead to counter veiling behavior by rational capitalist individuals. The government could do nothing to stimulate or deflate the economy. All it could do was to synchronize the rate of grown of money supply and real output. But once it became obvious that in mature capitalist economies—and even in underdeveloped, imperialist dominated economies such as Pakistan—money supply was endogenously determined, even this policy role of the capitalist state became suspect and rational expectations based macroeconomics (sometimes called ‘Monetarism’) fell into disrepute. Representative agent macroeconomics has usually been seen as an admission of policy irrelevance. But this is very seriously misleading. When representative agent macroeconomists analyze behavior as if they were only one consumer, producer and financer in the economy they are not saying to the capitalist state: “Leave the economy alone, everyman is rational”. Quite the contrary, they are saying “the representative model provides the authoritative paradigm for evaluating every man’s behavior, adopt policies to force everyman to behave as a rational representative agent of capital”. That is why policies of privatization, deregulation, liberalization, monetary policy marketization, immigration control and corporatization of technology are being forced upon all countries. That is why representative agent macroeconomics advocates such a Paul Krugman and Paul Wolfowitz (both Jews) are the most enthusiastic supporters of the never ending American slaughter in Afghanistan and Iraq. Representative agent macroeconomics is an admission of the inherent irrationality of capitalist order and a strident, militant call to arms. “We will force you to behave as capitalist representative agent and slaughter you if you do not obey us. There is no alternative!”

Keynesianism survives largely because the representative agent ideology—more popularly and comprehensively known as neo con economics—has failed to mobilize resources to enforce capitalist rationality on society as a whole and to eliminate conflict. It articulates the false pretence that capitalism is rational on its own terms and therefore harmonious. As we have seen this is a false claim. Capitalism is conflictive, exploitative and unfair. An agency is necessary to reconcile everyman to the imbalances and frictions generated systemically by capitalist order. That agency is the state and Keynesian policy therefore remains relevant. Orthodox Keynesian policies were discredited in the 1970s when the Phillips’ curves broke down. The Post-Keynesians have argued that these failures occurred because policy makers failed to take account of two of Keynes fundamental insights—the non neutrality of money on the one hand and role of uncertainty and expectations in the determination of market outcomes on the other. Post Keynesians analyze distributional issues and attempts to take account of the political context and implications of macroeconomic policy making. Like Keynes the Post Keynesians accept the basic postulates of mainstream economics but qualify its predictions by reference to capitalist reality—Post Keynesians pride themselves on their realism. They can be seen as revisionists who insist that changed conditions require a reinterpretation of economic orthodoxy and a reformulation of economic methodology to take account for example of accelerated financialization, persistent unemployment, globalisation etc. The capitalist market economy has changed so drastically that require far reaching revision of microeconomic analysis. Their microeconomic analysis concentrates on monopolistic pricing and output decision, the impact of macroeconomic conditions on the firms’ investment decision, the need to regulate financial markets to ensure that the relative autonomy of the state monetary authority is preserved and an analysis of firm behavior taking account of decreasing costs increased scale and the need to preserve capacity, which becomes excessive in times of economic down turn. Post Keynesians accept the opportunity cost theory of value; some even endorse rational expectations theory in a qualified form. Neither Keynes nor Post-Keynesians present a distinct methodology separate from mainstream Economist. Their emphasis is on qualifying mainstream economics policy conclusions and identifying the limitations of this analysis. The Post Keynesian represents a qualified, partial departure from economic orthodoxy and in political terms they provide an analytical framework for the development of Social Democrat policies. Social Democratic parties in metropolitan capitalist countries—America, France, Germany, Scandanvia and Japan—have since the mid 1980s moved towards endorsing economic orthodoxy and many Post Keynesian (sometime called “Right Keynesians”) have sought to justify Keynesian policies with neoclassical references. Left wing Post-Keynesians have moved closer to the Sraffians and analytical Marxists.

17.2: Sraffians and Marxists Peiro Saraffa was the most profound and devastating critic of microeconomic theory in the history of economic thought. We have drawn extensively on his insights in the chapter on factor pricing and supply in this book. His 1926 paper “The Law of returns under competitive conditions” (published in The Economic Journal) and his slim 1960 monograph Production of Commodities by Means of Commodities identified fundamental logical flaws in microeconomics analysis and no mainstream economist has been able to refute Sraffa—although many have tried and some have even been awarded the Nobel Prize by the imperialists for trying and failing. Sraffa showed that it was impossible to derive the well behaved individual or aggregate supply curve and therefore capitalist commodity markets are likely to yield no determinate unique equilibrium. Neither is there any inherent tendency in these markets to gravitate towards equilibrium. Sraffa’s theoretical observations have largely been vindicated by empirical studies based on Chaos theory. Neither capitalist commodity market nor capitalist factor markets generate a uniquely efficient or equitable (just) price for as Sraffa demonstrates the productivity of capital does not determine profit. The conception of capital as a generic term has no basis in logic outside the realm of finance and financial values are arbitrarily determined by speculative expectations. Therefore the pattern of income distribution generated by capitalist markets does not represent any technical imperatives for maximizing efficient or equitable utilization of resources. Rather as Sraffa shows the distribution of incomes generated by market outcomes reflects the distribution of power within that capitalist order. The rate of profit is an outcome of the struggle for power between capitalist and workers says Sraffa and it is this rate of profit which determines the price of finance (or capital in general). The rate of profit reflects the relative power of capitalist and workers and is not determined by the marginal productivity of capital—the technical capability of factories or otherwise of speculative expectations about investment outcomes. The essential incoherence of neoclassical analysis has thus been convincingly demonstrated by Sraffa. Capitalism is not a rational system in the sense that the ends it sets itself cannot be realized. Political force must be employed to sustain the social acceptability of capitalist market outcomes. Thus Sraffa negates the utility theory of value and the marginal cost theory of price. As we shall see below he also rejects the labour theory of value. However he seems to have presented no coherent theory of value himself. Indeed most Sraffian economists—Ian Stedman for example—argue that the concept of a “theory of value” is unnecessary for understanding capitalist economics. Sraffa subtitled his “Production of Commodities by Mean of Commodities” monograph as a “Prelude to a critique of economic theory”. Although he lived for more than a quarter of a century after the publication of “The Production of Commodities” (he died in 1983) he never wrote this promised critique. Modern Sraffians continue in this tradition of excavating the hidden assumptions underlying microeconomics, evaluating the relevance of these assumptions to capitalist market reality and exposing the incoherence of microeconomic analysis. Sraffa’s original motivation, as evident in his 1926 paper, was to make microeconomic analysis more useful for capitalist businessmen. In this article he argued that the firm should be modeled so that account could be taken of the necessary expense of marketing non homogenous products to non homogeneous customers and the implication of the growth of finalization (he called it ‘credit growth’) on the optimum size of the firm. He emphasized the need for microeconomics to focus on “issues of importance to businessmen”. It is therefore somewhat paradoxical to see Sraffa as a radical critic of capitalism. He is a radical critique of microeconomic theory only—not of capitalist order. He wants to develop a more realistic and useful theory for sustaining capitalist order and in this has much more in common with Keynesians and Post Keynesians rather than with Marx’s followers who are in principle committed to transcendence from market capitalism to state capitalism. Sraffa’s criticism of microeconomics goes much further than the criticism presented by Keynesians, however like them he fails to develop an alternative framework for the analysis of the capitalist transaction form. His key finding that prices of commodities are determined by the distribution of power between classes simply leads to the more fundamental question: what determines this distribution of power and how is it sustained. Neither Sraffa nor any of his followers have been able to seriously address this question. This is one reason why Sraffian economists have generally moved away from dynamic analysis and from issues raised by complexity (chaos) theory in particular.

Marx described (what we now call) microeconomics as ‘Vulgar economics’ and contrasted it with ‘political economy’ (the thought of Ricardo, Smith etc). He was of course writing at a time when neoclassical economics was not fully articulated and systemically synthesized. Marx published Capital Vol. 1 in 1871 and died in 1883 and the key propositions of modern microeconomics were synthesized in the late 1890s by (e.g.) Marshall. Marxists see economics as a legitimating paradigm for (market) capitalist exploitation. In the Marxist view exploitation takes place through the labour process where surplus product takes the form of surplus value appropriated through the private ownership of the means of production. The market is the arena for the realization of this surplus value in the form of gross profit and the distribution of the gross profit in the form of rent, interest and net profit. Money is not neutral. It is the “nexus rerum” of capitalist order and plays a crucially important role in the conversion of surplus product into surplus value. Capitalism is seen as passing through several stages—petty commodity production, finance capitalism, monopoly capitalism, imperialism etc. The relationship of the commodity market to the market for labour and finance changes as capitalism passes through these phases as does the relationship of the market to the state. On the whole the Marxists argue that in the capitalist development process the role of the state is enhanced as an instrument for the articulation of the dictatorship of the proletariat. Marxists argue that the capital market system is ridden with contradiction. It is not harmonious but conflictive. Capitalists are the private owners of the means of production—they exploit and prey upon the workers but the increasing concentration and centralization of capital creates opportunities for the working class to organize itself into a “class for itself”. It may gather under the leadership of a vanguard party which may succeed in making a revolution. The essence of this revolution is the abolition of the private ownership of the means of production and the abolition of the market. In the USSR and in People’s China (until recently) means of production were (on the whole) socially owned and prices and output decisions were made through periodic national plans. The plan was an essential instrument for the exercise of the dictatorship of the proletariat and the market (though never abolished) was subordinated to the plan. The purpose of planning however remained the maximization of capital accumulation (surplus). It is important to stress that this maximization of the rate of capital (surplus) accumulation was an end in itself. It was just not necessitated by the need to compete with the West. This is so because Marx believes that a principle consequence of the establishment of the dictatorship of the proletariat would be an exponential growth of production and consumption. Without this exponential growth of production the transition to communism would not be achieved and communism was the stage when everyone could satisfy unlimited wants. Marx was an Enlightenment ideologist and like Kant, Hegel, Mill and Habermas he conceived of freedom as everyman’s ability to do whatever he wants to do through subjecting universal material forces to his will. It is the ultimate commitment to capital accumulation (freedom) as an end in itself which justifies calling the USSR and China and Cuba and Vietnam and all other socialist orders state capitalist. The essential failure of these regimes originates in the fact that they endorse capitalist individuality. They continue to seek freedom, equality and progress for a class or state which in their view is representative of all of humanity. But if freedom and progress is legitimated at the collective / macro level there can be no moral transcendence at the level of individual consciousness. That is why “socialist man” and “specie being” and “New Man” never appeared in the USSR and China and the citizen of socialist republics continued to be personally accumulative and competitive. Both Gorbachev and Deng Zhao Peng abandoned the quest for socialist individuality and sought to harness individual acquisitiveness and competition for the construction and sustenance of state capitalism in the USSR and China. Competition among state owned enterprises and their relative autonomy from the central planning authority was first legitimated by Tito after his break with Stalin in the late 1940s. Yugoslavia practiced “self management” of its industrial system until its disintegration during the 1990s.

