Econ 54 FINAL
Jonathan and Mark want to move out of the dorms and rent a house for $800, or they could each live separately for $550. Mark says they should split the rent equally since it will be below both of their limits -Jonathan is willing to pay up to $450 and Mark is willing to pay up to $600. How much would Jonathan be willing to pay to continue living with Mark?
$550. At $550 he is indifferent to living with Jonathan or by himself. Notice that his reservation price didn't really matter.
Using at least two concepts from Ariely's Predictably Irrational, explain why healthcare costs will necessarily increase with a universal healthcare policy and why we can expect premiums to continue increasing in the future?
*The high price of free * because people are paying a monthly fee they will use more services than if they paid for each visit. The lure of free services causes people to use more than the optimal. *placebo* The high cost of services makes us feel like it is more effective and so people will go to the doctor for minor illnesses and injuries that could easily be treated at home for much less. The premiums will continue to rise because as more and more people use the services it will cause prices to rise the next year to cover the expected costs. As people see their premiums rising they will want to use more services than the previous year to get the most out of their insurance *(we value what we own)*. Because of the restrictions and fee limitations put on many insurance plans, there is a strong incentive for doctors and hospitals to be dishonest with their billing. *Since they are several steps removed from the actual money involved*, the amount of fraudulent billing is likely to be high. Doctors may not be completely making up services, but they may charge you for a level 3 visit, when it could have easily been charged as a level 1 visit with a significantly lower cost. Another step of removal is that the doctors and hospitals know that the insurance will reimburse them rather than the bill going directly to the patient.
Key concepts from Predictably Irrational
-Anchor price/arbitrary coherence: (compare everything else to the first thing we see/ what we're used to). - placebo effect -overvaluing items we own -dishonesty (other flashcard -something being free makes us want it, even though we'd be happier with something else. -relativity (think of those messed up faces)
What can you do if you want to sell your peach (good car)?
-Provide Carfax report -Offer to have it checked out by a mechanic -Provide maintenance reports and damage history
Downsides of minimum wage
-Unemployment goes up -Lowest skilled workers laid off first -Only 1/3 of min wage workers live in poor households -Increases inequality by changing education incentives for rich and poor groups -Only temporarily increases real wages - eventually prices rise and workers are no better off than before.
What are the benefits of auctioning off the right to pollute instead of taxing pollution?
-With an auction companies figure out their own costs and comparative advantage and will come to the most efficient outcome. -Pollution will be reduced at the lowest cost. -Some companies may be able to reduce pollution more cheaply than others, so taxing all companies at the same rate would be inefficient. Hence, efficient taxing requires that the government accurately identify each firm's cost and benefits of pollution. Taxes are still effective though, because it makes all costs to society explicit for firms
Spectrum of imperfectly competitive markets
1. (most imperfect) pure monopoly 2. monopolistic competition 3. oligopoly
Adverse Selection
A high-risk person benefits more from insurance, so is more likely to purchase it. Ex: Obama's health care: Requires that all people be able to buy insurance. However, because of adverse selection problems the plan also requires healthy people to buy insurance to keep average premium costs lower.
pure monopoly
A market structure in which one firm sells a unique product, into which entry is blocked, in which the single firm has considerable control over product price, and in which nonprice competition may or may not be found. EX: Magic the Gathering card makers
A village has six residents, each of whom has accumulated savings of $100. Each villager can use this money either to buy a government bond that pays 15% per year or buy a llama, send it onto the commons to graze and then sell it after one year. The price the villager gets for selling the llama depends on quality of fleece it grows. The quality of fleece depends on how many llamas are grazing. Number of Llamas Price per Llama 1 $122 2 $118 3 $116 4 $114 5 $112 6 $109 A. If each villager decides individually how to invest, how many llamas will be sent onto the commons and what will be the net village income? B. What is the socially optimal number of llamas for this village? C. The village committee votes to auction the right to graze the llamas to the highest bidder. How much will the grazing right sell for? What will be the net village income afterwards?
