The Government has a strong incentive to maximise the size of the labour force and ensure that as many people are working as possible. Fiscally it is more beneficial because tax revenues increase during periods of high employment, as the Government has more people earning and therefore it receives more tax receipts. Low levels of unemployment would result in reduced social security payments which can be more beneficially spent elsewhere in the economy.
If there are more people working then the economy is closer to the production possibility frontier, which results in people earnings increasing and there being and there possibly being a wider range of goods available in the economy. These factors may also result in higher rates of growth in the economy over time, as the higher levels of demand in the economy may encourage firms to innovate to maximise their profit potential in the larger economy.
Frictional and structural unemployment and hysteresis can result in huge social problems. People out of work encounter huge stresses in attempting to find new employment, as they feel worse about themselves and are concerned about their declining standard of living. This can also result in crime because some people may consider it an easier option. This can be especially true for individual areas, with the decline in an industry or service predominantly effecting the same social classes or skills groups. In some cases if they live close to each other in an area such an economic decline could increase crime levels significantly.
Employment is usually considered on a macroeconomic rather than a microeconomic level to deal with unemployment. It is considered more cost and time effective to alleviate structural and frictional problems with job centres and work schemes or tackle persistent unemployment through the whole economy. The microeconomic response would have to address individual markets and it would probably be a lot more difficult and inefficient to correct than a more general macroeconomic policy.
This article was written by Jonathan McHugh in June 2005
Showing posts with label natural rate of unemployment. Show all posts
Showing posts with label natural rate of unemployment. Show all posts
6/28/05
Why Is A High Level Of Employment Typically A Microeconomic Policy?
The Government has a strong incentive to maximise the size of the labour force and ensure that as many people are working as possible. Fiscally it is more beneficial because tax revenues increase during periods of high employment, as the Government has more people earning and therefore it receives more tax receipts. Low levels of unemployment would result in reduced social security payments which can be more beneficially spent elsewhere in the economy.
If there are more people working then the economy is closer to the production possibility frontier, which results in people earnings increasing and there being and there possibly being a wider range of goods available in the economy. These factors may also result in higher rates of growth in the economy over time, as the higher levels of demand in the economy may encourage firms to innovate to maximise their profit potential in the larger economy.
Frictional and structural unemployment and hysteresis can result in huge social problems. People out of work encounter huge stresses in attempting to find new employment, as they feel worse about themselves and are concerned about their declining standard of living. This can also result in crime because some people may consider it an easier option. This can be especially true for individual areas, with the decline in an industry or service predominantly effecting the same social classes or skills groups. In some cases if they live close to each other in an area such an economic decline could increase crime levels significantly.
Employment is usually considered on a macroeconomic rather than a microeconomic level to deal with unemployment. It is considered more cost and time effective to alleviate structural and frictional problems with job centres and work schemes or tackle persistent unemployment through the whole economy. The microeconomic response would have to address individual markets and it would probably be a lot more difficult and inefficient to correct than a more general macroeconomic policy.
This article was written by Jonathan McHugh in June 2005
If there are more people working then the economy is closer to the production possibility frontier, which results in people earnings increasing and there being and there possibly being a wider range of goods available in the economy. These factors may also result in higher rates of growth in the economy over time, as the higher levels of demand in the economy may encourage firms to innovate to maximise their profit potential in the larger economy.
Frictional and structural unemployment and hysteresis can result in huge social problems. People out of work encounter huge stresses in attempting to find new employment, as they feel worse about themselves and are concerned about their declining standard of living. This can also result in crime because some people may consider it an easier option. This can be especially true for individual areas, with the decline in an industry or service predominantly effecting the same social classes or skills groups. In some cases if they live close to each other in an area such an economic decline could increase crime levels significantly.
Employment is usually considered on a macroeconomic rather than a microeconomic level to deal with unemployment. It is considered more cost and time effective to alleviate structural and frictional problems with job centres and work schemes or tackle persistent unemployment through the whole economy. The microeconomic response would have to address individual markets and it would probably be a lot more difficult and inefficient to correct than a more general macroeconomic policy.
