Naked Economics Test 1 Ch. 1-4

Maximizing Utility

Individuals seek to maximize their utility, or do whatever is best for them to make themselves as well off as possible in the long run to fulfill their own preferences. ex. going to college will make you better off in the long run

Limits of Rationality, Bounded Rationality, behavioral economics

People do not always do what will make them better off. In theory, it should never be possible to make rational individuals better off by denying them some option. But people do not always do what will make them better off in the long run (lost weight, stop smoking, save for retirement). This is where behavioral economics come in, the reality part of economics.

Free Rider Problem

Somebody who lets somebody else or some other organization do the work but still derive benefit. (ex. installing a missile defense system saves everybody around it)

George Stigler

Showed that firms and professional associations often seek regulation as a way of advancing their own interests. (such as advocating licensing to protect their craft)

Helping Hand vs. Grabbing Hand (petty tyranny)

Developing countries cannot outline basic property rights, but they can receive bribes to create absurd laws for their own interest. This leads to petty tyranny. Excessive regulation pushes entrepreneurs into the black market.

Redistributive/distributive policies

it is not easy to move money from the rich to the poor. And the rich will do anything to keep their money, including moving money around, making investments to shelter income, or even moving completely.

Supply-side economics

states that lower marginal tax rates stimulate economic activity

Deadweight Loss

taxes that make neither party better off. Such as taxing a certain color of sports car: people end up not buying their favorite color sports car, and the govt does not make any money.

Govt allocation vs. private allocation

the government should not be delivering mail. The US postal service used to be good when a subsidy was required, but now UPS and FEDEX have shown that it can be done privately. Private firms > government firms

Market price, pricing decisions

Determined by supply and demand. Stocks are exact representations of supply and demand while Gap has some control over the price and it stays the same for a long time. But it is still based on supply and demand.

Bad vs. Good Regulation

Regulation can disrupt the movement of capital and labor, raise the cost of goods and services, inhibit innovation, and otherwise shackle the economy. At worst, regulation can become a tool fro self-interest as firms work the political system to their own benefit.

Market Allocation

agreements in which competitors divide markets among themselves. Firms will specify a location and customers they want to sell to. ex. Coca cola gained a huge market in east germany by passing free coke's through the berlin wall. Thus establishing a market in that location.

Laffer Curve

high tax rates discourage so much work and investment that cutting taxes will earn the government more revenue, not less. But this only works when taxes are very high.

Law of Unintended Consequences/ Perverse Incentives

inadvertent incentives that can be created when we set out to do something completely different. ex. mexico city attempted to limit emissions by controlling when people drove (certain license plates could only drive certain days) but people just ended up buying more cars or used their old ones which burned even dirtier.

in's of a market economy

incentive, innovation, investment, income

Lessons of markets:

make lives better: the only way firms can make profits is by delivering goods that we want to buy. Market is amoral: markets reward scarcity, which has no relation to value. (diamonds are worthless if you look at how useful they actually are whereas water is the most expensive thing that your body needs. but diamonds are costly only because they are rare.) (also why criminals are very innovative, to make money) self-correcting: when gas approached $4 a gallon, people corrected their situation by buying smaller cars and riding motorcycles. fixed prices => competition on other fronts: (when airline tickets were a set price by the government, airlines competed by making flights comfortable and fancy. now they are completely based on profit) trade makes everyone better off: Both firms and customers are actin in their own self interest. (ex. Workers take jobs in sweatshops because it is the best employment option they have)

Greg Mankiw

Debunked the myth that tax cuts increase revenue for all cases saying that you will not get something for nothing.

Joseph Schumpeter

Coined the term "creative destruction" whereby the market economy rewards winners and crushes losers

Communal vs. Private Property

Communal resources cannot be regulated with ease (such as rhinos). Leads to tragedy of the commons.

Cost/Benefit Analysis

Cost involves more than just money, it can also involve time and feelings (ex. standing in the rain for 6 hours to get free concert tickets). Every transaction we do a cost benefit analysis by weighing the cost of something versus how badly we need it. (If the price falls, it becomes more attractive to us and more beneficial).