A. 3 llamas will graze, and the village profit is $93 I think. (the prices listed correspond to what ALL the llama owners make. We're seeing that when the second person gets a llama, he gains $14, but the first guy loses $4, so the marginal income for the second llama is $14). B. They will have a llama graze only if its marginal contribution to village income is at least $15. Look at total income and pick the option with the highest total: If they buy 1 Llama and 5 bonds the total village income is 97 - 2 llamas and 3 bonds = 96 - 3 llamas + 3 bonds = 93 C. At $7 they are indifferent between the Llama and the government bond, so that is the most that will be paid for the grazing right. This is our economic profit: the difference between the opportunity cost of buying the llama (the $15 you could have gotten from the bond) and the $22 profit you get from the llama. This demonstrates how a more efficient group solution allows people to profit more than if they acted individually.
Page 249 of textbook: Given the following payoff matrix, what should United and American do? Who, if anyone, has a dominant strategy, and what is that strategy? When does equilibrium occur? Both raise spending: American gets $8, United gets $3 American raises spending, United doesn't: American gets $4, United gets $8 United raises spending, American doesn't: American gets $5, United gets $4 Neither raise spending: American gets $2, United gets $5
American has the dominant strategy to raise spending. United has the dominant strategy to leave its spending as is. Both will play these strategies. Equilibrium occurs when they play these strategies.
Page 248 of textbook: Given the following payoff matrix, what should United and American do? Who, if anyone, has a dominant strategy, and what is that strategy? When does equilibrium occur? Both raise spending: American gets $4, United gets $3 American raises spending, United doesn't: American gets $5, United gets $4 United raises spending, American doesn't: American gets $3, United gets $8 Neither raise spending: American gets $2, United gets $5
American has the dominant strategy to raise spending; United has no dominant strategy. United, knowing that American has this dominant strategy, will then choose to leave its spending as is. Equilibrium occurs when American raises spending, and United doesn't.
Moral Hazard
Arises when people behave recklessly because they know they will be saved if things go wrong. Ex: Financial Crisis of 2007: Mortgage insurance removes the risk of default from the lender. This moral hazard meant that people were not making decisions on the full weight of their own risk leading to a housing bubble.
progressive tax
As income increases, proportion of the income tax paid increases Ex: US income tax
Do negative externalites cause a dead weight loss? What about positive externalities? Why?
Both positive and negative externalities cause a DWL. Negative externalities cause a DWL because society would benefit from producing less of the good that produced the externality. Specifically, we'd benefit more if manufacturers actually adhered to the new equilibrium. Positive externalities also cause a DWL because society would benefit from more of the good being produced. (i.e. manufacturers aren't producing enough).
Head tax
Collects the same amount from every tax payer
Why is there a deadweight loss in an imperfectly competitive market?
Companies produce at a quantity that is less than socially optimal (companies have an incentive to restrict quantity if they can, to lower input costs). This increases the producer's share of economic surplus, which lowers total economic surplus. If they produced at the quantity where marginal cost equaled demand, they'd be at the socially optimal level. There would also be no dead weight loss
Value of Market Product (VMP) Do problem 4 on the practice final
Dollar value of the marginal product of labor. *Calculated by multiplying a worker's marginal product by the NET price of each product unit.* This is equal to the worker's wage in the long run when in a competitive market.
If you are an employer, how much will you offer job candidates for a starting salary? - 20% peaches worth $80,000 and 80% lemons worth $40,000 What can you do if you want to prove you are a peach?
E(salary) = .20 x $80,000 + .8 x 40,000 = $48,000 -Go to college -Go to Harvey Mudd -Work experience / internships -Prove your worth after you get hired
You interviewed for two companies last month and expect job offers from both. Today you got a call from ABC company offering you an annual salary of $75,000 and need an answer by the end of the day. The other company, Cookie Inc. will have an offer to you next week. Based on your research, Cookie Inc. has a 30% chance of offering you $90,000 and a 70% chance of offering you $65,000. Should you take offer ABC or wait for the offer from Cookie Inc.?