This article was written by Jonathan McHugh in June 2005
6/1/05
What Is Meant By Full Employment?
Full employment exists when all firms in the economy are able to hire all the labour that they want at the equilibrium wage rate and all the workers are prepared to accept jobs at that wage rate are employed. It also takes into account structural and frictional unemployment, discouraged workers and the effect of technology on employment. However, there are ways dynamically to adjust the level of employment through addressing problems with involuntary and voluntary unemployment.
In figure 1 the equilibrium of full employment is represented on point A (labour size N*, wage rate W*), as it is the intersection between line NS, the aggregate of workers desires to accept jobs at particular real wage rates and line ND, the aggregate of firms desires to employ labour at particular wage rates.
Any other level of employment would not be regarded as full employment and any wage above the equilibrium’s wage rate of W* would create unemployment. For example, trade unions may be able to ask for a minimum wage, say W1. At W1 the higher wage rates would create an incentive for more of the labour force to seek employment, as they would be financially better off. Similarly, the higher wages would create a disincentive for firms to employ as many workers, as their revenues would decrease. As a consequence there will be a move from full employment to unemployment, with the size of unemployment being between N2 and N3. This is created as a result of the W1 wage rate creating a greater desire for labours to supply their services than for the firms to employ them. The only way to reduce these effects and bring back full employment would be to reduce the wage rate from W1 to W*
Trade unions may also be able to put training requirements on working in a market, which would shift the NS curve to the left to NSu. In this example the size of unemployment created would be between N2 and N3 as a result of these employment barriers.
There are people who are unable to find work despite their desire to, as structural and frictional problems prevent them. Many people are unable to find work because there aren’t jobs available in their area or their professions are in decline. For example, a coal miner could be unemployed in his hometown as a result of the local pit which hired the majority of the village closing down, despite the fact that he has the desire to work. In such a case he may have to work elsewhere, even abroad to match his skills with a company, at possibly huge emotional distress.
Frictional unemployment exists because of the inefficiencies involved in matching up the right employee to the right job, which normally takes significant time and results in people being unemployed in the interim. The size of these unemployed workers for both structural and frictional problems is the difference between N*, the aggregate of workers prepared to accept jobs and N1, the aggregate of people willing to accept jobs at the correct price but are unable to find the right ones. They are not classified as disrupting full employment in the labour market, as they are unable to initiate the decision to accept or refuse an employers offer in the short run. However, over time these will erode individual reasons for lack of employment but will be replaced by similar circumstances elsewhere in the economy. If the government was able to reduce these effects then the NS curve would shift to the right, closer to the LF curve, the curve representing the aggregate of the willing to work labour market. As a result, the level of full employment would increase.
There are people who are able to work in the economy but choose not to as they do not have the inclination and find the opportunity cost of employment too great. For example, they may consider the cost of finding a job too strong to justify the benefits of working and so they remain economically inactive. The size of this hysteresis in an economy is the difference between N1, the level of the labour force offering their services and NT, the total size of the labour force population in the short run. These people are not classed as effecting the labour market as they have chosen to stay out of the economic bargaining for employment or to make the effort to approach firms. However, reducing the subsidies given to the unemployed or improving the skills for these people to give them higher earning potential would increase their incentives to work and it should shift the NS curve (and possibly the LF curve) to the right and increase the level of full employment.
Advances in technology can have bearings on the level of employment in an economy as firms realise that they are able to employ less employees with the same amount of output with new capital. Figure 2 shows a set of production possibility frontiers. If there was an improvement in technology there would be a shift in the PPF curve from y=f(N) to y=f’(N). Consequentially, the output level Y1 can be produced using only N2 levels of labour, a reduction of labour in the economy. However, the reduction in labour should reduce output costs which should lower market price and then stimulate market demand so that output may increase to Y2, an increase in employment to N3.