The upheavals in East Europe—which began with the Hungarian upraising in 1956 and culminated in the collapse of the Soviet Union in 1991—had profound impact on Marxist thought. Some would argue that Marxist disenhancement with Marx’s critique of capitalism began much earlier—with Bernstein’s revisionist interpretations at the turn of the 20th century and Lenin’s New Economic policy (1921–1924). The leading Marxist economics school today is that of the Analytical Marxists whose leading proponents—Morishima, Roemer, Itoh—distance themselves from Marx’s theory of value, endorse competition, efficiency and “market socialism” and the policies they advocate are almost identical with those of the Post-Keynesians. Classical Marxism is now virtually dead and Analytical Marxism has adopted the methodological framework of mainstream economics. Marxism therefore has almost nothing to offer for understanding contemporary capitalism. Ludwig Von Mises showed almost a hundred years ago that the outcomes generated through a system of perfect planning would be identical to the outcome configurations generated by a perfectly competitive market system. This is not surprising since both are mechanisms for maximizing utility / profit and the rate of capital accumulation. Analytical Marxism endorses this finding and concentrates its analysis on showing why actually existing capitalism fails to realize this result. Social ownership of the means of production is necessary for moving capitalist order from (output reducing) monopoly to efficiency maximizing competition. So say the Analytical Marxist. 17.3: Islamic Economics Capitalism is profoundly anti-religious. It comes into existence by de-legitimating religious knowledge, devaluing religious virtues (poverty, charity) in individual consciousness, restructuring society on the basis of universal contract rather than universal love and establishing a political order which replaces divine sovereignty with the sovereignty of human will as its fundamental governance principle. Capitalism emerged historically by destroying Christian social order in Europe. Today capitalism is seeking to destroy Islam in Asia and Africa. From the 16th century onwards religious leaders have sought to find a niche for religion within capitalist order. This was natural for thinkers such as Calvin and Luther and Berkley for Christianity has endorsed secularism since the time of St Augustine (4th century A.D). They believed that national monarchs (who established the precursors of capitalist states) could behave much as the Holy Roman Emperor had done for several centuries and sanction the authority of the Church in the governance of personal lives and social order. In this they were profoundly mistaken and the containment and infiltration of Calvin’s Saris Republic and Cromwell’s Puritan regime showed that capitalism was an all encompassing totalizer. It sought to and succeeded in creating its won individuality, society and state. As both Weber and Tawney have shown (though in different ways) the Christian legitimating of capitalist transactions—especially in the money market—was essentially a state sponsored project reliant upon the power of the European princes. Islamic economics is exactly the same project. It emerged as a Saudi Arabian initiative after the American protégé. Faisal seized power in Riyadh with the help of the US Air Force. The Americans were concerned to build up Faisal’s legitimacy as a Muslim world leader to counter the influence of Jamal Abdel Nasir, who had joined the Soviet camp after the Suez war of 1956.

Faisal became a champion of Islam. He gave refuge to Islamic scholars who were being persecuted and tortured by Nasir accommodated them within the Saudi bureaucracy and universities. Ambitious young men from within the Islamic parties of Egypt, Sudan, Pakistan and India saw this as an opportunity to build their career and create popular international Muslim support for Saudi policies, especially the policy to ally Muslim groups and countries with America. Islamic Economics was the most important epistemological paradigm developed through Saudi sponsorship to reconcile Islam and capitalism. The central message of Islamic Economics is that Islam is entirely compatible with capitalism. Islamic Economics has been described as “a branch of neoclassical economics … a series of minor qualifications to neo classical themes and texts”. Islamic Economics—an authoritative summary statement is to be found in Maulana Taqi Usmani’s monograph Islam aur jadeed maee’shat-o-tejarat—accepts economics as a value neutral science based on the laws of nature. The Laws of Demand and Supply are natural laws and price should be determined through their unimpeded functioning. Perfectly competitive market equilibrium generates output and price configurations which Islam recognizes as just; i.e. both efficient and equitable. Capitalist property is fully endorsed. The corporate property form and the transfer of ownership rights through continuous speculative market transactions is fully endorsed. The consumer is naturally a utility maximizer. He is not legally obliged to order his preferences according to the Shariah except that he should abstain from what is explicitly haram. Similarly according to Islamic Economics the producer and trader has right to seek maximization of profits. Accumulation as an end in itself and the commodification of money is thus legitimated. The explosive growth of the Islamic banking and finance industry as an adjunct to the world’s money and capitalist markets is a practical manifestation of this legitimation. As Henry and Wilson have shown billions of dollars are transferred to the West through Islamic banks and Islamic funds owned in the main by major capitalist finance houses. According to Maulana Usmani, “Islam does not possess an economic system of its own. It fully endorses the market system and the profit motive”, [Islam aur jadeed maee’shat-o-tejarat (p. 38–39)]. Therefore capitalist norms are legitimate and the utility / profit maximization objective is the purpose of resource allocation in the market. Incorporation of the economics of Muslim countries within global capitalist order is welcome since it would facilitate the optimum utilization of resources. According to the Islamic economists the Shariah is not a set of prohibition on capitalist practices but a means for promoting the long run self interest of citizens of capitalist states. Maulana Usmani argues that taking account of the Shariah injunctions (of halal and haram for example) strengthens the operation of the laws of demand and supply and eliminates monopolistic tendencies within capitalist markets. Shariah constraints on production and consumption are thus justified on rule utilitarian grounds. They are seen as necessary for realizing the full utility / profit maximization potential of the capitalist economy. Islamic Economics is an attempt to formulate principles and policies for establishment of capitalist justice by eliminating unnecessary inefficiency and inequity from capitalist order.

The technical writings of the Islamic economists formulate the utility / welfare function in a typically neoclassical manner. The theory of demand—detailing determinants of shifts in and movement along the individual demand and the legitimacy of aggregating individual preference schedules—is fully endorsed for non haram commodities as are conceptions of marginal utility, laws of return, elasticity etc. Altruistic concerns such as taking account of one’s utility maximizing action on the utility of others are sometimes taken into account in theorizing the consumption function. Such concerns are however integrated within the framework of orthodox consumer preference and rational choice theory. The list of products, especially financial products, considered to be prohibited by Islamic Economics is being gradually reduced and this once again reminds one of the similar relaxations of prohibitions by Christian clerics in the nineteenth century. Islamic Economics holds that the perfectly competitive capitalist market regulated by a night watchman capitalist state generates uniquely equitable and efficiently maximizing equilibrium output and price configurations. The concept of “general equilibrium” is enthusiastically endorsed in the technical writings of Islamic economists. Factor market functioning and regulation is theorized by Islamic Economics on neoclassical grounds. Capitalist property and capitalist employment contracts are recognized as legitimate by Islamic Economics. Factor markets (both labour and finance) are seen as functioning on the basis of the same demand and supply principle that determine product market outcomes. Hence neoclassical labor market analysis is fully endorsed. Wages are seen as being determined by the marginal productivity of labour. The interest equivalents sanctioned by Islamic Finance theory are expected to reflect the marginal productivity of capital—this is the basis for accepting the risk free interest rate as the basis for pricing Islamic financial products. Wage flexibility is applauded and institutional mechanisms creating rigidity are deplored. The neoclassical labour demand and supply curves are all endorsed by Islamic Economics, sometimes with minor modifications along Keynesian lines to create room for collective bargaining in the wage determination process. Both Keynesians and Islamic economists argue that this is not inconsistent with the systemic determination of wages on the basis of the marginal revenue productivity principle. There is of course no conception of transcending the capitalist employment on finance contract within Islamic Economics since Islamic Economics legitimates capitalist norms and the associated capitalist property form. Islamic Economics can thus be seen as a minor revision of conventional microeconomics theory and practices. A more substantive revision—while endorsing capitalist norms in the same way as done by the Islamic economist—is provided by Institutional Economics. 17.4: Institutional Economics