EV(ABC Co.) = 1.00*75,000 = 75,000 EV(Cookie) = .3 x 90,000 +.7 x 65,000 = 72, 500 Take ABC.
A peach is worth $15,000 and a lemon is worth $8,000. If there are 25% peaches and 75% lemons, what is the most you should pay for a used car in this market?
EV(used) = .25 x $15,000 + .75 x $8,000 = $9,750.
proportional tax
Everyone pays the same proportion of their income
Takeaways from Ariely's chapter on cheating/dishonesty
Given the opportunity, many "honest" people will cheat, but only a little bit (ex: only 3 out of 50 problems were cheated on, on average). - this is because we feel these small acts of dishonesty are too insignificant to reflect our character. Even when we have no chance of getting caught, we tend not to increase dishonesty wildly. Contemplating a moral benchmark before given the opportunity to cheat (like being asked to cite the ten commandments, or reading the honor code before a test) reduce cheating completely. Cheating is easier if it's a step removed from money (people would more readily steal a pencil from work than the 10 cents it costs)
HMO/HMO revolution
Group of physicians that provides health services to individuals and families for a fixed annual fee. The HMO Revolution: pay a flat fee that covers routine and catastrophic medical services
Until when should you continue to hire more workers?
Hire more workers as long as VMP is *greater than or equal to their wage* KNOW THIS WELL. Look at lecture 12 ex. for practice.
human capital & human capital theory
Human capital: the skills and knowledge gained by a worker through education and experience Human capital theory: a worker's wage is proportional to his/her stock in human capital.
Coase Theorem
If at no cost people can negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by the externalities.
How to lessen the deadweight loss caused by externalities.
If it was a positive externality, give them a subsidy so they'll produce more. For negative externalities, tax them.
free rider problem
Incentive problem where too little of a good/service is produced because nonpayers can't be excluded from using it. Ex: going to department store to get info about item from sales clerk, only to then buy the item online.
intermediary (middleman)
Intermediary is a person or firm who is in-between the producer and consumer. These people add economic value because they allow goods and services to find their way to the consumers who value them most.
When externalities are included in the cost of production, the number of units produced will be more or less than when the cost is not included.
Less: externalities are costs that are not included in the market supply and demand and once included will reduce total units produced and purchased since higher costs shift the supply and/or demand curves
You start a tutoring business and want to know how many people you should tutor per week to maximize your profit. our production costs are $25 per session. If you charge your clients the same rate, and their reservation prices are as follows, how many should you tutor? (Note: you're a monopolist). Customer 1: $65 Customer 2: $55 Customer 3: $45 Customer 4: $35 Customer 5: $28 Customer 6: $20
Marginal revenue (first calculate total revenue by adding the reservation prices, then look at the margin): With 1: $65 With 2: $45 With 3: $25 With 4: $5 With 5: $0 With 6: -$20 Want 3 customers, because then marginal revenue equals marginal cost (25).
Will markets with positive externalities over or under-produce? What about negative externalities?
Markets with positive externalities under-produce. Negative externality markets over-produce.
minimum wage
Minimum wage is a price floor that restricts wages from falling below a certain level. Minimum wage will be above the equilibrium wage.
What are the downsides of taxes? When should we tax?
Negative: -Taxes will always reduce the consumption/provision of the item being taxed -Income taxes reduce work -Sales tax reduce purchases Tax to minimize deadweight loss (ex: caused by externalities) and maximize total economic surplus.
public goods What do these suffer from?
Nonrival, nonexcludable goods Suffer from the free-rider problem.
Difference between perfectly competitive firms and imperfectly competitive firms
Perfectly competitive firms face perfectly elastic demand curve for its product. Imperfectly competitive firms have a normal downward sloping DC.
