Introduction to Economics (Anno 2022/2023), Appunti di Economia

Scarica Introduction to Economics (Anno 2022/2023) e più Appunti in PDF di Economia solo su Docsity! 1. Consumer Choice 1 1. Consumer Choice law as means of allocation of resources this is an important and relevant topic because of the modern energy issue topic (energy is necessary) so how can we make sure there is enough for everyone (there is small resource compared to the demand) this is an issue of allocating limited resources, the government is proposing taking a series of steps such as rationing, subsidies, taxation, which are all actions that come through legislation resource allocation the assignment of available resources to various uses, in the context of an entire economy, resources can be allocated by various means, such as markets, or planning allocation of resources comes through government action which determines and regulates it (the government therefore influences our choices and our business everyday), for example these days if the government would have not intervened, the price would have been way higher as price would have been driven by behaviour which would have caused a reduction of consumption (use would then be limited, and you would have to choose what you deem important) practical example: Italy has miles of beaches which are a resource because of tourism, beaches can be free or secluded (the first you take how it is, the latter may come with benefits but you have to pay) but how to decide which parts of the beach are secluded and which are free? the beaches are the state’s which can give a right to someone to limit and restrict access, there are European rules and national procedures to follow to grant allocation if the beach is free the issue would be people’s satisfaction one subject has specific rights such as right to exclusion, how log does it last, under which conditions how are they given (private law stuff), it is the right of exclusion practical example: the Covid19 brought an interesting question about vaccines, first of all the knowledge that allows the pharmaceutical industries to create vaccines and cures has an interesting: it can be used infinite times without no additional cost dedicated to its creation and therefore this can be taken advantage of to produce you however need resources, but how do we know that enough law as means of allocation of resources indifference curves the Edgeworth box diagram the budget line consumer choice: the optimum use of a limited income the compensation principle application of the compensation principle 1. Consumer Choice 2 resources are given to produce a specific application knowledge? through patents I can be the only legitimate user of the knowledge for a set number of years, but there was talk about suspending the patent for vaccines, the legal framework is therefore particularly important for the allocation of resources there are even deeper implications here: how do we make sure there are enough resources? we have to decide the use of the resource, everyone may choose something different, so is there any allocation that is preferable to another? is there some criteria? a rank? mitigating circumstances? indifference curves let us make 3 assumptions about consumer preferences: - each consumer knows their preferences and is able to articulate them so that we can portray them in the form of a chart - preferences are consistent: if a consumer tells us that some bundle of goods A is superior to bundle B an bundle B is superior to bundle C it follows that A is preferred to C - more is better: consumers prefer a bundle of goods that has more of both goods indifference curve a curve which tells us the various combination of goods that can make a particular consumer indifferent from the principle more is better we can deduct that any bundle that has both more of good x and more of good y (bundle A) is inherently better than the bundle of reference (R) and any bundle that has less of both goods (bundle B) is inherently worse, as we see in figure 1-2 all of this means that the indifference curve will go through areas I and III and therefore will be downsloping from left to right indifference curves are convex from the origin: this is because of the concept of diminishing marginal utility so consumers will attach a higher value to the first units of consumption of a good, and less to marginal units of that same good once they have an abundance of them there are an infinite number of indifference curves: while the indifference curve passing through R might be person X’s, person Y might prefer and afford basket A and choose that, so there are an infinite number of indifference curves some things to remember about indifference curves are: indifference curves do not cross: each indifference curve is uniformly higher than the one below, otherwise they would violate the rule of consistency, after all, a basket with more of both goods can’t possibly have the same utility of a basket which has less different consumers have different indifference curves: each person’s indifference curves are drawn specific to their tastes and can be described through ordinal functions 1. Consumer Choice 5 preferred basket D as he anticipates the gift Frank orders 125 mums and plants them, but after this happens uncle Dick calls and renounces his offer, at which point Frank has only $25 to buy tulips (point B), so now Frank has the possibility to sue his uncle Dick as he lost utility because of the influence of his uncle’s promise on the allocation of resources we can determine how much Dick owes Frank by dragging the income line until it is tangent to U1 (point C) which has a budget of $112, which means that Dick owes his nephew $38 anytime that a consumer is pushed away from his optimal allocation of income, harm is imposed, in principle money damages from this harm are calculable there is also another additional solution: let’s say that Uncle dick understands his mistake when there still enough time to plant tulips, at that point it is better for him to get Frank back on U2 by buying him 20 tulips and getting him to point E, this works because it attaches some value to the extra 50 mums he induced Frank into buying, if Frank refuses and comes to his senses only later than he loses the difference of $18 a third possibility is that we do not know his mapping and we have no way of knowing, Frank just claims a determinate amount of money we can make one of two assumptions: 1. Frank desires a garden with an equal number of both flowers and so he gives a zero value to mums with no matching tulips, so it is quite obvious that Dick’s behaviour cost Frank $100 as it reduced his income from $150 to $50, Dick can compensate Frank with 50 tulips moving him to point E, if he waits until after the fall season hw owes him 100 tulips, this gives us an upper bound cost zero substitution/value: two goods have zero substitution when, in a compensated sense, the consumer always chooses the same bundle of these two goods regardless of price 2. Frank enjoys the same utility no matter what combination of tulips or mums he buys, in which case his indifference curves are 45- degree downward sloping lines from left to right, at which point Frank has suffered zero utility loss from his uncle’s untrustworthiness, at that point Dick can offer $25 before