Econ Exam #3

Coase Theorem

As long as property rights are clearly stated and bargaining costs are minimal, private parties can arrive at efficient solution regardless of how property is assigned

The Winner's Curse

Auctions for product of certain value; winner posts the highest bid and item turns out to be not worth as much as you think it is.

3 most often heard critiques of market economy

1. Lack of adequate competition in some markets (monopolies etc. already been covered) 2. Distribution of income generated by market economies 3. Problem of external costs that arise form economic activity (aka externalities)

Maximin Strategy

A strategy chosen to maximize minimum gain that can be earned; choose most attractive "worst case" scenario Solution: "Nash Equilibrium"

Sources of Market Failure: Imperfect Information

Absence of full knowledge concerning product characteristics, available prices, etc.

Advantages and Disadvantages of Outsourcing

Advantages: -Economies of scale and specialization lead to lower costs and lower prices. Cheaper to buy than to make. Firm that specializes in making the inout has comparative advantage in production of that input; each firm does what its best at Disadvantages: - Loss of control over inputs; could erode customer confidence in product if they don't know where the inout came from

Oligopoly Models

All in common: behavior of any oligopolistic firm depends on behavior of other firms in industry

Local Provision of public goods: The Tiebout Hypothesis

An efficient mix of public goods produced when local land/housing prices and taxes come to reflect consumer preferences just as they do in the market for private goods Level of public goods provided is reflected by cost of living in area

Private, public, in between goods

1. Private goods: - Rival - Exclusive - Private Sector - Pizza 2. Public Goods - Nonrival - Nonexclusive - Provided by gov't - Air, national defense 3. Natural Monopoly - Nonrival - Exclusive - Cable TV With congestion, turn into private goods - Private sector or gov't 4. Open-access Good - Rival - Nonexclusive - Regulated by gov't - Ocean Fish

Oligopoly and economic preference

1. Profit-maximizing oligopolists likely to price above marginal cost. When price above marginal cost, underproduction from society's point of view- no allocative efficiency 2. Strategic behavior leads to outcomes that are not in society's best interest. Force themselves into deadlocks that increase costs and waste resources- no productive efficiency

Source of household income

1. Wages or salaries received in exchange for labor 2. form property- capital, land, etc. 3. government

Firm's scope of operation: insourcing

Insourcing- making inputs yourself Outsourcing- buying inputs from elsewhere -Vertical integration- "insourcing"- expansion into earlier/later stages of production; controls several stages of production process; lowers transaction costs and gives firm more power BUT: hard for manager to keep track of all stages; virtuality integrated firm might not achieve minimum efficient scale

Price discrimination

charging diff prices to diff buyers

Monopolistic Competition

Many firms; differentiated products; price is limited decision variable; easy entry; price and quality competition; restaurants, hand soaps

Perfect competition

Many firms; homogenous products; price is not decision variable; easy entry; no price competition; wheat farmer, textile firm

Why do firms exist?

Minimize transaction costs by making things on a large scale Minimize production costs- not easy Having a firm make stuff if more efficient than doing it by yourself

Antitrust Policy: History: Clayton Act

Passed 1914 to strengthen the Sherman Act and clarify the rule of reason, the act outlawed specific monopolistic behaviors such as tying contracts, price discrimination, and unlimited mergers. FTC also founded at this time.

Solution 3

Private bargaining and negotiation- assign rights and let parties figure things out themselves; "free market" approach

Product differentiation

Strategy firms use to achieve market power; must have distinctive positive identities in mind of consumers; often achieved through advertising

Collusion Model Oligopoly

The act of working w/ other producers in an effort to limit competition and increase joint benefits *Cartel- Group of firms gets together and makes joint price and output decisions to max joint profits (Will produce up to MR=MC for ENTIRE MARKET- market price= monopoly price) Basically act as a big monopolist *Tacit Collusion- Collusion occurs when price- and quantity-fixing agreements among producers are explicit. Tacit collusion occurs when such agreements are implicit

William Shepard's 4 types of industry

1. Pure monopoly: 1 firm controls market, block entry 2. Dominant firm: 1 firm, more than half market share, no close rival 3. Tight Oligopoly: Top 4 firms= more 60%, evidence of cooperation 4. Effective Competition: low concentration, low barriers to entry, little or no collusion