Why are methods of distribution problematic?
Redistribution can exacerbate poverty and inequality -Erodes skills and removes incentives for education and training -When redistribution is offset by wages it disincentivizes work -Doesn't address underlying issues
How to efficiently split the costs incurred by externalities?
Split economic surplus (i.e. reservation price - actual price) evenly among those effected. DO NOT just equally divide the cost. Ex: Jonathan and Mark want to move out of the dorms and rent a house for $800 Mark says they should split the rent equally since it will be below both of their limits -Jonathan is willing to pay up to $450 and Mark is willing to pay up to $600 What they should do is have Jonathan pay $325 and Mark pay $475. That way, the economic surplus of each is $125.
How to calculate monopolist's DWL
Supah eazy. Just calculate area of triangle formed between the demand curve, the MC curve, and the vertical line passing through the quantity they're outputting. Notice how, at the socially optimal level (when DC intersects MC), DWL =0.
What are the supply and demand curves of externalities? Externalities lead to... Unaccounted externalities lead to...
Supply = Marginal Cost Curves Demand = Marginal Benefit Curves Externalities lead to inefficiencies Unaccounted externalities lead to over/under-production.
How are public goods funded?
Taxes
How do monopolists maximize their profits? What price do they sell at/ how to find this price? How to find their profit?
They produce the quantity where MC = MR. Go up to the DC (i.e. the AR curve) to find the appropriate price, P. Their profit will be *(P-ATC) x Q*. Note then that, if P = ATC, they'll earn nothing, and that they'll lose money if it's less than ATC!
How to calculate deadweight loss of externalities.
They'll give you the normal supply (private marginal cost) and demand (marginal benefit) curves, but they'll also include an additional supply curve that measures Private MC + XC (plus the externality cost, which effects demanders only). To calculate DWL, draw a line up from the original equilibrium point to the PMC+XC curve. The DWL is the area of the triangle formed between this line, the Private MC + XC and the D curve. We do this because manufacturers continue to adhere to the old equilibrium price, instead of paying attention to the new one, which creates a loss.
What are the costs of information? What reduces these costs?
Time: you spend time talking to people, going to stores, reading reviews Money: you may need to pay someone for access to the information Specialization reduces these costs. Ex: salesman who have specific knowledge to get you what you want quicker; Amazon.
Why do some advocate for methods of redistribution? What are some methods they propose?
To alleviate income inequality. They recommend in-kind or cash aid (like food, housing, education). Also propose Earned Income Tax Credit (tax cred for low income workers) and minimum wages.
What is the slope of marginal revenue in monopoly?
Twice the slope of the demand curve (so steeper).
Upsides and criticisms of universal healthcare.
Upside: designed to spread cost among all so that those who are the sickest don't have to suffer so much. Criticism: Universal healthcare will attract more sick people to the market, which will raise premiums. If healthy people are not required to remain on the plan, they will leave because they won't think it's worth it anymore. This will cause only the sickest to remain and pay their own bills, which defeats the purpose of universal health care.
Rational Search
Using costs and benefits to determine how much time you should spend searching for information
compensating wage differentials
Wage differences that compensate workers for risk, unpleasant working conditions, and other undesirable nonpecuniary aspects of a job. Ex: Garbage men and air traffic control people earn a lot.
commitment problem
When people cannot achieve their goals because of an inability to make credible threats or promises
At what point should you stop acquiring information? Does information face increasing or decreasing OC?
When the marginal benefit of doing so equals the marginal cost. Increasing OC.