Institutional Economics bases itself on the work of the anti Marxist, Austrian and German theorists writing in the late nineteenth and early twentieth century—Menger, Schmoller, Weiser and Weber among others. These scholars endorsed the meta-ethical assumptions of the neoclassical school but tried to modify its methodology by criticizing the concept of equilibrium. These authors celebrate disequilibrium since it allows the capitalist / entrepreneur to make “supernormal” profit and thus realize capitalism’s full potential as a dynamic and adaptive system. Capitalist order, argue these thinkers, is best suited to deal with uncertainty which is systematically structured into capitalist business decision making processes. The marginal productivity theory of income distribution is qualified to take account of disequilibrium and uncertainty. However the precursors of the Institutional Economics School have strong faith in the self regulatory capacity of the capitalist system, its capacity to sustain disequilibrium now and to benefit from it in a manner which allows capitalism to reach higher and higher levels of productivity growth later. State interference with the market is strongly deplored and as Hayek, the most preeminent successor of the Institutionalist precursors, argues the “visible foot” of the state stamps out the work of the “invisible hand” within the capitalist market. Hayek and other economists writing in this tradition have argued that the welfare state’s control of money supply has been a major cause of business cycles. State monopoly control over money supply—which is seen as absolute—should be abolished and the comprehensive privatization of the money market should be institutionalized. The level of money supply and the structure of interest rates should be determined in freely functioning money markets. Karl Manger and Bohn Bahker emphasized the natural character of capitalist institutions, i.e. property, money, credit, division of labour, trade etc. Both Manger and Hayek spent a lifetime tracing the historical development of these institutions. Their central claim is that these institutions have evolved spontaneously as expressions of the growth of human rationality. Capitalist institutions are universal, natural, rational and untranscendible precisely because of this spontaneous evolution. They have not been consciously engineered by a central authority claiming a monopoly of knowledge. Comprehensive social planning is impossible because knowledge appears in history as the unintended consequence of competitive and accumulative pursuit of self interest by capitalist individuals. The capitalist state should thus refrain from regulating the natural and rational evolution of capitalist market institutions Institutional Economics suffered something of a decline during the first half of the twentieth century due to the eclipse of the influence of the German Historical School and of American authors such as Henry George and Theorstein Veblen. Since the 1950s there has been a relegitimation of Institutionalist themes within mainstream economics due to the success of authors such as Robert Coase, Douglas North and Oliver Williamson in refocusing Institutional Economics so that it has become a supplement to neoclassical analyses. Modern revisionist Institutionalists (Coase, North, Williamson and their followers) argue that institutions—defined as rules, enforcement mechanisms and beaurocratic hierarchies—should be designed to support market transactions. These institutions have four crucial functions (a) legitimate capitalist property (b) enforce capitalist contracts (c) structure informational transmissions and (d) manage monopolistic / oligopolistic competition.

Orthodox Institutionalists—Karl Manger, Max Weber and recently Hayek—saw themselves as “evolutionists”. Their central message was that (a) history is a process through which Reason triumphs over unreason (b) capitalist institutions—corporate property, division of labor, finance—reflect a rational restructuring of norms, procedures and organizational hierarchies which (c) takes place spontaneously and unintentionally. Hence the orthodox Institutionalists were concerned with justifying capitalist institutions, not with designing them. On the other hand designing institutions for the legitimation of capitalist property and the enforcement of capitalist contracts are the principle concern of modern revisionist Institutionalists. They accept that the institutions which emerged after the triumph of capitalism in Western Europe and America are quintessential expressions of human rationality. These institutions are seen as the ideal types which should be the basis for evaluating all institutions everywhere in the world and at all times. All institutions everywhere should be modeled on the institutions which emerged spontaneously and unintentionally in Europe and America in the eighteenth / nineteenth centuries. However the revisionist Institutionalists assert there is no guarantee that this “modeling” will take place spontaneously and unintentionally. Revisionist Institutionalists (sometimes called “Neo institutionalists”) accept the Marxist teaching that non Europeans “are people without a history”. Asians and Africans are savages like the Red Indians and the Aborigines of Australia. Unfortunately America and NATO do not have the capability to slaughter all Asians and Africans as America slaughtered eighty million Red Indians. Since all Asians and Africans cannot be slaughtered—witness America’s failures in Iraq and Afghanistan and Somalia—they have to be forced to design capitalist institutions. “Rational Institutionalization” has to be rammed down the throats of Asian and African nationals through World Bank and IMF sponsored Structural Adjustment and Poverty and Growth Reduction Assistance programs. Oliver Williamson the leading contemporary Neo Institutionalist is also widely credited with the primary authorship of the imperialist Washington Consensus. It was recognized that Washington Consensus policies could be effectively implemented only if the subject people on whom these policies were being imposed submitted to (or internalized) capitalist rationality. A key element of World Bank policy intervention in Asian and African countries (and also of it’s subordinate agencies such as the Asian Development Bank, the African Development Bank and the Islamic Development Bank) became the designing and restructuring of institutions which could: Increase monopolistic market competition. Reduce the social embeddedness of production, consumption and distribution units and networks—i.e. destroy the traditional bazzar (sabzi mandi) and the extended family (the Zhaghzai tribe) as an economic unit

Commodify and corporatize information Impose capitalist quality and accountancy (‘disclosure’ and ‘corporate governance’) standards on an ever broadening range of production and trading activities. Financialize more and more production and trading activities and enhancing their securitization and risk trading the social hegemony of money and capital markets and establishment of the interest rate and stock prices as the key value referents throughout society. The enhancement of the scope of insurance markets is of key importance in this context Universalize capitalist property by systematically (institutionally / legally) relating earnings to the rate of growth of capital accumulation Restructure civil and judicial administration and all state bureaucratic hierarchies in general so that they become primarily focused on the defense of capitalist property rights the enforcement of capitalist contracts and on the facilitation of capital accumulation as the socially legitimated supreme end in itself. The World Bank advises that the institutional redesigning process in Asian and African countries should begin by asking the question “what is inhibiting the development of markets?” Institutional design should then explicitly relate to the weaknesses of existing and missing markets and the concern / objective of institutional redesign should be to strengthen capitalist market growth and sustain capitalist individuality. As capitalist markets and capitalist individuality strengthen and evolve the institutional infrastructure must reactively adapt to this re-articulation of capitalist rationality. Institutions should thus serve as the hand maiden of capitalist individuality, capitalist markets and civil (anti–religious) society. Since capitalist institutions are seen as “rational” the World Bank thinks that they can easily be transplanted from America to Pakistan “(Pakistan) do(es) not have to go through a long learning process in institutional development (Pakistan) can complement and modify institutional forms and learn from America”. In any case imperialist pressure is being exercised to force Asian and African countries to submit to international norms, standards and procedures leading to enforced and compulsive institutional restructuring. Pakistan is being coerced not just by the WTO, the IMF, the World Bank, the Asian Development Bank and the Islamic Development Bank but also by the International Accounting Standards Organization (ISO) and the financial rating agencies. The purpose of this coercion is to force Pakistan to dissemble its institutional infra structure rooted in Pakistan’s own norms and historical traditions and to rebase these institutions on internationally legitimated capitalist norms, procedures and standards. An important consequence of this rebasing of the institutional structure of Asian and African countries is the destruction of the old blood and tradition based communities (biradries in Pakistan) and the increased social dominance of interest based networks. What unites people within the later type of networks is “interest tangentiality”, they identify with other as members of a group, not because they love each other but because of the utility of others in the pursuit of one’s own self-interest. Thus a “cyber community” has come into existence linking members of the elite in imperialist countries and in the neo-colonies of Asia and Africa. Members of this interest based “community” perceive a significant common self-interest in the continued hegemony of global capitalist order. Building and sustaining such “interest communities” and destroying bridaries is a key project assigned to imperialist sponsored and funded NGOs in Asia and Africa. The World Bank also advocates the wholesale import of laws, procedures and enforcement systems from the West to facilitate interest based community building in Asia and Africa. It also recommends the “export of the enforcement of contracts”—Asia and Africa should let America decide all judicial issues relevant to market transactions. Reducing jurisdictional authority of Asian and African states and eroding their national sovereignty is the key to the building of internationally linked interest based communities. Localization and decentralization of state authority in Asia and Africa are thus crucially important aspects of the imperialist project for coercing Asian and African countries to undertake institutional restructuring.

Revisionist Neo-Institutionalist Economics can be seen as “pre-microeconomics” in the sense that it tries to set out the social arrangements that are required to induce and force everyman to behave as a capitalist individual / rational agent should behave. In other words, it prepares the grounds for the application of microeconomic principles and policies which emanate from the application of these principles. Adam Smith had also spent a great deal of time in both The Wealth of Nations and The Theory of Moral Sentiments in setting out the institutional arrangements required for the growth of the market and the continued expansion of the division of labor. Like the modern, Neo-Institutionalist Smith had focused his attention on the education, judicial and civil administration systems arguing that a capitalist restructuring was essential both for the emergence and sustenance of capitalist individuality and for articulating the systemic social dominance of the market. Like the revisionist Institutionalists, Smith was theorizing about how to turn an undeveloped mainly pre-capitalist society in which capitalist governing elite had recently captured power (eighteenth century Britain) into a mature capitalist order. Modern revisionist neo-institutionalists can be seen as extending / reviving this Smithian tradition and their work therefore has a complimentary relationship with microeconomics. Behavioral economics—which we examine in the next section of this chapter—shows that sustaining capitalist individuality and its social dominance is a contradiction ridden and necessarily never completed project. Behavioral economics tries to modify some assumptions underlying microeconomic analysis to take account of this uncomfortable fact to ensure that microeconomic analysis better corresponds to capitalist reality. 17.5: Behavioral Economics Behavioral Economics is being increasingly incorporated in microeconomics. It is no longer a sub-discipline. Microeconomics accepts that behavioral economics draws attention to facts and issues that should be taken into account by economic analysis and this can be done be a broadening of the scope of mainstream microeconomic models of market operations. “Behaviorally informal” microeconomics generates more accurate predictions without requiring a fundamental change of methodological premises. Therefore, an explicit objective of behavioral economists is to get their analyses recognized a “normal economics”. Essentially Behavioral Economics is the application of the principles of orthodox psychology to the analysis of capitalist agents in capitalist markets behavior. The standard behavioral economics approach is to modify some assumptions of microeconomics analysis to reflect some psychological consideration in order to make the microeconomic model more “realistic”. Whether the modification of these selected assumptions leads to an erosion of the “realism” of the other (non modified) assumptions of the microeconomic model is rarely considered.