This piece was written by Jonathan McHugh in June 2005
In figure 1 the equilibrium of full employment is represented on point A (labour size N*, wage rate W*), as it is the intersection between line NS, the aggregate of workers desires to accept jobs at particular real wage rates and line ND, the aggregate of firms desires to employ labour at particular wage rates.
Any other level of employment would not be regarded as full employment and any wage above the equilibrium’s wage rate of W* would create unemployment. For example, trade unions may be able to ask for a minimum wage, say W1. At W1 the higher wage rates would create an incentive for more of the labour force to seek employment, as they would be financially better off. Similarly, the higher wages would create a disincentive for firms to employ as many workers, as their revenues would decrease. As a consequence there will be a move from full employment to unemployment, with the size of unemployment being between N2 and N3. This is created as a result of the W1 wage rate creating a greater desire for labours to supply their services than for the firms to employ them. The only way to reduce these effects and bring back full employment would be to reduce the wage rate from W1 to W*
Trade unions may also be able to put training requirements on working in a market, which would shift the NS curve to the left to NSu. In this example the size of unemployment created would be between N2 and N3 as a result of these employment barriers.
There are people who are unable to find work despite their desire to, as structural and frictional problems prevent them. Many people are unable to find work because there aren’t jobs available in their area or their professions are in decline. For example, a coal miner could be unemployed in his hometown as a result of the local pit which hired the majority of the village closing down, despite the fact that he has the desire to work. In such a case he may have to work elsewhere, even abroad to match his skills with a company, at possibly huge emotional distress.
Frictional unemployment exists because of the inefficiencies involved in matching up the right employee to the right job, which normally takes significant time and results in people being unemployed in the interim. The size of these unemployed workers for both structural and frictional problems is the difference between N*, the aggregate of workers prepared to accept jobs and N1, the aggregate of people willing to accept jobs at the correct price but are unable to find the right ones. They are not classified as disrupting full employment in the labour market, as they are unable to initiate the decision to accept or refuse an employers offer in the short run. However, over time these will erode individual reasons for lack of employment but will be replaced by similar circumstances elsewhere in the economy. If the government was able to reduce these effects then the NS curve would shift to the right, closer to the LF curve, the curve representing the aggregate of the willing to work labour market. As a result, the level of full employment would increase.
There are people who are able to work in the economy but choose not to as they do not have the inclination and find the opportunity cost of employment too great. For example, they may consider the cost of finding a job too strong to justify the benefits of working and so they remain economically inactive. The size of this hysteresis in an economy is the difference between N1, the level of the labour force offering their services and NT, the total size of the labour force population in the short run. These people are not classed as effecting the labour market as they have chosen to stay out of the economic bargaining for employment or to make the effort to approach firms. However, reducing the subsidies given to the unemployed or improving the skills for these people to give them higher earning potential would increase their incentives to work and it should shift the NS curve (and possibly the LF curve) to the right and increase the level of full employment.
Advances in technology can have bearings on the level of employment in an economy as firms realise that they are able to employ less employees with the same amount of output with new capital. Figure 2 shows a set of production possibility frontiers. If there was an improvement in technology there would be a shift in the PPF curve from y=f(N) to y=f’(N). Consequentially, the output level Y1 can be produced using only N2 levels of labour, a reduction of labour in the economy. However, the reduction in labour should reduce output costs which should lower market price and then stimulate market demand so that output may increase to Y2, an increase in employment to N3.
This piece was written by Jonathan McHugh in June 2005
How Might Unemployment Be Above The Natural Rate?
Prior to the drop in demand the economy was resting at point A, wage level W* and employment level N* in figure 4. There is a shift in the demand for labour by the firms from P0 to P1 as a result of less profitability in the economy. If the employees as a result of trade unions encourage wage stability (or sticky wages) then the price level would remain at W*. This has the effect of creating voluntary employment between N1 and N* as the real wage has been forced up as the price level has lowered and the wages have remained the same. If employees do not perceive a price level fall but supply to their expected real wage not money wage, then NS0 remains the supply curve as they haven’t perceived the fall in the price level. They will then accept a lower monetary wage as the real wage has increased as a result of the price level falling faster than their wages. This is still voluntary, as a further fall in money wages would reduce real wages back to the equilibrium level. In the long run the stickiness of wages should erode following contract negotiations over time, which should shift the labour supply curve from NS0 to NS1, resulting in full employment at N* but a lower wage rate of W2.