Cartel Why are these unstable
a coalition of firms that agree to restrict output for the purpose of earning an economic profit. These are unstable because cartel members face the prisoner's dilemma: the dominant strategy for each member is to reduce price. If they each do this though, they come out with less profit than if they stuck to the agreed price.
price setter
a firm with at least some latitude to set its own price
Prisoner's Dilemma
a game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy
rival good
a good for which consumption by one person *does* diminish the quantity or quality of consumption by others Ex: if I eat your apple, then you can't have it
excludable good
a good for which it is easy to prevent consumption by those who do not pay -Ex: Costco membership
nonexcludable good
a good that is difficult, or costly, to exclude nonpayers from consuming. Ex: National defense
nonrival good
a good whose consumption by one person *does not* diminish its availability for others. Ex: public park
monopolistic competition
a market structure in which many companies sell products that are close, but not quite perfect substitutes Ex: convenience stores. Same stuff, but different product list/brands and different location
credible promise
a promise to take an action that is in the promiser's interest to keep
Nash Equilibrium
a situation in which economic actors each choose their best strategy *given the strategies that all the other actors have chosen* -Note: this is not necessarily the best strategy, and there can be multiple Nash equilibrium!
dominant strategy
a strategy that is best for a player in a game regardless of the strategies chosen by the other players
payoff matrix
a table that shows the payoffs that each firm earns from every combination of strategies by the firms
credible threat
a threat to take an action that is in the threatener's interest to carry out
commitment device
a way of changing incentives so as to make otherwise empty threats or promises credible
2. Consumers know that some fraction of all new cars produced and sold in the market are defective. The defective ones cannot be identified except by those who own them. Assume that cars do not depreciate in value with use. Suppose consumers are risk-neutral and value non-defective cars at $10,000 each and defective cars at $6,000 each. a) If consumers are willing to pay $8,000 for a new car, what percentage of new cars are defective? b) If you saw a used car for sale with a price tag of $6,500, would you purchase this car? c) How many used cars for sale in this market will be good cars?
a) 50% of each type. b) No, because it is higher than your reservation price for a defective car and an owner of a good car would not sell his car for that price. c) None, unless the owners of good cars have a way to prove they are offering a good car for sale
2. Consumers know that some fraction of all new cars produced and sold in the market are defective. The defective ones cannot be identified except by those who own them. Assume that cars do not depreciate in value with use. Suppose consumers are risk-neutral and value non-defective cars at $10,000 each and defective cars at $6,000 each. a) If consumers are willing to pay $8,000 for a new car, what percentage of new cars are defective? b) If you saw a used car for sale with a price tag of $6,500, would you purchase this car? c) How many used cars for sale in this market will be good cars?
a) 50% of each type. b) No, because it is higher than your reservation price for a defective car and an owner of a good car would not sell his car for that price. c) None, unless the owners of good cars have a way to prove they are offering a good car for sale
Wilson, Prentice, and Beth will all benefit from a water filter in the lake near their homes. Filters cost $1500 each and one is enough for all 3 houses. They each have different reservation prices based on their incomes and none would be willing to purchase the filter alone. Reservation prices: Wilson $600, Prentice $500 and Beth $300. a) Is it possible to negotiate a way to split the cost where they are will all end up happy? b) Will the government provide the filter if the residents must vote for the tax? If the government provides the filter, is this an efficient outcome?
a) No, because their total surplus is only $1400 b) -Depends on the type of tax used to fund the project: ●Headcount Count Tax - will pass (because must split $1500 up between 3, resulting in $500 each. This is less than or equal to 2/3 of the people's reservation prices, so it will pass. ●Proportional Income Tax - won't pass. Because their total surplus is less than $1500, 2/3 people would have to end up paying more (assuming that those with the lowest income don't need to pay).