Solutions to Common Pool Problem

1. Restrict output- # fish caught leads to mad rush in beginning of season 2. Tax product i.e. fish 3. Rules and regulations improve "allocative efficiency"- minimum fish size requirements and net size

The ultimatum game

2 players; nash equilibrium can only be determined by playing the game over and over

Problem with Rent Seeking

3 big ones: 1. Firms make more through lobbying than through improving efficiency or quality of their product- no incentive for economic efficiency 2. Lobbying shifts resources away from production- lobbying uses real resources aka time and money that could be used for more product 3. Lobbying can convince politicians to spend $ in ways that put a substantial cost on society but produce no real benefit

Kinked Demand Curve Model

A model of oligopoly in which demand curve facing each individual firm has a "kink" in it. Results from assumption that competitor firms will follow if a single firm cuts price but will not follow if single firm raises price

Antitrust Laws: Antitrust Division (of Department of Justice)

Also empowered to act against violators of antitrust laws. Initiates action against those who violate antitrust laws and decides which cases to prosecute and against whom to bring criminal charges (FTC can't do charges)

Gini Coefficient

Commonly used measure of inequality of income derived form lorenz curve and 45 degree line divided by max possible area; when income perfectly equally distributed, gini= 0 Maximium coefficient is 1

Repeated games: Tit-for-tat strategy

Company's strategy that lets competitor know the company will follow the competitor's lead- follower mimics leader, optimal strategy for getting other player to cooperate

Market Solutions to Imperfect Info

Consumers RESEARCH products in stores and on internet "search"- we try to increase amount of info we know about quality of product

Externality

Cost or benefit resulting form some activity or transaction that is imposed or bestowed on parties outside activity or transaction. Sometimes called "spillovers", "third party effects", or "neighborhood effects" ex. pollution

Antitrust: Sanctions and remedies

Courts empowered to impose a number of remedies if they find that antitrust law has been violated. Can... - forbid continuation of illegal acts - force defendants of dispose of fruits and of their wrong - restore competitive conditions

Antitrust: History: Rule of Reason

Criterion introduced by the Supreme Court in 1911 to determine whether a particular action was illegal "unreasonable" or legal "reasonable" within terms of Sherman Act; mere size was not an offense and behavior key; standard oil case

Oligopoly

Few firms; either differentiated or homogenous; price IS decision variable; significant barriers to entry; strategic behavior; automobiles, aluminum; **Behavior of an 1 firm depends greatly on behavior of others- "interdependent"

Bertrand Competition

Firms choose prices. 2 firms keep underbidding e/o in attempt to steal market share. Results in P=MC=AC (PC price) as firms push price lower and lower.

Fixed Production vs. Variable Technology

Fixed production- relationship between output and generation of an externality is fixed. Only way to reduce externality is to reduce production Variable- the amount of externality produced at a given rate of output can be reduced by changing production techniques

Price-Leadership Model

Form of oligopoly in which one dominant firm sets prices and all smaller firms follow its policy Assumes dominant firm maximizes profit subject to constraint of market demand and assumes dominant lets smaller sell as much as wanted Uses "residual demand" curve- demand leader faces after all follower firms sell whatever they want to at price chosen by leader

Antitrust: Consent Decrees

Formal agreements on remedies among all parties to an antitrust case that must be approved by the courts. Can be signed before, during, after a trial. Ex- paying a fine and stopping, selling of productive capacity

The Common Pool Problem

Idea of externalities can also be seen in use of "open access" goods (like ocean fish- rival but nonexclusive); cost to society higher than the personal cost fisherman sees

Utilitarian Justice

Idea that ' a dollar in the hand of a richie is worth less than a dollar in the hand or a poor". Marginal utility of income declines with income, transferring income from fish to poor will increase total utility

What do FTC and DOJ do?