Voluntary unemployment occurs when a decline in the output of the economy from Y* to Y1 (shown by figure 3) prevents firms from selling as many goods as before. As a consequence there will be a shift in the labour demand curve from ND0 to ND1 in figure 4 and the firms will not hire beyond N1 as any extra employment would reduce their profits. As a result the labour demand curve B C N1 is kinked at C on figure 4. If the money wage stays at W* then D will not be anywhere near the unconstrained supply or demand curves, creating involuntary employment as a result. Consequentially, because workers cant price themselves in being employed at lower wages there will not be a reduction in the level of unemployment in the economy.
Returning to figure 1, with NC (the constrained labour demand) being the total level of employment and W* being the wage rate there would be cyclical unemployment between NC and N* and structural and frictional unemployment between N* and N1. At wage rate W1 cyclical unemployment would be between NC and N2, classical unemployment between N2 and N3 and frictional and cyclical unemployment between N3 and N4. Such demand deficient unemployment can add to hysteresis and result in increased structural unemployment and a shift of the labour force and labour supply curves to the left as a result of discouraged people not being able to find positions and loosing their skills.
5/8/05
Define and explain fully what is meant by full employment. Why might unemployment be above the natural rate? Why is a high level of employment typical
Now we know that full employment is any level of unemployment found in natural labour market equilibrium with only voluntary unemployment, let us look at natural unemployment. Structural unemployment is commonly talked about in the press, as a major initiator in the U.K. is often perceived as the transformation that came about in the 1980’s party due to Thatcherite policies (more or which later). It is caused by a market failure arising from “mismatches between job applicants and vacancies with respect to skills, occupations or localities.”[2] These mismatches then occur because within the national labour market there are numerous different markets based on the above variations. Most commonly is the geographical factor. This occurs when an employee suitable for a vacancy lives far enough from the vacancy to make the cost of accepting the job greater than the benefit. The opportunity cost of being unemployed (being employed) is too great. For example a highly skilled ship carpenter may be located in Tyneside, while a there is a vacancy in
Our ship carpenter would require learning new skills to be compatible with the job. He would have to catch up with any changes in the required composition of output (in this case perhaps safety features required or new materials to work with). Structural unemployment is considered voluntary, as it is technically the employee’s choice not to move to a market where there is excess demand rather than supply.
With frictional unemployment we have a number of employees and employers; each with relevant skills and vacancies, but who have not yet been able to find each other or because of imperfect information (and attempts to correct it) not hired anyone yet. For example another ship worker and a company looking for a nautical engineer - it takes time to find the vacancy advertised and will then have to be interviewed, his references checked and the company decide if they can find anyone with more experience relevant or if he is sufficient. In addition the workers reservation wage, the wage he or she expects to obtain, may be inaccurate. This is especially common when seeking jobs in unfamiliar regions and even countries in the EU, and means that workers are either over-valuing themselves or will be undervalued by a prospective employer.
Structural and frictional unemployment can be shown diagrammatically. On figure 1 we can see a labour demand curve ND, a total labour force LF and an labour supply curve NS(aj) (The ‘aj’ is for accept jobs and represents the number of people who will accept jobs at a wage rate). There is a natural equilibrium wage rate of W* and N* employment at point A. 0 to N* represents full employment at this equilibrium, while N* to N1 represents structural and frictional unemployment.