The Mayor of Sweetums would like to put in a public park near the high school. The park will cost $1 million dollars to build and a new tax will be levied to pay for the park. This town has 25,000 residents and they do not all value the park the same. 10,000 citizens have a reservation price of $60 for the park, 10,000 citizens have a reservation price of $40 and 5,000 citizens have a reservation price of $5. a) If the Mayor wants to propose a head tax, what amount will each person be taxed, and will this new tax be passed by a majority vote? b) Will everyone be happy if this new tax is levied and the park is built? c) With a head tax, everyone pays the same amount, yet some people argue that head taxes are not fair. Explain an alternative tax plan that the Mayor could propose that would be passed. d) If this park had to be provided by the private sector, is it likely that the park would be built?
a) The head tax will cost each resident $40 and it will pass through a majority vote (both a simple and super majority). b) No, everyone will not be happy. The 5,000 residents who only value the park at $5 still have to pay $40. c) Assuming that each resident's reservation price was proportional to their income, the mayor could pass a proportional tax which would be slightly lower than each residents' reservation price (lower because the sum of the reservation prices is actually greater than the cost of the park). The problem with this, is that likely the value of the park to residents is not based on their income and more likely based on their use or proximity to the park. If their reservation prices are not proportional to their income it will be very difficult to come up with a tax plan that makes everyone happy. d) The total value of the park in this community is $1,025,000 and the cost is $1,000,000. This leaves $25,000 in economic profit available. If a private company is able to do perfect price discrimination and capture the entire market they will earn $25,000 in profit. As long as the opportunity cost is lower than $25,000 the park will likely be built.
How to solve that stupid Bink/Wabash problem.
a) Wabash has the greater marginal cost of having to reduce 3 units, so it would be more willing to buy. b) Starting from the 3 mandatory for each, go own for Bink and up for Wabash for each unit sold. Bink will sell 2 because it will continue selling until is marginal cost is greater than its marginal revenue ($33). If it sold 3, its marginal cost would be $44>$33. So, it only sells 2. This is okay for Wabash because at 1 reduced unit, its MC is exactly $33, the price Bink offered.
Externalities
activities that generate costs or benefits to people not directly involved in those activities. -Ex: honeybee keeper lives next to an orchard and a school. The bees pollinate the orchard trees, but sting the schoolchildren.
Regressive tax
as income increases, proportion of income tax decreases Ex: US sales tax
price discrimination How do firms use this to increase economic surplus? How does this effect profits?
charging different buyers different prices for the same items. If firms charged each buyer their own reservation price, they'd increase economic surplus. Profits can increase through price discrimination because companies can attract extra sales from customers with lower reservation prices without having to lose the higher revenue from customers with higher reservation prices.
collusion
companies agree to reduce production and increase price
super majority
earn more than 50% of the vote.
simple majority
earn more than anyone else
Oligolopy
industry structure where a small number of large firms produce products that are either close or perfect substitutes. Ex: the cement industry, cell phone providers
High cost of free
medical insurance for routine care causes over-use and *leads to increased premiums in future years*.
risk averse
preference of a certain payoff over an uncertain one with the same expected value/ would refuse any fair gamble (50/50).
asymmetric information Why does this cause inefficiencies?
situations in which buyers and sellers are not equally informed about the characteristics of goods and services for sale in the marketplace. Asymmetric information causes market inefficiencies because search costs can be high. Hence, once a decision has been made people make commitments to end the search (apartment lease, marriage vows, employment contract).
marginal revenue
the additional income from selling one more unit of a good
marginal product of labor
the additional output a firm produces as a result of hiring one more worker
Expected value
the expected payoff with outcome uncertainty. Multiply the probability of each event by its payoff and take the sum of all events.
Tragedy of the Commons
the tendency of a shared, limited resource to become depleted because people act from self-interest for short-term gain
statistical discrimination
using information about group averages to make conclusions about individuals
constant returns to scale
when all inputs are changed by a given proportion, output changes by the same proportion
positional externality
when an increase in one person's performance reduces the expected reward of another's in situations in which reward depends on relative performance Ex: Curved grading, steroid use, campaign spending Often leads to control agreements, to prevent an arm's raise
winner-take-all market
where small differences in human capital translate into large differences in pay. -does not necessarily mean only one winner, but only a select few who are only slightly better get the big payday (think pro tennis).
Risk-neutral
willingness to take a bet with an expected value of zero
