Micro Final

Coase Theorem assumptions

(1) No transaction costs; (2) perfect information; (3) no free riding; (4) well-established property rights.

market failures in healthcare, per Arrow

(1) Our preferences are not well-behaved, due to the fact that we do not allow people to be priced out of the market, and since more health care is not always better; (2) imperfect competition (barriers to entry); (3) asymmetric information (doctors know far more than patients); (4) people buy services without knowing their price.

five assumptions of the first fundamental welfare theorem

(1) Perfect competition; (2) well-behaved preferences; (3) perfect information; (4) no negative externalities; (5) no public goods.

two methods by which adverse selection can be reduced

(1) Signaling; and (2) screening / third-party verification.

situations in which monopolies can increase welfare

(1) There are large economies of scale (natural monopoly situation); (2) there is a negative externality in the market; and (3) there is a monopsony of the type that is able to lower prices.

assumptions necessary for competitive markets to yield socially efficient outcomes

(1) Well-behaved preferences (especially non-satiation); (2) perfect competition; (3) perfect information; (4) no externalities; (5) no public goods.

circumstances under which Coase Theorem fails

(1) practically impossible to assign property rights; (2) high transaction costs; (3) imperfect information; (4) free riding

Coase Theorem

If trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. Under these circumstances, there is no need for government intervention.

reservation price (in the context of price discrimination)

A buyer's reservation price is the absolute maximum price he would be willing to pay. Sellers would obviously like every buyer to pay his reservation price; their attempts to realize this are the origin of price discrimination.

asymmetric information

A condition that occurs if one of the assumptions of perfect competition is relaxed, and one party to an economic transaction has more information than the other -- i.e., where there is no perfect information. Information asymmetry can lead to adverse selection, and is related to moral hazard and the principal-agent problem.

externality

A cost or benefit that is not transmitted through prices, or which is not incurred by the parties who engaged in the transaction which caused the externality.

ways in which a firm can make demand for its products less elastic

A firm can: (1) eliminate rivals (e.g., through predatory pricing); (2) advertise; (3) make it hard to switch products.

"too big to fail"

A firm which is so large and interconnected with the rest of the economy that it cannot be allowed to fail by the government. This is related to moral hazard: if a firm really believes it's too big to fail, it will act as if it's insulated from downside risk.

non-rivalrous good

A good for which the marginal cost of producing one additional unit is zero.

non-excludable good

A good which people cannot (should not) be barred from consuming for free.

example of situation implicating both adverse selection and moral hazard

A man hides a preexisting condition from his health insurance company (adverse selection). After he buys insurance, he engages in riskier behavior, knowing that his insurance will cover the costs of health care if he is injured (moral hazard).

natural monopoly

A natural monopoly is a condition where it is most efficient for production to be concentrated in a single firm.

key difference between adverse selection and moral hazard

Adverse selection and moral hazard both stem from information asymmetry, but the former stems from pre-deal asymmetry and the latter from a different kind of asymmetry after the deal.

adverse selection and efficiency

Adverse selection leads to inefficient outcomes because it creates a situation in which fewer transactions are conducted than would be in a Pareto efficient market; in other words, adverse selection leads to deadweight loss.

Cournot-Nash equilibrium

An equilibrium in which each of the parties in a game is playing its best response.

causes of deadweight loss

DWL can be caused by a price floor (like the minimum wage) or ceiling, which force prices to deviate from the market price; by taxes or subsidies; by monopoly pricing; or by externalities.

"tragedy of the commons"

Depletion of shared resources by individuals, each of whom is acting rationally in according with his own self interest. This happens in markets where goods are rivalrous but non-exclusive.

second fundamental welfare theorem

If the government enacts a lump-sum wealth redistribution then lets the market take over, the market will achieve a Pareto efficient outcome on its own. It follows from this that inefficiency / deadweight loss is a result of government interference in *pricing*, and does not result from not simple, lump-sum wealth transfers.

The Market for Lemons

In a market where the quality of products cannot be ascertained by buyers, sellers of high quality products (plums) will choose not to place their products on the market, because they will only be able to command an average (weighted) price. This makes the pool of available products even worse, reducing prices further, and driving out those with medium-quality goods. In the end, there will only be a market for bad goods -- lemons. This can be corrected with third-party verification (CARFAX) or with warranties (signaling).

market power

Market (pricing) power is the ability of a firm to profitably raise the market price of a good or service above marginal cost. In a perfectly competitive market, all firms are "price takers," not "price makers," and lack market power.

examples of imperfect competition

Monopoly, monopsony, oligopoly, oligopsony, imperfect information.

Pareto efficiency

Pareto efficiency is a situation in which nobody can be made better off without someone else being made worse off -- i.e., in which there are no more transactions that would be beneficial (or neutral) to everyone in the market. A Pareto efficient market has no deadweight loss.

public goods

Public goods are those which are: (1) non-rivalrous (meaning that the marginal cost of creating each additional unit is zero); and (2) non-excludable (

principal-agent problem

Refers to the difficulties inherent in aligning the interests of an agent (employee, corporate manager, politician, lawyer, doctor, fiduciary, stock broker or fund manager) with those of his principal (employer, shareholders, voters, client, patient, beneficiary, investor). Principal-agent relationships often have information asymmetries, which can lead to moral hazard (e.g., an arrangement where a hedge fund manager gets compensated when the fund does well, but loses less when it goes down).

who does signaling help most?