Technical change in an industry can have a huge effect on the numbers in full employment as it can change the demand curve for labour. Figure 2 shows a set of production possibility frontiers. Starting at output Y1 if we then had an improvement in technology, shifting the p.p.f. from its initially fixed position y=f(N) to y=f’(N) we see that Y1 can be produced using only N2 labour. This causes a reduction in employment, but also a reduction in unit costs of production; meaning firms’ profit maximising price is lower. This will mean a reduction in market price. Should this stimulate the market demand (as it should if it is anything but perfectly inelastic) there can be an increase in output, say to Y2, which will require an increase in employment. That said a further move in technology to the p.p.f. y=f’’(N) will mean Y2 can be produced at only N4. This is clearly an important factor in full employment as technology is always being pushed forward by companies seeking to gain production advantage over their competitors.
It is possible here to link the last three factors together. Some external explanations for unemployment focus on the changes to production structure caused by economic globalisation and economies of scale from large international factories instead of small little ones, creating mismatch problems and so greater structural unemployment[3]. Hysteresis has commonly been sited as increasing structural unemployment. This is whereby after a long period of job searching workers loose motivation and confidence, the skills gap broadens as time goes on and frictional unemployment can soon change to structural. Employers are reluctant to hire someone who has been out of work for some time as the reason for the gap may not be obvious. This causes the natural rate to rise. Full employment’s natural equilibrium may be affected therefore by larger technical changes and longer periods of mass unemployment.
An additional cause of natural unemployment is classical or real wage unemployment, or that caused by an overly high national minimum wage. Either trade unions or workers collectively have negotiated a wage higher than the equilibrium real wage, W* on fig 1, let us say W1. This creates a position where the real NS (AJ) curve runs horizontally from W1 to the point where it meets NS (AJ) and then follows it upwards, shown by the red line on fig 1. This intersects ND at point B. NSu illustrates the union supply curve. We can now clearly see we have lower full employment, at N2, with unemployment due to an inflated real wage being N2 – N3, and structural and frictional unemployment being N3 to N4 (N3 being how many people would accept jobs at W1, and N4 being how many would seek jobs at W1). This remains natural unemployment, and N2 full employment because that is the equilibrium at W1, and it is institutional factors that cause the wages to remain high. It must be realised though that this type of unemployment is rare in modern economies now.
Demand deficient unemployment can have two effects. One is on voluntary and so natural rate of unemployment, the other creating involuntary, cyclical or Keynesian unemployment as we shall see in a moment. The dependent factor is whether or not workers expect and can respond flexibly to a drop in the price level. Consulting figure 3 we see a diagram not adjusted for price level. Initial equilibrium is at W*, A, N* where NS (P0) and ND (P0) (for price level P0). The economy experiences a sudden drop in price level to P1 and Demand. If the workers are successful in maintaining the price level at W* through contracts and sticky wages we have a restricted supply curve as with real wage unemployment. The resulting unemployment N1 – N* is voluntary as workers have inadvertently or not forced ‘real’ wages up (because the price level has dropped while money wage levels remain the same). If workers do not perceive a price level fall but supply to their expected real wage not money wage, then NS (P0) remains the supply curve, because they haven’t perceived the fall in price level, but will accept a lower monetary wage as real wage has increased (price level has still fallen further than wages). Again this is voluntary, as a further fall in money wages would reduce real wages back to equilibrium levels. However this can only happen if they perceive the fall in price level. It may not be possible, if they do perceive it, to move to NS(P1) due to sticky wages of some and long term labour contracts, so it is only possible in the long run which will still create some voluntary unemployment. Equilibrium will only return in the long run if wages are perfectly flexible though and they can drop to W2 in figure 3.
This is voluntary and so natural rate unemployment. However in reality a fall in price level is very rare, indeed
If we look at a fall in aggregate demand without a drop in price level, that is to say a perfectly elastic aggregate supply curve, like that in figure 4, we can obtain involuntary, Keynesian or cyclical unemployment, when unemployment is above the natural rate. Y* gives us a natural rate of unemployment that can be seen on figure 4 when we realise that N*, i.e. quantity of labour demanded, is a function of Y*, the demand for the product of labour. We will have only natural unemployment.