Make sure firms aren't... -price fixing- competitors get together and decide to raise prices (like cartels) -tying contracts- making a customer buy something from someone else in order to be allowed to buy from you -Interlocking directorates- someone serves on board of 2 competing forms

Examples of Oligopoly

Man-made fiber; primary copper; laundry equipment; cigarettes; malt bevs.; Lamp bulbs

The Search model

Marginal Cost of Search- TIME- biggest cost in any search, also spend money on gas driving - marginal cost of finding info increases- easy to find a little it of info but gets much harder to find more detailed info. MC slopes ^^ Marginal benefit of search- Better quality for a given price- find best product; Lower price for a given quality- find the best deal Marginal benefit of more info decreases; little helps a lot, but more details help less Optimal search- MB=MC

Perfectly Contestable Market

Market in which entry and exit are costless. Prices pushed to long-run average cost by competition, and positive profits don't persist

Monopoly

One firm; single, unique product; price IS decision variable; not easy entry; constrained by market demand; public utility; patented drug

Tacitly Collude

Repeated games- When repeated, firms may realize it's better if neither advertise, so tacitly collude to do what is best for both

Nash equilibrium

Result of all players playing their best strategy given what their competitors are doing. In other words, neither player would want to change their strategy given what the other player has chosen.

Solution 5

Selling or auctioning pollution rights gov't can decide how much total pollution is acceptable then auction/allocate "tradable" "pollution permits" that give rights to pollute a certain amount

Asymmetric Info in Labor Market

Signaling- an attempt by informed side to communicate valuable information that is otherwise hidden Ex. Advanced degrees, good grades, etc. proxies for unobserved skill level of potential employee Screening- employer looking for the signals

Hidden Actions/"Principal-agent" Problem

Sometimes goals of the agent (person deciding what to do or how to behave) are incompatible with those of the principal (person affected by agent's actions) When agent's actions can't be observed by principal, agent is likely to pursue goals rather than principal

Rent Seeking

Special interest groups spend millions of dollars lobbying gov't officials for support on issues that benefit the group. Benefits that result from such policy is called "rent", so this lobbying= Rent Seeking

Dominant Strategy

Strategy that is best no matter what the opposition does. Both players have a dominant strategy, likely both will advertise. Advertising game example of "prisoners' dilemma" games

Regulation of natural monopolies

Unregulated, natural monopoly will choose to produce where MR=MC, =quantity lower than socially optimal quantity and will charge a price higher than socially optimal price When P=MC, gov't must give it a subsidy, bc monopolist would be losing money P=MC<ATC (economies of scale) Another option: P=AC; monopolist earns 0 (normal) profit and gov't doesn't have to subsidize firm for it to stay in business

"Capture Theory" of Regulation

serves as public interest by reallocating resources in a way that increases total surplus. Some believe regulation often serves interest of firms rather than social efficiency; result of strong lobbying groups associated with some industries

Sources: income from government

transfer payments- payments by gov't to people who don't supply goods pr services in exchange

Antitrust: History

trust- arrangement in which shareholders of independent firms agree to give up their stock in exchange for trust certificates that entitle them to a share of the trust's common profits. Group of trustees then operates trust as monopoly, controlling output and setting price

Adverse selection

Asymmetric info- when seller knows more info about product than buyer leads to- Adverse selection- Can occur when buyer or seller enters into exchange with another party who has more info. The agent who knows more uses this knowledge to "self-select" in a way that harms those who don't have the info

Firm's scope of operation: outsourcing

BC of flaws above^ might make more sense to outsource rather than insource. Quality of input product is easily verifiable; there are many producers of input product

Imperfect Info: Gov't Solutions

-"Lemon Laws"- help protect customer in case of asymmetric info - Gov't collects and disperses info that is not easily available to public - When info is costly, may be cheaper for gov't to produce it at once for everyone (i.e. drug side effects)

Cons of Cartel

1. Diff costs & products makes it hard to figure out output and distribute profits evenly- makes some firms mad and drop out 2. For successful cartel, entry must be blocked- not always possible 3. Inherently unstable bc of cheaters and free riders. More firms= more unstable

Monopolistic Competition in the long run

0 in long run; Demand curve must be tangent to average total cost curve

3 features that distinguish monopolistic competition from monopoly and oligopoly and 1 feature distinguish from perfect competition

1. Firms can't influence market price by size 2. Good *but not perfect* substitutes 3. Unrestricted entry and exit (0 profits in long run) ex. pizza places in NYC 1. Firms differentiate their products- product not all same