Signaling is best for the person on the buy side, but can be costly for the person on the sell side.

situation in which signaling will not lead to equilibrium outcome

Signaling is not worth the cost where the price of signaling exceeds the DWL caused by the information asymmetry signaling is meant to correct, and will not lead to an equilibrium outcome under these circumstances.

examples of natural monopolies

The best-known examples are public utilities like water, electricity, railroads, gas, and pipelines. Duplication of their facilities would have such a high cost as to be inefficient -- i.e., detrimental to the economy as a whole.

deadweight loss

The loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal; it represents transactions that do not take place due to a mismatch between the amount supplied and demanded at a given price.

first-degree price discrimination

This is when you're able to find the buyer's reservation price (the highest price he's willing to pay); the best example is an auction.

Coase Theorem example

Train produces sparks, which burn $100 worth of crops along the side of the railroad track. If you assign the legal right to the farmer, the railroad will buy a spark guard for $50; if you assign the legal right to the railroad, the farmer will give the railroad $50 to pay for the spark guard.

examples of positive externalities

Various benefits to society at large that result from: research ("knowledge spillover"); education; fireproofing your house (reduces neighbors' risk of fire); a personal garden in front of a house

examples of signals

Warranties are a kind of signal, since a seller who is offering a "bad" product would be less likely to offer a warranty. Education and work experience are signals as well.

price discrimination

When one producer of a good or service charges different buyers different prices, enabling the producer to capture more consumer surplus than it could if it charged a single price. This can be seen in intellectual property, where firms use IP law and DRM to segment the market (US and China, for example, are separate markets) and prevent arbitrage.

the problem of non-excludable goods

Where a good is non-excludable (whether or not it's rivalrous, like a common good, or non-rivalrous, like a public good), the free market is not likely to lead to the most efficient outcome. This is due to the "tragedy of the commons" and the free-rider problem.

examples: exclusive, non-rivalrous

cable television, satellite radio

examples of public goods

defense, lighthouses, public fireworks, clean air, street lights (but not necessarily museums, libraries, law enforcement and schools -- from which people *can*, in theory, be excluded)

examples of negative externalities

pollution (air, water and noise); climate change; systemic risk (banking); antibiotic resistance resulting from past use (or misuse) of antibiotics; crime tied to the opening of a liquor store

second-degree price discrimination

This where a seller offers quantity discounts (Costco) or multiple classes of the same product (first and business class seating on airplanes).

examples of actual Pigovian taxes

"sin" taxes: cigarette taxes; alcohol taxes; carbon taxes

adverse selection examples outside of insurance

(1) A landlord offers contractors a submarket rate to maintain his properties, and attracts only the worst contractors; (2) an employer advertises a submarket wage, and attracts only lower-quality employees; (3) the used car market; (4) the dating market; (5) the lending market (closely related to the insurance market).

assumptions of perfect competition

(1) All firms are price takers; (2) all goods are homogenous; (3) perfect information; (4) no barriers to entry; (5) no externalities or public goods.

examples of moral hazard

(1) Behavior of an insured after purchasing insurance (e.g., of a person who has fire or auto theft insurance); (2) behavior of someone who has purchased a warranty (e.g., on a computer); (3) behavior of someone who has reason to believe they will be "bailed out" by the government (e.g., a debtor, a home buyer, or an employee who thinks he or she might get worker's comp or unemployment insurance) or a parent.

well-behaved preferences

(1) Completeness (always possible to pick a preferred bundle); (2) non-satiability; (3) preference for mixes (hence convexity); and (4) rationality (if you prefer A to B and B to C, you prefer A to C).

types of price discrimination

(1) First-degree; (2) second-degree; (3) third-degree; (4) two-part tariff.

examples: exclusive, rivalrous

consumer goods

examples: non-exclusive, rivalrous

fisheries, the town green

non-exclusive, non-rivalrous goods

public goods

adverse selection

A product of asymmetric information, adverse selection is when "bad" products or services are more likely to be selected than good ones. The asymmetry leads fewer goods or services to be exchanged than would be otherwise -- see, e.g., the used car market.

rent-seeking

An attempt to gain economic rent by manipulating the political environment rather than creating new wealth. May include attempts to capture certain monopoly privileges. Examples: political lobbying to gain a greater share of existing wealth; guilds or licensing.

Bertrand oligopoly

This is a form of oligopoly where firms compete on prices rather than quantity.