However a fall in demand prompts a reduction in output to Y1 as that is all the firm can sell in a quantity controlled goods market. This creates demand for labour of N1, creating a labour demand curve B C N1, kinked at C on Figure 3. If the money wage remains at W* we can see D is nowhere near either the unconstrained supply or demand curves, thus we have involuntary unemployment. Lowering the money wage will not actually reduce unemployment, as workers can’t price themselves into being employed.
We can see this translated onto figure 1 where we see Nc – the constrained labour demand, being the total level of employment, giving us at W* cyclical unemployment of Nc to N* and structural and frictional unemployment N* to N1. We may also have some real wage unemployment at the same time with real wages too high at W1 and cyclical unemployment Nc – N2, classical N2 – N3 and N3 – N4 frictional and structural. It is entirely possible to have a situation of cyclical unemployment in the case of a large economy such as the
High level of employment is consistently a macroeconomic policy objective for a number of reasons. First there is extensive political pressure from the public, nearly everyone has to have, and wants a job. Employment is essential to the economy, as with out it there simply would be no economy; high levels of employment are likely (but not certain) to provide higher levels of aggregate demand as more people have more money to spend and will also help to raise average standards of living. Employment provides individuals with earning that are then taxed by government. Public choice or individualist public policy theorists would argue that it is in bureaucrat’s interest to maximise revenues from employment tax so they can expand their budgets for their own prestige[5]. This is a little torturous, however it is clear that government would want to maximise its tax revenue and limit its social welfare payments. Costs are not just the direct welfare payments but additional social costs of unemployment. Structurally unemployed individuals will naturally have a lower income and as Mocan argues it is likely to increase income inequality in the country if structural unemployment grows, and can then foster additional social problems causing even more cost to the public purse[6]. In my opinion however government’s main aim is to reduce unemployment, either by moving people into employment or into being inactive. In the short run government can raise employment by stimulating demand (the opposite of cyclical unemployment – above) or focusing on policies to reduce structural and frictional unemployment, for example through job centres, CV clinics and so on. In the short run they could also raise the level of the inactive population.
Encouraging people to become inactive has significant benefits. As the group consists of those in education, encouraging the structurally and frictionally unemployed to enter training can help them transfer to industries with demand greater than supply of labour by updating skills in the medium and long run. This will also have the effect, especially amongst the young, of pushing forward the countries Production Possibility frontier that will increase employment in the long run. Having some unemployed move to the inactive market also means that if there is an external increase in demand to domestic labour, say through an increase in demand for exports, the economy will have room to expand.
Governments have effects on the levels of employment both directly and indirectly through policy instruments. The effect of the levels of unemployment assistance on both employment and unemployment levels has been a key issue in the last 25 years. Larsen describes how some have blamed systems in the EU for high unemployment, and although the concept of eurosclorosis has been largely discredited (see chapter 6 of Blanchard), the effects of a poorly planned benefit system are clear. Figure 5 shows an initial equilibrium at A, with Wage W*, and N* employment, and N* - N1 unemployment. An increase in the amount paid for unemployment benefits or the time they are paid for will reduce the opportunity cost of being unemployed both for those inactive and employed. Marginal individuals will decide they are better off registered as unemployed rather than employed or inactive. A well structured social security benefit system that pays benefits only for those actively seeking employment, and forces people to accept jobs will increase employment.
Eurosclorosis theorists argued that over regulation of employers regarding employment would create additional costs of employing someone, thus reducing the labour demand curve. The same effect is seen with any cost or tax. This is shown in figure 6. A tax on employees will reduce real disposable income from any money wage, thus a lower supply curve at any particular money wage, and this is shown in figure 7. The effects of these actions are primarily on employment as they involve a shift in N*.