Behavioral Economics organizes around experimental findings that suggest “incompleteness” of standard microeconomic analysis. We will now briefly review some major themes of modern Behavioral Economics. (An excellent recent survey has been published by C. Camerer et al Advances in Behavioral Economics, Princeton 2006). Expected Utility Theory Standard expected utility theory assumes what is known as “the independence axiom”. Formally this axiom can be stated as follows: the frequency with which a utility maximizing individual chooses between package p over package q does not change when both packages are mixed with some common package r. Behavioral economists have consistently shown that this assumption is false. They have developed “Prospect Theory” to deal with the unrealism of this fundamental assumption of Expected Utility Theory. They show that when analyzing choice under uncertainty it is not enough to know the packages (usually called “lotteries”) over which the utility maximizer is exercising his choices. The theorist must also know the utility maximizing agent’s situation at the time the choice is being made. Experiments designed by Behavioral economists have shown that the utility maximizing agents evaluate gains and losses from specific choices in different situations. There is a specific situation reference point from which choices are evaluated. Expected utility theory is thus modified to take account of the situation specificity of the choice process. The Endowment Effect In standard microeconomic analysis demand is a function of income / wealth and prices. Behavioral economists argue that this does not take account of the dependence of wealth prices on a chooser’s “endowment”. Experiments undertaken by them have shown that a chooser values a good more if it is part of his endowment than if it is not. The “endowment point” is a reference point and utility maximizing choosers are shown to have a kink in their evaluation around this “endowment point”. Hyperbolic Discounting Standard choice theory assumes that inter temporal choices do not depend on the decision date. Whether the utility maximizing agent chooses consumption in the initial or sequential periods has no effect on the choices if the budget constraint is the same in both cases. Behavioral experiments show an “immediacy effect”. Utility maximizing agents display a tendency to choose earlier smaller rewards over later larger rewards when the smaller earlier rewards offer immediate satisfaction but reverse this preference when satisfaction is delayed. Social Preferences Standard microeconomic theory assumes that a utility maximizing agent’s choice depends only on his own monetary pay off. Behavioral experiments have shown that in utility calculations individuals take account of the effect of choices not only on their own but also on others’ monetary pay off—remember Islamic microeconomists have also argued that this is what the “Islamic consumer is ought to do”. Behavioral experiments also show that individual utility maximizer agents are influenced in their choices by the character of the agents they are interacting with in the exercise of their choice. Thus, a utility maximizing chooser is more likely to take account of the impact of his choice on the utility of a person who has the character that the chooser approves of—a “good Muslim” in making his own utility calculation would pay greater attention to the impact of his choice on the utility of other “good Muslims” rather than on the utility of non good Muslims. Islamic economics and Behavioral economics (especially in social preference applications) have strong convergence tendencies.

The focus of Behavioral Economics is on individual choice of utility maximizer and on motives underlying that choice. Behavioral analysis starts with psychological experiments that show violation of some assumptions of some microeconomic theory. New variables are then added to the standard theory which “explain” deviation from the predictions of standard models and describe systematic biases in decision making. Usually behavioral research ends up by showing how these systematic “irrationalities” (often called “baises”) can be accommodated within the microeconomic framework of analysis. Behavioral Economics seeks to develop more “realistic” definitions of the objective function and its constraints that the utility maximizing agent seeks to maximize. However microeconomists have often found it difficult to measure using economic data the new variables that the Behavioralists suggest should be taken account of. Usually, it is impossible to identify the “reference point” of Prospect theory of the consumers in actually existing markets in an unambiguous manner. Moreover as we have stressed throughout this book microeconomics is above all a moral science. The key question therefore is ‘what is the optimum reference point that a rational utility maximizing consumer ought to have, so that existing empirically verified reference points of utility maximizing agents can be evaluated on that basis of the optimum? Behavioral economics is of course constitutionally incapable of addressing this issue. Essentially Behavioral Economists spell out the manifold difficulties that choosers face in acting “rationally”. Behavioral Economics shows how difficult it is for a normal person to act and feel as microeconomics expects / instructs him to do. Men cannot perform the mental tasks embodied in the assumptions underlying microeconomic models or can do this only with extreme difficulty. Some features of the optimization procedure are typically performed incorrectly by the typical decision maker. Behavioral economists assume that such irrational / incorrect behavior can be taken account of without abandoning the microeconomics paradigm. Some Behavioral analysis can be interpreted as producing some hints on how choosers can be induced / forced to behave “rationally”. But the question why choosers “ought” to behave “rationally” cannot of course be answered by any economic school—microeconomics, Marxist, Sraffian, Institutionalist, Islamic, Behavioral whatever. Behavioral Economics has psychological foundations—indeed it is sometimes described as “economic psychology”. It explores the psychological mechanisms behind the economic behavior of a typical capitalist chooser (investor / consumer / policy maker) within capitalist society, identifying the difficulties he faces in acting “rationally” (i.e maximizing his utility in a manner which maximizes the rate of capital accumulation in society as a whole). The central message of Behavioral Economics is that standard microeconomics models should become more realistic. Assumptions underlying these models should be modified to take accounts of the “realities” of behavioral regularities within actually existing (mature) capitalist societies. Most Behavioral analysis is focused on showing that minor changes in microeconomic models, leaving the basic microeconomic theory unchanged, are required to make these models more realistic. Standard models should in particular take account of the context dependence of decision making by capitalist choosers. But the key questions for microeconomics is of course, how can the capitalist chooser be induced / concerned to abandon his many “irrationalities” and choose as he “ought” to choose. The social science discipline which directly addresses this question nearest to Economics is Management. We now turn to an analysis of the answer to this question from management theory. Management sciences take up this crucially important issue of capitalist governance.

17.6: Management Sciences As we have seen in this book economics has the following main purposes: To justify capitalist norms, regulatory procedures and transaction forms To develop ideal types ‘models’ against which the behavior of actually existing individuals, societies and sates can be evaluated To develop policies which can induce and force individuals, institutions and governments to adopt capitalist norms, behavior patterns and regulatory procedures Microeconomics is principally concerned with the first two objectives. It justifies capitalist market order by pretending that it provides a value neutral analytical ‘box of tools’ which can be utilized to achieve the optimal allocation of resources. It shows how society functions equitably and efficiently (both terms defined on the basis of capitalist epistemology) when people are fully capitalistically rational. These models of perfectly rational behavior provide a basis for assessing price and output determination processes within both product and factor markets. They show how consumers, producers and regulators ought to behave so that capitalistically optimal resource allocation can be achieved and sustained. Microeconomics is however weak as far as its policy prescriptions are concerned. It subscribes to Smith’s “invisible hand” and Manger and Hayek’s “spontaneity” doctrines. Once capitalist property rights are enforced (‘law and order’ ensured says Smith) capitalist markets will spontaneously, unintentionally, necessarily and continuously produce optimal equilibrium outcomes. Even the Institutionalist and Evolutionists recognize that this is a very naive and simplistic model of actually existing capitalisms. People do not normally behave as capitalism says they ought to (remember the behavior patterns of Abdullah Zhaghzai and his family members). They have to be forced to accept capitalist norms. Force is exercised within society and within the state. The key capitalist institution is not the market but the corporation. Markets exist in non-capitalist societies; corporations on the other hand are peculiar to capitalism (as is finance). Capitalism created the corporation. The corporation is a legal person totally dedicated to the maximization of shareholders’ value. Corporations can exist only within capitalist order, for the maximization of (surplus) value—accumulation as an end in itself—has never been recognized as the raison d’etre of any non capitalist society throughout human history, corporations are the quintessential form of capitalist property. It is only when corporations achieve hegemony within a market that it becomes a capitalist market. If corporations do not exist or are subordinated to non capitalist property forms the market is not a capitalist market. Like our Sabzi Mandi it remains a socially embedded bazar whose output and price configurations do not reflect a quest for continuously higher levels of capital accumulation. It is the science of Management and not microeconomics which focuses theoretical attention on how decisions are made within the corporations and among corporations. Since these are extra market; a prior decisions—decisions the corporation takes before it enters the market—microeconomics has almost nothing to say about them. It calls the corporation, a “firm” and in most microeconomic analysis the firm is treated as a mysterious closed “black box”.