Cournot oligopoly

This is a form of oligopoly where firms compete on quantity rather than price.

two-part tariff

A price discrimination scheme whereby the price of a good is divided between a lump-sum charge and a per-unit charge. This enables firms to capture more consumer surplus than they would otherwise. For example, memberships at gyms, discount stores, cover charges at bars, credit cards with an annual fee.

reasons natural monopoly arises

A natural monopoly is one which exists because the cost of producing a product is lower if there is only one than if there are many, due to economies of scale. These arise where (1) capital costs predominate (due to high fixed costs and low marginal costs), (2) creating economies of scale that are large compared to the market, which (3) leads to high barriers to entry. In a field with very high fixed costs, a firm must have a certain number of customers to make any profit.

tournament-style reward, including its downsides

A reward given for work already done (e.g., a huge bump in pay once you make partner or make the major leagues); this can be used to alleviate the principal-agent problem inherent in employment. The problem is that while this will incentivize hard work where people are not yet working hard, it may lead to cheating where they are already working as hard as they can.

moral hazard

A situation in which the party who takes a risk is insulated from the downside (which will nonetheless affect others); moral hazard can result in more risk-taking than is socially desirable.

definition of market failure

A situation where the allocation of goods by the free market is not efficient -- i.e., there exists an outcome where a market actor may be made better-off without making anyone else worse-off.

Pigovian tax

A tax applied to a market that supplies negative externalities, which is intended to correct the market outcome. A Pigovian tax should be equal to the size of the negative externality; if it is, it should theoretically reduce consumption of the good back to the socially efficient level (i.e., prevent over consumption -- the danger when there are negative externalities). A Pigovian tax forces market actors to internalize costs.

Hotelling model

Also known as Hotelling's law, this states that it is often rational for producers to make their goods as similar as possible; think of the analogy to the food carts on the beach, which end up with an incentive to push as close to one another as they can (an analogy for products).

pro-business vs. pro-competition (pro-market)

Businesses may engage in rent seeking, trying to obtain monopoly privileges such as pricing power. They may also collude in order to obtain such privileges. Under a "pro-business" philosophy, this would be desirable. On a "pro-market" philosophy, however, it would not. Another way of saying this is that pro-business policies produce larger profits and deadweight loss, while pro-market policies increase consumer surplus and total welfare.

collusion and the Prisoner's Dilemma

Collusion is likely to unravel because although collusion may yield the best outcome for all firms taken together, any individual firm will always have an incentive to cheat. Price fixing does not maximize profits for any individual firm.

when collusion is sustainable

Collusion is most likely to be sustained in an infinitely-repeated game, because either party can threaten to play Cournot-Nash in the subsequent round; where interactions are finite, you generally can't collude at all, even in the first instance.

first fundamental welfare theorem

Competitive equilibrium will lead to a Pareto efficient allocation of resources. This is often described as a confirmation of Adam Smith's "invisible hand" hypothesis (namely, that competitive markets lead to an efficient allocation of resources).

why must signals be cheaper for the "good" than the "bad"?

In order to be effective, a signal must be perceived to correlate with whatever quality the buyer is looking to purchase; if signals are equally costly for the "good" and the "bad," they will cease to have any value as signals. Without this, there will be no separating equilibrium.

difference between signaling and third-party verification

In the employment process, signals include education and experience; recommendations are third-party verification.

examples of signaling

In the job market, signals might include (1) education; (2) work experience; (3) criminal record (negative signal). Ideally, public funding of higher education would be equal to the society-wide value of the signal provided -- and would not include the private value. In the IPO context, an owner can signal by retaining a large share of the company -- something which will not be appealing to owners of "bad" companies.

determining whether you have Pareto efficiency

Is there a trade that would make *both* people better off? If there is, then you are not at Pareto efficiency.

examples of situations that commonly lead to market failure

Market failures are common when you have: (1) information asymmetries; (2) principal-agent problems; (3) non-competitive markets; (4) externalities; or (5) public goods.

third-degree price discrimination

Market segmentation: here the seller is able to segment classes of buyers. Example: (1) student or senior discounts at the movie theater; and (2) airline tickets are cheaper weeks before the flight than the day of.

problems of monopolies

Monopolies set prices above marginal cost and have an incentive to produce less than a competitive market would supply. This is to say that they are inefficient, and create deadweight loss. They also waste resources through rent seeking, and may produce negative externalities by being "too big to fail."

why do monopolists make less stuff than firms in perfect competition?

Monopolists make less stuff because as price makers, they actually reduce the price of their product by increasing their supply. In other words, they make less on every additional unit produced than they did on the unit before.

purpose of advertising, in economic terms

The purpose of advertising is to make demand for a product less elastic.

necessary condition for a signal to lead to a separating equilibrium

The signal must be less costly for "good" than "bad" types.

adverse selection in the insurance market

The basic problem is this: insurance firms would most like to sell policies to the least risky individuals; but the most risky people have the most incentive to buy insurance. This can create a spiral: insurance firms will price insurance at a level where it is only attractive to the riskiest people (who value it more).

free-riding

This is a problem where some group of people are able to consume more of a good or service than they pay for. It can lead to the underproduction of public goods, and thus to Pareto inefficiency, or to the "tragedy of the commons."

relationship between information asymmetry and signaling

Where there is an information asymmetry in a market, a seller can spend time and/or money acquiring a "signal" that the buyer will have reason to believe correlates with higher value. This is a means of escaping the market failure that is often caused by information asymmetry.