In conclusion we can say that full employment involves any level of employment that results from natural equilibrium in the labour market, with a natural rate of unemployment existing at the same time. This can vary for structural, frictional and real wage unemployment. Unemployment may rise above the natural rate when Keynesian demand deficient or cyclical unemployment occurs, usually during a recession, as there is no change in the price level. Governments have a high level of employment as a policy aim because it allows for what I believe to be their primarily aim of reducing unemployment, either by increasing employment in the short run buy boosting demand in a Keynesian way or in the long run by increasing labour productivity by moving people into the inactive section of the population so they can retrain. Government seek to reduce unemployment, because of political pressure, it allows them to maximise tax revenue and can reduce the chance of instability by increasing aggregate demand.
** All general facts, theories on types of employment and unemployment and factors affecting them, and graphs above are taken from Lecture notes – Mr M Macmillen 2005
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Bibliography
+ Mr M. Macmillen - EPP Lecture Notes – 2005
+ Oliver Blanchard - Macroeconomics, second edition – 1999
+ Christian Larsen - Structural unemployment. An analysis of recruitment and selection mechanisms based on panel data among Danish long term unemployed. –2003 – International Social welfare 12 pp170-181
+ Mocan, H. Naci – Structural unemployment, cyclical unemployment and income inequality – 1999 – The review of economics and statistics 81 (1) pp 122 – 134
+ Camarero and Tamarit – Hysteresis vs. natural rate of unemployment – 2004 – Economic Letters 84 pp 413 - 417
12/10/04
Consider A Market For A Homogenous Good With Two Firms. Making The Appropriate Assumptions About Market Demand...
Consider A Market For A Homogenous Good With Two Firms. Making The Appropriate Assumptions About Market Demand,
b) Now suppose that one of the firms behaves as the Stackelberg quantity leader. Compare the equilibrium outcomes of Cournot verses Stackelberg
Stackelberg equilibriums act differently to Cournot equilibriums as Stackelberg equilibriums are asymmetrical. This creates a situation whereby the first firm makes a decision about output or price and the second firm has to react. Consequentially it creates different levels of income between the firms, unlike the Cournot equilibrium where profits are shared equally. Also, Stackelberg firms are less Pareto-inefficient, as they earn less net abnormal profits.
Unlike Cournot markets Stackelberg markets are not simultaneous but sequential, with one firm not making decisions based upon another firm’s future actions. Referring back to the example in part A consider that IBM is the first member if the computer industry. This enables it to be the quantity leader and set the level of output not based upon but inspite of Dell the new entrant. As a new entrant to the industry Dell is in no position to influence the market too significantly and has to react to the output decisions of IBM. This is because if Dell attempted to increase its output to match IBM’s levels it would risk lowering the unit price of computers too severely to justify entering the market. As a result, in a perfect Stackelberg model IBM would produce 50 units (based on there being 100 potential units in the market) and Dell 25 units, with both companies earning 25 abnormal profits per unit. This is different to the Cournot equilibrium where both firms would produce 33 1/3 units each, and earn 33 1/3 per unit as Game Theory requires a more even distribution of profits between companies.
Nash’s Game Theory explains how each firm has the ability to have high output or low output to influence profitability. We are taught that in order to maximise profits each firm will have to anticipate the other firms move. Both firms want to be in a position where they have high output but their rival produces a very low output, which would create 3 units of abnormal profits for the firm with the larger output but 0 for the firm with the lower output (see table below). If both firms happened to produce at low levels of output then they would earn the largest combined amounts of abnormal profits (4 units in the right table), as the price level would be driven up. However, if both firms attempted to produce at the highest level of output then they would create the lowest level of abnormal profits (2 in the right table), as the price level would be driven down.
Firm B
Output High Low
Firm A High (1,1) (3,0)
Low (0,3) (2,2)
Cournot equilibriums are more Pareto-inefficient than Stackelberg equilibriums. In Cournot equilibriums although both firms are choosing their second best options their abnormal profits combined are larger than Stackelberg equations. The Cournot example resembles that of both firms producing at lower levels, creating 4 units of abnormal profits. The Stackelberg equilibrium on the other hand would resemble the example of firm A (IBM) producing 3 units of abnormal profits but firm B (Dell) producing no units of abnormal profits. Consequently there would be one less unit of abnormal profits under Stackelberg than Cournot and therefore would be more Pareto efficient. The figures used in the second paragraph on the amount of abnormal profits per unit and the amount of units produced in each equilibrium show the Cournot equilibrium to create the value of 2222 2/9 abnormal profits, whereas the Stackelberg equilibrium would create the value of 1875, therefore the has been a greater loss of utility to the consumers under the Cournot equilibrium.