Problems with provision of public goods

1. If good produced, parks and public spaces are nicer, and everyone benefits. "Free Rider Problem" 2. Payment small relative amount that must be collected to provide service. Amount of work done will not be affected a lot by amount I contribute "drop in the bucket" problem * Public goods will be under provided without gov't intervention *Optimal Production of a Public Good is where societies demand curve crosses Marginal Cost Curve *Problems of Optimal Provision- to produce optimal amount of each public good, gov't must know something it can't know= everyone's preferences and willingness to pay

Explaining inequality

1. Life-cycle effects- "picture" of income distribution is a snapshot at a particular time. People beginning and ending careers are in lower quintiles 2. Living arrangements and work patterns- how many wage earners; part time vs. full time 3. Idiosyncratic factors- luck- huge bonus, good stock market. etc. 4. Human capital investment-

Types of product differentiation

1. Physical differences: appearance, quality 2. Location: spatial differentiation 3. Services 4. Product image: promotion, advertising, marketing, packaging - Differences actually exist is irrelevant, what is important is that consumers think differences exist.

Antitrust Policy: History: Wheeler-Lea Act

1938- Extended the language of the FTC Act to include "deceptive" and "unfair" methods of competition Alcoa Case, 1945- Even though Alcoa wasn't doing anything "unreasonable" a judge still decided to break up its monopoly simply bc monopolies are bad -Per Se Rule- courts declare a particular action or outcome to be a per se (intrinsic) violation of antitrust law, whether the rationale are reasonable or not (now mere size IS offense)

Prisoners' dilemma

A game where players are prevented from cooperating and in which each has dominant strategy that leaves them both worse off than them cooperating

The Cournot Model

A model of a 2-firm industry (duopoly) in which a series of output adjustment decisions leads to a final level of output between the output that would prevail if market were organized competitively and output that would be set by a monopoly 3 assumptions: 1. Only 2 firms 2. Each firm takes output of the other firm as given 3. Both firms maximize profit Results in price higher than PC price and lower than monopoly price

Perfect price discrimination

occurs when firm charges maximum amount that buyers are willing to pay for each unit "first degree"

Neuroeconomics

Experimental. Watching brain activity while making choices. Useful for studying rusk, altruism, future outcomes, other things

Externality Solution 1

Direct Regulation of Externalities "command and control" taxes, subsidies, legal rules, public auctions put legal limits on amount or type of externality produced

Public (aka Social) Goods

Goods that are nontrivial in consumption and/or their benefits are non excludable (or nonexclusive) In unregulated market economy w/ no gov't to see that they are produced, public goods would at best be produced in insufficient quantity and at worst not produced at all

Bureaus

Government departments, agencies, "owned" by taxpayers, funded by gov't appropriation, that implement govt programs Have less incentive to eliminate waste and inefficiency since they cannot be sold or put out of business If others dissatisfied, they can try to vote for representatives who want to change organizations or cut funding. Long, roundabout process

Sources: Income from wages and salaries

Human capital- stock of knowledge, skills, talents Compensating differentuials- differences in wages result from differences in working conditions

Game Theory

In all conflict situations, there are decision makers (players), rules of the game (strategies), and payoffs (prizes). Players choose strategies w/out knowing opposition strategy Solution= nash equilibrium

Externalities: Solutions

Internalizing or eliminating externalities. 5 approaches: 1. Direct gov't regulation 2. Gov't imposed taxes and subsidies 3. private bargaining and negotiation 4. legal rules and procedures 5. sale/auctioning of rights to impose externalities

Antitrust: History: Landmark Antitrust Legislation

Interstate Commerce Commission- federal regulatory group created by congress in 1887 to oversee and correct abuses in railroad industry Sherman Act- Congress 1890, act declared every contract or conspiracy to restrain trade among states or nations illegal and declared any attempt at monopoly, successful or not, a misdemeanor. Interpretation of which specific behaviors were legal fell to the courts

Solution 4

Legal Rules and Procedures- laws and liability rules can proved firms with an incentive to stop polluting injunction- court order forbidding the continuation of behavior that leads to damages liability rules- laws that recquire A to compensate B for damages imposed