Management is also specific to capitalist order. Management subsumes administration as the market subsumes the bazzar and corporation subsumes property in capitalist order. Management is unknown in Islamic history before the imperialist conquest. We built and rebuilt the Ka’aba over several centuries, organized trade spanning four continents, developed an all Asia transport and communications network, undertook incessant jihad for a thousand and four hundred years all without any study and practice of Management. Management does not exist in non-capitalist society because management is dedicated to deploying resources to produce continuous maximization of surplus. The corporation turns private property into a legal fiction—the share holder “owns” the corporation just as much as the citizen of the USSR “owned” the Socialist Republic and participated in the exercise of the dictatorship of the proletariat. This devaluation of private property leads to the transfer of control of the resources of the corporation from its legal owners to those trained to use these resources to realize surplus, the corporations’ raison d’etre. Managers monopolize “knowledge” on the basis of which resources are used solely for the purpose of a continuing, never ending increase in their quantity (capital accumulation). This is known as ‘efficiency’ in capitalist epistemology. As we have said capitalism’s central value is freedom. Capitalist individuality is nurtured not through repression but through freedom. Promoting freedom requires that the preference for preference itself (capital accumulation as an end in itself) be prioritized over all specific preferences. A famous French philosopher of the twentieth century Michel Foucault said that capitalism requires a delicate balancing of “unity” and “diversity”. Simply put this means that every capitalist individual must: dedicate his life principally to accumulation be willing to explore many varied ways through which accumulation is achieved and accelerated Capitalist order has a unifying purpose—the maximization of utility / profit / rate of accumulation—but seeks the achievement of this purpose through an ever expanding diversity of thought and acts. Management, particularly self-management and self-discipline are crucial in capitalist order because it is through management that diversity of thought and action is organized in a manner which sustain continuing accumulation as the raison d’etre for individual being and social life. This becomes evident when we examine management theory. Management theory is an American project. It appeared as an academic discipline in the universities of Pennsylvania and Chicago in the late nineteenth century. Management is par excellence a multidisciplinary theory. It combines themes from psychology, sociology, cultural anthropology, philosophy, political science, economics, mathematics and statistics. A first attempt to provide a coherent theoretical framework for the study of management was developed in Henri Fayel’s theory of Universal Management Process. He argued that management consisted of the performance of five basic functions (a) planning (b) organizing (c) commanding (d) coordinating and (e) controlling the managed. Management in Fayal’s view is a process which begins with planning and culminates in controlling the managed. The purpose for which these functions are performed is the achievement of efficiency defined in all management literature as the production of greater output value with lower input costs. Fayal saw management as an orderly and rational process and Frederick Taylor—the inventor of ‘scientific management’—built upon this view. This approach focused upon improving quality cutting costs and systematizing work processes. Taylor sought to create “a mental revolution” in both managers and workers so that they saw each other as allies and not antagonists.

Taylor sought to derive “best practice” operational standards through systemic observation, experimentation and analysis of various aspects of the work process. On the basis of extensive time and task studies, Taylor made recommendation about work process reorganization, employee selection and training and worker remuneration systems. He saw the capitalist worker as being primarily motivated by high wages and developed a complex remuneration system which links productivity and wage growth. Taylorist’s methods often proved very effective in raising productivity and reducing costs at the plant level. Work motion study was developed into something like an exact science by Taylor’s followers. Attempts were made by them to combine production and cost control techniques and this led to the evolution of a more complex view of worker motivation. Joseph Jaran taught management to view the worker as “an internal customer”. The worker was to be motivated through teamwork, partnership, problem solving and brainstorming. Other “stakeholders” specially those within the corporatist supply chain could also be motivated through the use of these methods. The emphasis on quality management emerged from these insights. Feigenbaum showed that ultimately it was the customer who determined quality—quality was therefore a subjective, not an objective factor and managing customer preference was the key quality improvement. Operations management showed how important this was in purchase, inventory management, product and service design, design of the work flow process and data processing and communication. This concern with worker, suppliers and customer perception facilitated the emergence of the Human Relations management school. In this view successful management requires that a manager be capable of working effectively with people of diverse backgrounds, perceptions and motivations. The manager must be capable of fusing this diversity into the singularity of accelerated capital accumulation (efficiency and productivity growth). HRM instructs managers to be particularly sensitive to employee diversity. Human resource management (HRM) is an explicit response to the growth of unionization in America. It emerged as a reaction to the 1935 Wagnar Act which recognized the unions’ right to collective bargaining. HRM preaches that satisfied workers are less likely to join unions. Productivity could be enhanced by changing the attitude of the worker towards each other and towards management. HRM researchers tried to show that emotional factors were more important determining factors of productivity growth than physical aspects—such as lighting, job description and formal organizational communication systems, etc. Management should consciously foster worker enjoyment of work. Mary Follett, a pioneering HRM philosopher, urged managers to motivate performance not simply demand it. With the separation of ownership from control the line demarking “management” from “operative” has become ambiguous. Both work for capital and Follett argued that the worker could be taught to become “an organization man”. He could be taught to practice self-management (self-control) and shed his traditional adversarial identity. He could be taught that productivity growth, efficiency enhancement and profit maximization was necessary for his own well being. People are the key to productivity growth. Technology, standards and work rules do not guarantee productivity growth. Instead profit growth depends on skilled and motivated workers committed to capitalist norms—utility / profit maximization as an ultimate end in itself.

The complexity of capitalist order reflected in its dialectical pursuit of unity through diversity has been appreciated by authors who seek to address management on the basis of a systems approach. They view the corporation as a co-operative system dedicated to the pursuit of common end—i.e. productivity, efficiency, profitability maximization. Communication is the necessary means for linking the individual worker’s motivation (his willingness to serve) to the corporation’s purpose (maximization of profit). Understanding intra organizational communication necessitates that the corporation be viewed as a complex dynamic network structuring and sustaining capitalist individuality as an essential means for the realization of its purpose (profit maximization). Management systems analysts portray the corporation as a living thinking system and emphases organizational learning. Interaction between Chaos theorists and some system’s management thinkers has led to the realization that environmental feedback is the key to organizational learning. Systems theory therefore underlines the importance of viewing the corporation as part of a complex whole (capitalist order). Several attempts have been made by management theorists to combine different elements of the Scientific Management, HRM and the Systems Approach. The most widespread of these is the Contingency approach which emphases that there are no universally applicable principles for relating diversity to singularity. Difference situations require different approaches—scientific management may be more suitable for increasing efficiency in a steel mill and the HRM approach may be a useful means for enhancing productivity in a corporation which mainly employs copywriters. As a whole Management theory emphasizes that capitalist individuality is not spontaneously produced in the market. It has to be structured and sustained within corporation hierarchies (which are extra market phenomenon) through interaction between the corporation and its stakeholders and though the regulation of the corporation by the capitalist sates. Management theory therefore provides a much more realistic analysis of how capitalist order functions than does microeconomics. However, microeconomics provides the ideal types—the optimizing models—on the basis of which actually existing markets can be evaluated in term of their conformance with capitalist ideology. Management science may therefore be viewed as a practice for moving capitalist realities towards capitalist ideals. 17.7: Conclusion As we have stressed throughout this book microeconomics provides: a justification of capitalist order and an analytical framework for identifying optimum transaction forms and regulatory procedures for achieving capitalist objectives—the organization of individuality, social and political relationships focused upon accelerating the rate of capital accumulation for its own sake. At present there is no paradigmatic rival to microeconomics (neoclassical economics) which can serve these ends more effectively than it.

Institutional economics and complexity analysis may have the potential to articulate a more coherent understanding of capitalist reality. The Institutionalist emphasis upon meso (i.e. institutional structure) responses to disequilibrium and its understanding of the capitalist market as a dynamic system incorporating uncertainty in its formal analysis makes it useful for understanding how innovation and entrepreneurship is being institutionalized in capitalist order. Some Institutionalists also develop a framework for showing that despite its evolutionary characteristics the market system possesses inherent characteristics for assimilating crises situation in its normal functioning process. They can provide a much needed discourse for understanding capitalism’s resilience to systemic shocks. The evolutionary variants of Institutional Economics may provide a more profound and better explanation of capitalist state capacities and policies than modern microeconomics. Based on orthodox microeconomic foundation, Institutional / Evolutionary Economics is also functional in that it allows the analysts to methodically relax ‘Citrus Paribas’ assumptions of standard microeconomic theory to develop a better understanding of the functioning of capitalist markets. This is also true for Behavioral Economics, which is also functional and realistically adding depth to microeconomics analysis. Complexity theory applications to the study of market functioning can also deepen microeconomic analyses. These applications (especially those on the basis of Chaos theory) identify non linear relationships among elements within the market system and investigate the capability of the market system to self organize. Chaos theory applications in the physical sciences show that often behind apparently chaotic behavior there is an organizing force which Lorenz called “a strange attractor”. Complexity theorists working on market systems sometimes claim that behind the apparent persistence of dis-equilibrating price and output configuration there exist similar “strange attractor(s)” which produce business cycles but (may) also ensure that the cyclical behavior of the capitalist market system is self corrective and self sustaining. If Complexity analysis can identify “strange attractor” or “attractors” it will make a major contribution to the understanding of capitalist market order. In Pakistan and in some other Muslim countries, Islamic Economics has an important ideological role to play. Like Islamic Democracy theory, Islamic Economics is concerned to provide an Islamic legitimation of capitalist order. Both Islamic Democratic theory and Islamic Economics justify the integration of Muslim moral, social and political life within global capitalism. All economic schools of thought—neoclassical, Post-Keynesian, Sraffian, Marxists, Islamic Economics, and Institutionalists etc.—seek to provide a justification of some form or another of capitalist order (liberal, social democratic, socialist or Islamic) and to devise policies which are expected to promote capitalist efficiency and capitalist justice. None seek the transcendence or overthrow of capitalist order. This is because theory is always a justification of practice and appears long after a particular practice has become systemically hegemonic. Thus, microeconomics (neoclassical economics) was formulated more than a century after liberal capitalism had become systemically hegemonic in most parts of the Western Europe. A fully articulated theory of state capitalist (socialist) functioning was developed decades after the Bolshevik revolution broke out. The theory explaining capitalist transcendence will appear after the capitalist political order has been challenged (most likely) by the Islamic revolutionaries and the capitalist epistemology and ideology have been delegitimized. That theory may also explain how Abdullah Zhaghazai views and solves the problems related to production, consumption and exchange as he pursues non-capitalist objectives, consciously rejecting freedom, equality and progress; i.e. capital accumulation as an end in itself.