Invisible Hand of the Economy

Created by Adam Smith, the invisible hand is what runs the market economy without government intervention or regulation but rather through supply and demand.

Adam Smith

Created the invisible hand whereby the economy works in self interest, where prices are set by supply and demand in a laissez-faire economy.

Profit Motive

Firms attempt to maximize profits. (ex. this is why goods are produced in china and why slaves were desirable to landowners)

Jeffrey Sachs

Estimated that sub-Saharan africa would be a third richer today if malaria had been eradicated in 1964. Promotes the use of DDT as the cheapest way to eradicate the disease

Opportunity Cost/Trade-offs

Every decision we make involves some sort of trade off. Often we may trade off utility now against utility in the future. ex. whacking your boss on the head to fulfill desire now will have less utility than suppressing your desire now to keep your job and make money.

Aligned incentives

Good policy uses incentives to some positive end. London raised the cost of driving during peak demand and thus people preferred to bike or bus during these hours. It not only decreased traffic on roadways, but also decreased emissions.

Lessons about Govt & Economy

Government has the potential to enhance economic productivity and improve lives. some govt activity may shrink pie but nonetheless be socially desirable: policies that guarantee some pie for everybody will slow the growth of the pie itself (US has higher per capita income, but also a higher proportion of children living in poverty) some govt involvement is purely destructive

Effects of Regulation

Government regulation can cause tolls, licensing, vehicle emissions testing, citizenship testing,

Market Entry Barriers

How difficult it is to enter a market is a large factor in price and monopoly building. Barriers can include physical, natural, and legal (such as patents) Ex. ISP's have incredibly large entry barriers (setting up telephone towers), whereas technology does not (leapfrogging into the newest technology allows new firms to do better than old.

Libertarian Paternalism

Individuals do make systematic errors of judgement, but society should not force you to change your behavior; instead, we should merely point you in the right direction. A different way of getting you to do the right thing without outlawing it or taxing it. Much of it is a product of inertia (opt in vs. opt out) the govt sets you on a course and it is your job to change it. Govt gives the public a "nudge" in the right direction.

Govt Inefficiency, monopolies

Monopoly stifles any need to be innovative or responsive to customers. DMV has a monopoly on issuing drivers licenses. Because it would be very unorganized if it were private businesses. Thats also why the lady at the desk is so bitchy.

Game Theory & Prisoner's Dilemma

Prisoner's Dilemma is when both prisoners could be best off if neither talks, but if one does and the other doesn't, he serves life in prison. Therefore it is safest for both to confess and serve 25 yrs when they could have only served 5.

Government Makes Market Economies Possible

Private Property rights: Physical (police, military), Intellectual (copyright, patent) Uniform rules & regulations: Rule of law: a) equality before the law b)enforcement c) Well publicized law Rooting out fraud: impartial, efficient law enforcement judiciary (in india a man was released from prison for murder awaiting trial after waiting 37 yrs because the witnesses and investigating officers were all dead) circulating a sound currency Infrastructure: transportation, communications, utilities

Ronald Coase

Privately settling externalities (neighbor and the bongo player with a battle of value). But the relevant property rights must be clearly defined.

Public Goods & Free Riders

Public Goods Include: Parks, Defense, Basic Research (NASA, DARPA, NIH) Technology Transfer (govt transfers technology to the private sector) Public goods have two salient characteristics: first) the cost of offering the good to additional users is very low or even zero. Second) it is very hard, if not impossible to exclude persons who have not paid for the good from using it (you cannot stop a ship captain from seeing a lighthouse).

Tax Policies (progressive, regressive, etc)

Regressive Taxes - burden falls more heavily on the poor because the tax is a larger fraction of their income (a sales tax is a greater fraction of the poor persons income). Progressive Taxes - equal fraction of income rich vs. poor

Price discrimination

Selling the same thing to different people at different prices. Airline companies charge differently depending on when, where, supply, demand, and many other factors, which are different to each individual.