At equilibrium Stackelberg leaders produce more than Stackelberg followers, whereas in a Cournot duopoly both firms would produce and charge the same amount. However, a Cournot market is able to extract the most abnormal profits and is therefore the more Pareto-inefficient.
This piece was written by Jonathan McHugh in December 2004
b) Now suppose that one of the firms behaves as the Stackelberg quantity leader. Compare the equilibrium outcomes of Cournot verses Stackelberg
Stackelberg equilibriums act differently to Cournot equilibriums as Stackelberg equilibriums are asymmetrical. This creates a situation whereby the first firm makes a decision about output or price and the second firm has to react. Consequentially it creates different levels of income between the firms, unlike the Cournot equilibrium where profits are shared equally. Also, Stackelberg firms are less Pareto-inefficient, as they earn less net abnormal profits.
Unlike Cournot markets Stackelberg markets are not simultaneous but sequential, with one firm not making decisions based upon another firm’s future actions. Referring back to the example in part A consider that IBM is the first member if the computer industry. This enables it to be the quantity leader and set the level of output not based upon but inspite of Dell the new entrant. As a new entrant to the industry Dell is in no position to influence the market too significantly and has to react to the output decisions of IBM. This is because if Dell attempted to increase its output to match IBM’s levels it would risk lowering the unit price of computers too severely to justify entering the market. As a result, in a perfect Stackelberg model IBM would produce 50 units (based on there being 100 potential units in the market) and Dell 25 units, with both companies earning 25 abnormal profits per unit. This is different to the Cournot equilibrium where both firms would produce 33 1/3 units each, and earn 33 1/3 per unit as Game Theory requires a more even distribution of profits between companies.
Nash’s Game Theory explains how each firm has the ability to have high output or low output to influence profitability. We are taught that in order to maximise profits each firm will have to anticipate the other firms move. Both firms want to be in a position where they have high output but their rival produces a very low output, which would create 3 units of abnormal profits for the firm with the larger output but 0 for the firm with the lower output (see table below). If both firms happened to produce at low levels of output then they would earn the largest combined amounts of abnormal profits (4 units in the right table), as the price level would be driven up. However, if both firms attempted to produce at the highest level of output then they would create the lowest level of abnormal profits (2 in the right table), as the price level would be driven down.
Firm B
Output High Low
Firm A High (1,1) (3,0)
Low (0,3) (2,2)
Cournot equilibriums are more Pareto-inefficient than Stackelberg equilibriums. In Cournot equilibriums although both firms are choosing their second best options their abnormal profits combined are larger than Stackelberg equations. The Cournot example resembles that of both firms producing at lower levels, creating 4 units of abnormal profits. The Stackelberg equilibrium on the other hand would resemble the example of firm A (IBM) producing 3 units of abnormal profits but firm B (Dell) producing no units of abnormal profits. Consequently there would be one less unit of abnormal profits under Stackelberg than Cournot and therefore would be more Pareto efficient. The figures used in the second paragraph on the amount of abnormal profits per unit and the amount of units produced in each equilibrium show the Cournot equilibrium to create the value of 2222 2/9 abnormal profits, whereas the Stackelberg equilibrium would create the value of 1875, therefore the has been a greater loss of utility to the consumers under the Cournot equilibrium.
At equilibrium Stackelberg leaders produce more than Stackelberg followers, whereas in a Cournot duopoly both firms would produce and charge the same amount. However, a Cournot market is able to extract the most abnormal profits and is therefore the more Pareto-inefficient.
This piece was written by Jonathan McHugh in December 2004
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