Distribution of benefits and costs

Legislation= 4 groups based on distribution of costs and benefits: 1. Widespread benefits; widespread costs - traditional "public goods legislation"; positive impact on economy; total benefits>total costs 2. Concentrated benefits; widespread costs -"Special interest legislation" - Harms economy; total costs>Total benefits; pork barrel spending 3. Widespread benefits; concentrated costs - "Populist Legislation"; those who pay cost fight this legislation; those who benefit usually see such little potential benefit that they remain rationally ignorant 4. Concentrated benefits; concentrated costs - "Competing-interest legislation"; Fierce political battles (labor unions vs. employers)

Marginal Private Cost (MPC) and Marginal Damage Cost (MDC)

MPC- cost of consumption or production paid by consumer firm MDC- additional harm done by increasing level of externality-producing

Characteristics Of Public Goods

Nonrival in consumption- One's enjoyment of the benefits of a public good does NOT interfere with another's consumption of it Nonexclusive (nonexcludable)- Once a good is produced, no one can be excluded from enjoying it's benefits Ex. Public art

Market Failure

Occurs when resources are misallocated, or allocated inefficiently. Results in waste or loss value Sources: 1. Imperfect market structure, noncompetitive behavior 2. Imperfect information 3. presence of external costs and benefits 4. existence of public goods

Market Failure (con't)

Occurs when resources misallocated or allocated inefficiently. Waste or lost value, review 4 sources on other card

Poverty Line

Officially established income level that distinguishes poor from nonpoor.

Public Choice in Representative Democracy

Public choices- Gov't decides 2 major things: level of various public goods to provide; amount of taxes collected and how to collect them "Median Voter model"- preference of median voter will dominate other choices

Sources: income from property

Property income- income form ownership of real property and financial holdings. Form of profits, interest, dividends, rents

Behavioral Economics

Psychology + Econ- People make mistakes, may not maximize utility "Bounded Rationality"- Our brains get full; overwhelmed by choices, prone to inertia "Bounded Willpower"- even if we know what's best for us, we are too lazy to do it

Externality Solution 2

Taxes: gov't can force firms to internalize externality by taxing product that is causing externality Tax should be set to Marginal Damage Cost OR tac better- pollution rather than product (process)

Adverse selection in labor markets: "Efficiency Wage"

Theory- high wages attract better employees and encourage all to work hard

Monopolistic Competition in the short run

To maximize profit, will increase production until MR=MC

Regulation of Mergers

To stop firms from getting too much power... Herfindahl-Hirschman Index- Mathematical calculation that uses market share figures to determine whether or not a proposed merger will be a challenged by gov't. <1500, industry considered "unconcentrated" 1500<x<2500, industry "moderately concentrated" >2500, "highly concentrated"

Marginal Social Cost

Total cost to society of producing an additional unit of a good or service. MSC= sum of the marginal costs of producing the product MPC and correctly measured damage costs involved in process of MDC MSC=MPC+MDC

Horizontal Merger Guidelines

When "highly concentrated" DOJ or FTC will likely challenge any merger that pushes the index up more than 200 points

Economies of Scope

When it is more efficient for firms to produce different products; It is cheaper to produce different items in one firm; average cost per unit falls as the firm supplies more types of products as scope increases

Moral Hazard

When one party to a contract alters their behavior in a costly manner because the cost of that behavior has been passed on to the other party to the contract

Positive Externalities

When positive externalities, market equilibrium is less than the social optimal quantity, thus deadweight loss created- market not socially efficient; gov't subsidizes consumption of such products to socially optimal level; public education, flu shots, etc.

Economic Efficiency & Resource Allocation

Why it's not efficient: 1. No allocative efficiency- once a firm gets market power by differentiation, profit-maximizing strategy is to hold down production and charge a price above marginal cost 2. No productive efficiency- Final equilibrium is to left of low point on average total cost curve

Lorenz Curve

Widely used graph of the distribution of income, with cumulative % of families plotted along the horizontal axis and cumulative % of income plotted along vertical axis

Coordination game

a game where each party is better off doing the same thing as the other player; 2 possible nash equilibria

"Fixing" externalities

either "internalize" externality or ELIMINATE externality If we force firms to pay full cost of production, they'll either produce less or find ways to eliminate externality

Antitrust Laws: Federal Trade Commission

federal regulatory group created by congress 1914 to investigate structure and behavior of firms engaging in interstate commerce, to determine what constitutes unlawful "unfair" behavior, and to issue cease-and-desist orders to those found in violation of antitrust law.