"Superstar" phenomenon (thinking at the margin)

Small differences in talent tend to become magnified into huge differentials in pay as a market becomes very large. The best will make the most money. The superstar is in a huge demand because there is only one, a very small supply. Ex.The most popular radio talk show host will make a large difference in profit from the second best despite a marginal difference in character.

Milton Friedman

Spokesperson for a less intrusive government. Wanted there to be a range of lawyers not only "cadillac" lawyers.

Daniel Kahneman

Studied behavioral economics and bounded rationality. "how human decisions may systematically depart from those predicted by standard economic theory"

Sherwin Rosen

Studied the superstar phenomenon (lebron james) and marginal thinking.

Taxes as Fiscal Drag

Taxes exert a cost on the economy. They take money out of our pockets, decreasing our utility. Taxes can cause individuals to change their behavior in ways that make the economy worse off without necessarily providing any revenue for the government. (ex. people quitting their jobs because taxes are too high.) Called deadweight loss (ex. guy steals photo album of no value to him and decreases your value by taking it)

Government Solutions to Externalities

Taxing bad behavior or banning it all together.

Redistribution

The Government redistributes wealth. Both to the poor in the form of welfare and food banks, but mostly to the middle class in the form of Medicare and Social Security

Externalities

The gap between the private cost and the social cost of some behavior. In this sense, the market fails and encourages firms to cut corners in ways that make society worse off as a result. (ex. pollution by cars. you don't pay for, but somebody does).

Self-interest

The market aligns incentives whereby individuals act in their own best interest. Individuals will act to make themselves as well off as possible.

Creative Destruction (schumpeter)

The process by which the market economy rewards handwork and progress not only because it rewards winners, but because it crushes losers. (ex. typewriters went out of business the moment computers were made)

Human Capital

The stock of competencies, knowledge, social and personality attributes, including creativity, embodied in the ability to perform labor so as to produce economic value. (ex. Brad Pitt acts because it is what will get him the most money and what will add most to the economy). Human worth

armey curve

The term describes the concept that in anarchy [when there exists no government, the economic output of a country is low, and in a country where all decisions are made by government, economic output of the country is low. Therefore, a mix of private and government decisions maximizes economic growth.

Effect of minimum wage

There is a trade-off: increasing minimum wage helps those workers whose wage is being raised but hurts those who are never hired in the first place or are fired due to cut backs.

Paul Volcker

Warned against the corruption involved in stock options. Where ceo's will do things in the short run to sell for a profit that is disastrous for the company in the long run.

Adverse selection

When a firm with a good incentive and a good motive turns out bad. ex. indian fertilizer companies were being subsidized by the government and thus never created anything, but the workers still got paid despite the company never actually running itself or making any profit. (east german car companies made cars that were worth less than the raw materials used to make them, thus taking perfectly good steel and ruining it.

Principle-agent problem

When a person in a company has incentives to make the customer worse off while bettering himself. CEO's do this all the time. (ex. most mergers do not add value to the merged firms and many decrease the value, but all of them make ceo's benefit from the merger) Stock options also only benefit the ceo's with no impact on the customer.

Positive Externalites

When an activity has a good impact on society. (one with both is cigaretts smoking. It kills the person who smokes earlier, but it also saves the government the social security cost.)

Centralized economy disutility/inefficiencies

When government controls some element of the economy, scarce resources are allocated by autocrats or bureaucrats or politicians rather than by the market. (ussr govt mandated that all the resources went to sputnik rather than feeding the poor)

Government outsourcing

When the government hires private firms to do its work rather than government employees (govt hires private contractors to build highways). In-q-it invests in private technology firms and the cia will make a deal with them to get their product.

Incentives in Economic Systems

When we are paid on commission, we work harder; if the price of gasoline goes up, we drive less. Incentives factor into every decision we make.

Thinking like an economist

recognizing the trade-offs inherent to fiddling with markets and regulations that are good.

Gary Becker

said that "economy is the art of making the most of life" he studied self-interest and maximizing utility