Review Questions What is “representative agent” macroeconomics? Why cannot ‘representative agent’ macroeconomics describe how actually existing capitalist order works? What purpose does ‘representative agent’ macroeconomics serve? What are the central themes of Keynesian macroeconomics? How does the Hicksian IS-LM framework reconcile Keynesian macroeconomics with mainstream economics while preserving a niche for the use of Keynesian policy? What is Hicks’ “liquidity trap” and what does it show about the effectiveness of monetary and fiscal policies at different stages of the business cycle? Discuss the role of the capitalist state in the Keynesian model of capitalist order? Discuss the implications of rational expectations theory for macroeconomic policy? Explain the failure of Monetarism. How does representative agent macroeconomics symbolize / illustrate the irrationality of capitalist order? Why do even Neo Con capitalist states continue to practice orthodox Keynesian policies? Outline the main theories of Post Keynesianism? Why Post Keynesianism is usually regarded as “revisionist” rather “rejectionist” of Economics orthodoxy? Discuss Sraffa’s views on (a) the shape of the firm and market supply curve (b) the concept of “capital” and (c) the determination of the rate of profit and the pattern of income distribution in capitalist order. Why is Sraffa regarded as the most profound and devastating critic of microeconomics? Is Sraffa a radical critic of capitalist order? Why not? Outline Marx’s theory about the exploitative character of capitalist markets. Why is it justified to call Socialism as a State Capitalist order? Why has Analytical Marxism almost no relevance in understanding capitalist order? “Capitalism is profoundly anti-religious”. Do you agree? “Islamic Economics is a sub discipline of neo classical economics”. Do you agree? What are the major microeconomic theories endorsed by Islamic Economics? Q22. Are Islamic banks really “Islamic”? Why does Islamic Economics have no conception of the transcendence from capitalist order? What are the similarities between the Institutional analysis of capitalist markets and microeconomic analyses of capitalist markets? Outline the Institutional critique of microeconomics. Discuss and evaluate the Institutionalist perspective on the evaluation of capitalist institutions. Does this view justify the Institutionalist prohibition of the state regulation of capitalist markets? What are institutions and what functions do they perform within capitalist order? What is the difference between the objectives of classical and revisionist Institutionalism? What are the similarities in the assumptions underlying classical and revisionist Institutional Economics? Why are Asian and African countries being forced by the World Bank and the WTO to establish Western institutions and destroy their national institutions? What are the essential features of institutional restructuring enforced by imperialist agencies such as the World Bank and the WTO on Asia and Africa?

What is the impact of capitalist reinstitutionalization on the social and economic salience of communities in the Asian and African countries? “Revisionist Institutionalist Economics is pre microeconomics”. Discuss. What is Behavioral Economics and what is its relationship to standard microeconomics? Describe Behavioral Economics’ methodology. Discuss some Behavioral modification to the assumptions underlying standard microeconomic theories. “Behavioral Economics shows why it is impossible for normal persons to act rationally”. Discuss. How does Management complement microeconomics? Why does the theory and practice of Management not exist in non capitalist societies? How does Scientific Management seek to universalize capitalist norms and practices among the corporation’s (a) workers (b) other stake holders and (c) customers? Why does Operations Management emphasize the importance of managing customer preferences? What does the Human Resource Management (HRM) School suggest should be done to accelerate efficiency and productivity growth? Analyze the systems approach to the sustenance of capitalist individuality. What is the main message of the Contingency approach to Management theory? What is required for the production and sustenance of capitalist individuality? What are the strengths and weaknesses of economic schools which seek to provide an alternative explanation of capitalist order? Why has no general theory for the overthrow of capitalism been produced? When will such a theory appear? GLOSSARY Absolute barriers are those that rule out new entry whatsoever over some time horizon Absolute price is the price of a commodity in some monetary terms Acquisition represents the absorption of one company by another one Allocative efficiency refers to the market situation where resources are allocated to activities that earn higher rates of return. Firm is allocative efficient when it produces output where marginal cost equals price Arbitrage is the practice of making profit by purchasing a commodity from where its price is lower and reselling where price is higher Arc price elasticity reflects the change between two points along a demand curve Asymmetric in economics refers to a state in which two agents (buyer Vs. seller or seller Vs. sellers) carry inharmonious and unequal status Average expenditure equals the wage paid per worker. Labor supply curve measure average expenditures Average fixed cost is fixed cost per unit of output, calculated by the ratio of fixed cost to output Average product is the ratio of output to labor Average revenue is given by the ratio of total revenue to output Average total cost measures total cost per-unit of output, calculated by dividing total cost by the output level Average variable cost is the ratio of variable cost to output Average-cost-pricing means setting price equal to average cost of production. This is usually practiced in case of natural monopolies Backward bending labor supply curve has an initially positive sloped but becomes negatively sloped at higher wage rates, reflecting an income effect greater than substitution effect

Bads are the goods which give negative marginal utility to a consumer. Bertrand model is that oligopoly model which says that firms produce a homogenous good, each firm treats the price of its competitors fixed, and all firms decide simultaneously what price to charge Bilateral monopoly is a market structure where a monopsonist buyer of an input faces a monopolist seller of that input Binding arbitration is a process in which a third party determines the wages and other work related conditions on behalf of the negotiating parties (usually managers and union) Black-market is the practice of selling a commodity above its legal price Budget constraint or budget line shows the largest available bundles of two commodities with given prices and income. Its slope measures the relative price of x Budget set shows the set of all income feasible consumption bundles Budget share is the proportion of income that is spent on a particular commodity Capital controversy refers to the theoretical debate fought between two Cambridges on the nature and role of capital as a means of production Capital is money that is invested in order to make more money Capitalist production is the organization of production of goods and services for the sake of accumulation of capital as an end in itself Cardinal utility function contains information about utility differences as well as preference ordering that it represents Cartel is a form collusive business venture where all or some oligopolistic firms directly agree to cooperate in setting price and output levels in order to maximize their joint-profit Choice of technique is the problem of choosing optimal combination of inputs to produce a specific level of output at given factor-prices Collusive oligopoly means firms involve in cooperative decision makings in order to maximize their joint-profit Commercialization of leisure means the organization of leisure time for further enhancement of capitalist production by arranging activities for the sake of making profit, such as entertainment industry, through capitalist enterprise Comparative-static-analysis is analytical technique in which results of two static equilibrium states are compared with each other Competition is a process which involves rivalry among multiple individuals who are struggling against each other to obtain the same scarce resource Competitive advantage means delivering the same service at a lower cost, called cost advantage, or greater service for the same price, called differentiation advantage Competitive wage is a contract that allows an employee to adjust his time allocation between the number of hours to work and rest each day or each week Complements are the goods which share negative cross price elasticity Compounding is the process of calculating the amount to which a payment will grow at some time in future (by accumulating interest on interest) Concavity is the property of a set which says that a set is concave if a line joining any two points in that set remains entirely below that set

Concentration ratio measures the size of the largest firms’ share in total market sales. This ratio refers to the degree to which production in any specific industry is concentrated in the hands of a few large firms Constant returns to scale means returns to scale is 1, reflecting the fact that output increases at the same percentage rate as do all inputs Consumer equilibrium is the consumption bundle that shows a consumer doing the best that he can do. It is the point where indifference curve is tangent to the budget line reflecting the fact that subjective valuation of a consumer for a commodity is equal to that of market Consumption bundle is the quantities of each consumption commodities that a consumer has available for his consumption. It is shown by a point in a commodity space representing some commodities Convexity is the property of indifference curve which says a weighted average sum of any two bundles, say bundles A and B, is preferred to those bundles themselves. Mathematically, convexity is the property of a function which says that a function is convex if a line joining any two points of that function remains entirely above that function Corner solution shows that the consumer purchases zero amount of one of the two commodities and he specializes in the consumption of other one Corporation is a distinct legal entity that exists independent of its owners Cost efficiency in production takes place at efficient scale of production in competitive markets; i.e. production should take place where average total cost is minimum possible Cost refers to the sum of expenditures needed to produce a given level of output Cournot model is an oligopoly model in which firms produce a homogenous good, each firm treats the output of its competitors as fixed, and all firms simultaneously decide how much to produce Cross price elasticity shows relation between quantity demanded of one commodity and price of another. It measures the proportional rate of change in quantity demanded of one good due to proportional change in price of another good Deadweight loss is the net loss in social welfare resulting from any other than competitive market approach, say by monopoly power. It is measured by the difference between output (produced and made available for consumption) by the perfectly competitive firm on the one hand and the monopolist on the other Decreasing returns to scale means returns to scale is less than 1, reflecting the fact that output increases at a less percentage rate than all inputs Demand curve shows all consumer equilibrium points as does the price consumption-curve but drawn in a price-commodity plane. It demonstrates the negative relationship between price and quantity demanded of a commodity due to negative sign of substitution and income effects Demand function shows the relation between consumption of a commodity and all factors that can change its demand, the prices of all goods and income of a consumer Demand function shows the relation between consumption of a commodity and all factors that can change its demand, the prices of all goods and income of a consumer

Demand refer to the amount of a commodity that a consumer is willing and able to purchase Derived demand is the principle which says that inputs are valued only because they can be used to produce valuable goods and services Determinants of demand are factors that affect a consumer’s decision of ‘how much amount of a commodity to purchase’ with his income Dilemma represents the problems which arise when addressing an issue the resolution of which leads to several equally unacceptable consequences Diminishing marginal product of a factor refers to the tendency of marginal product of a factor to decrease, other factors held constant Diminishing marginal rate of substitution (DMRS) is the tendency of MRS to decline. The more x one has and less of y, the less is the relative value placed on the extra unit of x compared to that placed on y. DMRS comes from the assumption about people behavior that they have a taste for variety in their consumption Diminishing marginal rate of technical substitution refers to the tendency of MRTS to decrease as more labor is added to production process Diminsihing marginal utility says that the utility derived from the consumption of a commodity decreases as more of it is consumed Discounting is the practice of reducing the value of a future payment to calculate its value today Diseconomies of scale refers to the phenomenon of increasing long run average cost as the scale of output expands Division of labor means allocation of task between workers such that each one of them performs fewer distinct tasks in producing output; i.e. each worker produces a very small part of total output produced Dominant firm model is a market with one firm having a market share of more than 50%, though other small firms do exist with negligible market shares Dominant strategy is the optimal strategy or option no matter what the opponent does Duopoly is a market where two firms compete with each other Dynamic efficiency is to achieve the most from given scarce initial resources over time to maintain permanent pressure of scarcity. It also refers to the generation of new resources through innovation Economic (wo)man is an abstract rational economic agent whose self is subordinated to his (her) infinite desires Economic rent is the payment for an input over and above what is required to keep it in its current use; i.e. the difference between the payments actually made to an input and the minimum amount that must be paid to keep it in its current use Economies of scale refers to the phenomenon of decreasing long run average cost as the scale of output expands Edgeworth model of oligopoly provides a solution to the problem of price-war such that prices do not fall to marginal cost of production. It explains the cyclical behavior of prices in oligopoly markets Efficiency means producing maximum output from given inputs or resources Efficient scale of production is the point on long run average cost curve where average cost of production is the least Elasticity is a pure algebraically signed and unit-free measure of responsiveness between two variables. It measures percentage rate of change in the dependent variable due to change in the independent variable

Elasticity of demand shows what happens to demand for a commodity when the variables which affect demand undergo some change, that are the price of the good in question, price of related goods and income Engels curve represents all points of consumer equilibrium at all positive income levels, but in income-commodity space as opposed to ICP which is drawn in commodity-space Entrepreneur is a person who takes risks for finding new channels of profitable investments for the sake of further accumulation of capital Equilibrium is the position where there is no further tendency for change. In the context of market, it refers to the situation when demand is equal to supply Equilibrium price is the price where demand is equal to supply Equi-marginal principle states that at consumer equilibrium, the ratio of marginal utilities to prices is equal for all goods consumed. Verbally, it says that marginal utility of the last rupee spent on one good should be equal to the marginal utility of the last rupee spent on another good Euler’s Theorem says that when the production function displays constant returns to scale, it satisfies the adding up property: output equals sum of the marginal products of inputs times their level of use Excess-demand refers to the situation when demand is greater than supply at some positive price level Excess-supply refers to the situation when supply is greater than demand at some positive price level Expansion path is the set of all cost-minimizing input combinations at all output levels, given the prices of inputs and knowledge about technology Explicit cost refers to expenses which the entrepreneur has to pay from his own pocket for the purchase of inputs External growth is a companies’ expansion in sales or output achieved through the purchase of necessary resources externally (i.e. via mergers and acquisitions) Factor-price ratio is the ratio of input prices—ratio of wage rate to rental rate—and measures the relative prices of factors Factors of production are inputs that are not embodied in output and are retained after the end of production process. They include labor, land, capital and entrepreneur Firm equilibrium means firm doing its best to maximize profit. This is characterized by the condition when marginal revenue equals marginal revenue Firm is an entity that undertakes the activity of production for maximizing profit Fixed cost is the part of cost that does not change as output changes and that can’t be avoided in the short run Fixed factor is the input that cannot be changed in short run (also called fixed input) Fixed-proportion production function refers to the situation when there is only one technically efficient way of producing a given amount of output and, hence, shows no possibility of trade-off between inputs; i.e. there is no way to substitute labor for capital or vice versa Franchise monopoly is a monopoly business created out of state granted legal rights or protection Full income is a consumer’s maximum possible labor income (including non-labor income) assuming all of his time is sold at the market wage rate

Giffen good is a commodity which has positive segment of demand curve due to the positive income effect larger than the negative substitution effect Herfindahl-Hirschman Index is a measure of market concentration that is calculated by summing the squared market shares for competing firms in an industry Homogeneity of degree zero is the property of a function which says that if each of the arguments of a function is multiplied by a positive number, the value of the function remains unchanged. Demand functions are also homogenous of degree zero in prices and income meaning doubling all prices and income changes only the units by which we count, not the physical quantities demanded Hypothesis is a proposition which affirms or denies some fact Imperfect competition means market structure where any of the single conditions of perfectly competitive markets are missing or lacking Implicit cost stresses the cost of foregone alternative actions though no physical payment is made against them out of pocket Income effect is the change in demand due to change in income holding the final price fixed. It has a negative sign for normal goods and positive for inferior goods with regard to price change Income elastic demand is greater than 1. The demand changes by more than the change in income in percentage terms Income elasticity of demand shows percentage change in demand due to percentage change in income Income inelastic demand is less than 1. The demand changes by less than the change in income in percentage terms Income-consumption curve (or path) is a curve showing all points of consumer equilibrium at positive income levels, drawn in the commodity-plane Increasing returns to scale means returns to scale is greater than 1, reflecting the fact that output increases at a greater percentage rate than all inputs Indifference curve represents all combinations between two goods that give equal satisfaction or utility to a consumer Indifference map shows a family of indifference curves representing the utility an individual can obtain from all possible consumption options Industry is the collection of all firms concerned with a particular line of production Inertia shopping rule says that consumers tend to buy from the firm that charges the lowest price, but if he is already buying from a firm and another firm enters the market with a lower price, he gives his current firm a chance to meet the entrant’s price before shifting his demand Inferior good has a negative relationship between income and its demand. It displays negative income elasticity Inferior goods are goods for which there is negative relationship between income and demand Interior solution occurs when consumer opts to consume positive amounts of both the commodities. Interpersonal comparison of utility refers to the idea that in order to obtain social welfare function by adding up the utilities of more than one individual, one must be able to compare and rank the utility scales of all individuals (which is impossible because utility is a subjective phenomenon, known as impossibility of interpersonal comparison of utility)

Intertemporal budget constraint is the budget constraint applicable to income and expenditures involving more than single time period Intertemporal choice is the choice involving different periods of time Inverse demand curves shows quantity demanded of a commodity as a function of its price Iso-cost line represents different input combinations that cost the same amount Iso-quant curve shows different combinations of inputs that yield same level of output Labor demand curve shows the number of workers firms are willing to hire at different wage levels Labor refers to the amount of time an individual chooses to offer in the market at a specific wage rate Labor supply curve reflects the working hours which the workers are ready to sell at different wage levels in the market Law of demand says that other things held constant, there is inverse relationship between demand and price of a commodity Law of one-price means a commodity can be sold at one and only one price in a competitive market. This happens due to arbitrage Law of supply says that other things held constant, there is positive relationship between supply and price of a commodity Leisure is all the time spent off the market job Limit pricing is a pricing strategy used by existing firm by setting a price such that an entrant can’t make profits at that price Limited liability ownership means that an investor’s liability to debt is limited to the extent of their shareholdings or initial investment Limited partner in partnership is one who, like shareholders, risks only his initial investment in a firm Linear demand curve is one for which the slope is constant at all points while elasticity varies from zero to infinity Lock out is a firm’s refusal to operate its plant and employ its workers Long run average total cost curve is the envelop of short-run average total cost curves Long run equilibrium of a competitive firm and market is achieved when marginal cost, average total cost and price are all equal; i.e. P = MC = ATC. In the long run equilibrium, no firm has incentive to exit or enter the market Long-run is the time duration when all inputs can be changed Luxuries are the goods which have income elasticity greater than 1 Marginal condition for profit maximization implies that maximum profit output is one where marginal revenue equals marginal cost and marginal cost curve cuts marginal revenue from below Marginal cost is the change in total (or variable) cost due to change in output Marginal expenditures represent the amount needed to purchase an extra unit of labor. Technically speaking, marginal expenditure on labor is the change in total wage bill due to hiring of one extra unit of labor Marginal product of a factor is the change in output due to change in an input Marginal productivity theory of income distribution asserts that the income share of a factor of production is determined by its contribution in output produced Marginal rate of substitution (MRS) measures the rate at which the extra unit of x is substituted with y to keep utility constant

Marginal rate of technical substitution (MRTS) measures the rate at which labor can be substituted for capital still producing the same level of output Marginal revenue is the change in total revenue due to one unit change in out Marginal revenue product also indicates the change in revenue of a firm due to the sale of output produced by one additional input, but it is less than the VMP of a competitive firm (if we do make a distinction between the two) Marginal utility is the rate of change in utility due to change in the consumption of a commodity. Marginal utility is usually assumed to decline as more of a commodity is consumed, other things held constant Marginal-cost-pricing means setting price equal to marginal cost of production Market demand curve relates the price of a commodity to the total demand for that commodity by all individuals in the market. Economists wrongly claim that such a negatively sloped curve can be obtained by horizontal summation of all individuals’ demand curves Market demand is the sum of all individuals’ demand at a particular price. Graphically, it is the horizontal summation of individuals’ demand curves at all price levels Market or price mechanism is the tendency for price to change until market clears Market period refers to the time duration when the supply quantity available for immediate sale cannot be increased Market supply is the sum of supply by all individual firms at different price levels Merger represents the decision of a number of independent firms to form a single corporation Microeconomics a branch of economics concerned with the description of competitive process: its functioning, consequences and legitimacy. It also provides a theoretical foundation for legitimizing the motive of self-interest as the corner stone of society Monopolistic competition refers to a market structure characterized by many sellers competing with each other on differentiated products and facing easy market entry conditions Monopolistic exploitation is the difference between the wage offered by a monopolistic firm and that offered by a competitive market Monopoly is a business dominated by single firm which ignores pricing reaction of any other firms to its pricing decision Monopoly power refers to the extent to which a firm can control market price Monopsonistic exploitation is the difference between the wage offered by a monopsonistic firm and the one offered by a competitive market Monopsony is a business structure where only a single buyer faces the entire market supply Nash equilibrium is a set of actions where each player does the best it can, given the best of its competitor Natural monopoly is a business with increasing returns to scale at the level of the whole market. The result of such a business structure is that the average total cost (ATC) curve keeps declining as firm expands its operation Necessities are the goods which have income elasticity less than 1 Neutral goods are those which have zero marginal utility to a consumer Non price rationing is the use of mechanism other than price to ration or equate the demand for something with its available supply

Non-collusive oligopoly means that the firms are competing with each other in the oligopoly market instead of joining hands together and therefore have to be attentive of the reactions of other firms when making price decisions Non-Giffen inferior good is an inferior good but has a negatively sloped demand curve. Non-satiation is a claim about consumer psyche which says that a consumer is always greedy; i.e. he prefers more goods to less Normal factor is one whose use increases with the increase in output produced Normal good is one for which an increase in income leads to an increase in demand. It has positive income elasticity Normal goods are goods for which there is positive relationship between income and demand Normal profit means all firms are earning zero economic profit in the market Oligopoly is a market structure in which few firms compete with each other while entry barriers are significant One-shot game is one in which players take actions and receive pay-offs only once Opportunity cost is the value of second best alternative Opportunity cost of a particular choice is the satisfaction that would have been derived from the next best alternative foregone; in other words, it is the value of forgone activities in making a certain choice or decision Optimum bundle is that combination of (x,y) which lies on the highest indifference curve. It is that bundle for which the utility of the consumer is maximum Ordinal utility function represents a consumer’s taste showing only the order of the preferences, not the utility differences Organic growth is the growth in companies’ sales or output achieved by making investment internally (i.e. excludes growth through M&A) Own price is the price of a commodity in some monetary terms Paradigm refers to some metaphysical beliefs regarding the behaviour of subject which form the conceptual framework (hard core) of any scientific discipline through which the world is viewed. It also involves some standard experimental and theoretical techniques to apply the fundamental laws to a variety of situations in order to match paradigm with nature Partnership is a firm owned and operated by two or more people Pay-off matrix refers to a tabular representation of profit (or payoff) to each player given its decision and the decision of its competitor Perfect complements are the goods that are used in specific combination with each other. Perfect substitutes are those commodities that have equal value to a consumer and he ranks them same in order in terms of taste Plant comprises the physical capital of a firm at a particular location used for producing commodities—i.e. it is the unit of production in a firm Point elasticity measures elasticity at a specific point on a demand curve Price cap regulation is a regulatory method designed to encourage efficient production by allowing firms to share in any cost savings that they have achieved in production process Price ceiling is the maximum price of a commodity that can be legally charged for that commodity. Such a price is set below its equilibrium price.

Price elastic demand is greater than 1 in absolute value. The quantity demanded changes more than the change in price in percentage terms Price elasticity of demand shows the percentage change in quantity demanded due to percentage change in price Price elasticity of supply is the percentage change in quantity supplied due to percentage change in price Price inelastic demand is less than 1 in absolute value. The quantity demanded changes less than the change in price in percentage terms Price setting behavior means firm is facing downward sloping demand curve and hence can set price Price-consumption curve (or path) is a curve showing all points of consumer equilibrium at all relative prices Price-floor is the minimum price that must legally be offered for a commodity. This minimum price is set above the equilibrium or market price of a commodity Price-rigidity is a characteristic of oligopolistic markets which explains why firms can be reluctant to change prices even if costs or demand change Price-taker is a consumer who does not have any control to determine market prices and accepts them as given information by the market for making his choice decision Price-taking behavior is a competitive behavior when all agents in the market lack any control to determine market prices and take them as given information by the market for making their choice decisions Prisoner’s dilemma attempts to demonstrate why two agents might not cooperate even if it is in their best interests to do so Privatization is the sale of state owned enterprise to private individuals Producer equilibrium is the cost-minimizing input combination point where iso-quant and iso cost line are tangent to each other Product innovation is the practice of continuously bringing new and more expansive goods and services in the market in order to sustain continuous economic growth Production function is a relation between the amount of output a firm can produce with given inputs Production is the activity of combining and processing goods, called inputs, in technological process to convert them into some other goods, called output. Proprietorship is a firm which is owned and headed by a single person Rate of return regulation means setting a maximum rate of return on invested capital that a utility is allowed to earn Rate of time preference measures the rate at which the consumer is willing to substitute second period consumption for first period consumption Rationality is a hypothesis about consumers by which they can make logical and consistent choices based on universal greed Reaction function is the relationship between a firm’s profit-maximizing output and the amount of output it believes its competitor will produce Relative barriers are the ones which place a new entrant at a disadvantage, but they are not insurmountable ones Relative price is the price of one good in terms of another. It is the rate at which one must give up another commodity to obtain one good in terms of specific good. Repeated game is one where actions are taken and pay-offs are received by players over and again

Representative commodity always shows a proportional change in its demand as income of consumer increases. This holds only if taste of consumer always remains unchanged for a commodity as income increases Representative consumer is a mystical consumer in economic theory whose taste is supposed to be followed by all individuals living in capitalist society; i.e. his taste represents the taste of all consumers Reserve capacity is the fact of designing plants with some flexibility in productive capacity so that average variable cost curve has a flat stretch over a range of output Resource is anything that can satisfy a human want Return to factor / inputs refers to the behavior of change in output in response to change in a single input: what happens to output as we change single input Returns to scale measures the percentage change in output due to percentage change in all inputs: what happens to output as we change all inputs Saving is the residual amount of income left out of consumption expenditures Scarcity is a subjective phenomenon which refers to the degree by which people’s desire for something exceeds its availability Self-interest is an economic hypothesis about human behavior which says that while doing something, an individual must always look for his own objectives or desires; i.e. each activity should be motivated by the expectation of fulfilling one’s own desire Self-interest is the essence of rationality of an economic man. It is the ability of an economic man to rank his preferences as per his personal desires Short run equilibrium of a competitive firm is achieved when it produces where its price is equal to marginal cost of production, i.e. P = MC Short run total cost is the total cost of production, given some level of fixed factor. It is the sum of fixed and variable cost components Short-run Expansion path is the set of all cost-minimizing input combinations at all output levels, given the prices of inputs, knowledge about technology and the level of fixed factor usage Short-run is the time duration when at least one input is fixed Shut down rule says that under circumstances of loss, firm should try to minimize its loss. Firm should shut down its business only when operating loss is greater than its fixed cost. Alternatively, it should shut down when revenue is less than variable cost of operation Slope measures the rate of change in the dependent variable due to change in the independent variable Social indifference map ranks the sum of all consumers’ preferences in a consistent manner and is expected to have same properties as individual indifference map Social sciences work out the laws governing the behavior of individuals and social institutions of a society that prioritizes maximization of freedom as its ultimate objective Social utility or welfare is the sum of all individuals’ utilities or welfare living in a capitalist society Speculation occurs when something is purchased in the expectation of selling it at a higher price in future without increasing its value by processing it in some way. It is an unproductive and freeloading activity that is wholly separable from the real economy where production of goods and services takes place.

Stackelberg model of oligopoly in which one firm sets its output before other firms do Static efficiency is getting the most in terms of human satisfaction from given resources (also called Pareto efficiency) Strategy is the rule or plan of action defined for playing a game Strike refers to the refusal of a group to work under the prevailing working conditions Substitutes are goods that can be used in place of each other because they serve more or less the same purpose in the eyes of a consumer Substitutes are the goods which posses positive cross price elasticity Substitutions effect shows change in demand for a good due to change in its own price keeping real income constant. It always moves opposite to the price change and, hence, has a negative sign Super normal profit refers to positive economic profit earned by firms in the market Supply function simply says that sellers’ decision to sell a particular amount of output depends upon the own price of commodity that they are selling, prices of inputs and technology Supply is the amount of output that individuals are willing to sell at positive price Supply of saving reflects the amount of savings supplied by an economic agent at different rates of interest Sustainable monopoly is natural monopoly that can prevent entry and keep others out of market Tastes are all the hypothetical exchanges that an individual is willing to make at various terms of trade Tatonnement process refers to a hypothetical perfect market setting where an impartial and costless auctioneer coordinates market exchange Time allocation problem suggests that the fundamental scare resource in the economy is the availability of human time and a rational economic agent tries to allocate his time between work and leisure activities such that it results in maximum utility Total condition for profit maximization says that profit is maximum where slopes of total revenue and cost curves are equal and revenue curve is above cost curve Total effect is the observed effect of a price change on the quantity demanded of a commodity. It is the sum of substitution and income effects. Transaction cost is the cost of executing exchange; e.g. transportation and brokerage costs Transitivity is an assumption about consumer taste which says that given any triple of commodity bundles, A, B and C if A P B and B P C then A P C Unique solution is that which has only one solution value. Consumer utility maximization problem has a unique solution if indifference curves are strictly convex. The tangency condition shows the only one point at which utility is maximized Unitary price elastic demand is equal to 1 in absolute value. Change in quantity demanded and price are equal in percentage terms Utility function is a way of assigning a number to every possible consumption bundle such that more preferred bundles get larger numbers than the less preferred ones Utility-maximization is a hypothesis about consumer behavior which says that the objective of a consumer is to maximize utility subject to his income constraint

Value of marginal product indicates the change in revenue of a firm resulting from the sale of output produced by one additional input Variable cost is the part of cost that changes with output Variable factor is the input that can be easily varied in the short run (also called variable input) Zero economic profit means amount of profit which is necessary to keep an input in its existing use. It is attained when all inputs are receiving their market reward; i.e. their opportunity costs