fall or $50 after, this is a lower bound cost let’s suppose that Dick makes the same promise the next year, but Frank no longer trusts him and only buys 75 mums (leaving him the budget to but 75 tulips), at that point uncle Dick makes good on his promise (surprisingly!) and brings 100 tulips, at which point Frank is at point C (putting him at U2) and has 75 mums and 175 tulips, Frank could have obtained U2 with only $230 which means that of Uncle Dick’s gift only $79,2 had actual worth reputation value: there is a cost to reneging on a contract because it builds a reputation for unreliability, the benefits of dealing with someone 1. Consumer Choice 6 untrustworthy are lower than those of dealing with someone with untrustworthiness so the asset value of a positive reputation is positive dominic’s report card Dominic is a student who only does well at school with monetary incentive, his grade point average stays at 3.00 if he’s not paid, goes up to 3.50 if he’s paid $300 and goes up to 4.00 if he’s paid $400 he decides to allocate money in the following way: 6 computer games at $50 each and 100 units of everything else at $1 each, but when his mother finds out, she decides that only 3 computer games should be bought and that the units of everything else should be 250, but this to Dominic feels like it is only a deal that is worth $300 to bring back his son on his original utility curve, the father would need to give him $950, this makes Dominic go back to his original position but makes his father $550 worse off, but there is another (more extreme) solution: the corner solution corner solution: when the highest level of utility is found by setting consumption of one of the goods to zero, these solutions tend to occur when the consumer views a competing good as a poor substitute for a favoured good 2. Demand curve and consumer surplus 1 2. Demand curve and consumer surplus demand curves let’s say that this is Ken’s utility function a demand curve depicts the relationship between price and quantity consumed, keeping the utility and the other prices constant at this low demand er price the optimal consumption is dictated by point C, and if i continue plotting points, i get a continuous line describing the compensated demand for every price along the vertical axis it’s useful to have a compensated demand curve, as it can be used to describe the notion of consumer surplus while the original price is $2 we could reduce it to $1 finding the optimal allocation, doing so i find the compensated change in consumption by dragging the new budget line to the left in a parallel way until it is tangent to the original indifference curve compensated demand curve: the relationship between price and the optimal quantity consumed for some good, holding constant the consumer’s income uncompensated demand curve: the price-quantity relationship not subtracting the income effect, utility levels increase alongside it consumer surplus a demand curve has two views: alongside the horizontal axis, a demand curve is the quantity that a consumer is willing and able to purchase at any given price, holding constant income (really utility) and other prices alongside the vertical axis, a demand curve represents the maximum price that a consumer is willing to pay for each additional unit of consumption (also called inverse demand curve) let’s take Ken’s curve, he is willing to pay more than $2 a unit, except for the marginal unit, where the value he attaches is close to the market price if i use tiny price increases and assume you can consume the units in such small units, it turns out that the surplus is exactly $50 the consumer surplus is the difference between the price that a consumer is willing to pay and the price he has to pay demand curves consumer surplus market demand curve demand elasticity application: imposition of a tax U = √C +√H 2. Demand curve and consumer surplus 4 therefore saying whether or not a demand curve is elastic refers to the idea that over the relevant range of prices, revenues will either decrease or increase with an increase in price demand elasticity and total revenues: if demand is elastic, then price reductions increase revenue, if inelastic, then price reductions decrease revenues there is obviously a distinction is made between long and short-term: in the short term, demand may be quite inelastic in the longer run, however, owing to the high price there might be a stronger reaction to the tax than int he short run application: imposition of a tax so prior to the tax Ken’s optimal allocation is A, but when the government attaches a consumption tax of $1 on good X, Ken’s reaction (based on his utility) is basket B, the money (which is $17) goes to Jane, but the loss of utility of Ken is $25, so he has a negative income effect while she has a positive one, which is why it is not practical if, on the other hand, the government chooses to put a tax on income, Ken’s utility would only suffer the $17 that would go to Jane, as he would be freer to choose how to spend his income income taxes (so based on the shift of income) are generally better than consumption taxes (based on the shift of the price) as they do not generate deadweight loss (so do not imply a loss of net utility to society) and allow for the consumer a freer choice the difference in utility between points B and C represents the deadweight loss from a consumption tax alone a dollar is a dollar, no matter who holds it: when some interference in the market occurs, causing income to pass from person A to person B, we assume that the dollar is worth just as much to B as to A, this keeps us from making judgements about a redistribution of income across individuals transfer it occurs when a dollar loss to one person is exactly offset by a dollar gain by some other person, using the assumption that a dollar is a dollar no matter who holds it, no net losses are inferred from this move deadweight loss: a loss to one person not offset by a gain by others, when one person gains their utility from some market interference such as a tax and no one gains any utility ì, then a deadweight loss is said to arise another way to describe this inefficiency is through the notion of Kaldor- Hicks efficiency, according to which the imposition of the consumption tax results in a clear loss in efficiency, because in principle the two could strike a deal that would them be better off and Ken would be willing to pay Jane some amount of money (ideally the $17 and some portion of the deadweight loss, which amounts to $8) 2. Demand curve and consumer surplus 5 as long as as it is possible to think that Ken can make it worthwhile to Jane not to pursue the tax policy, then the imposition of the consumption is Kaldorf-Hicks inefficient, this can be restated in four different principles: 1. any move is Kaldorf-Hicks efficient if Pareto efficiency could be attained by some side payment 2. if the party who gains from the move can in principle compensated the one who lose and still be better off, it is at least Pareto efficient in some potential sense 3. if the party who loses from the move can in principle compensate the winner not pursue the move and still be better off than the move is Pareto inefficient 4. the dollar-is-a-dollar assumption is a short hand of the Kaldor-Hicks Kaldorf-Hicks efficiency: a move is said to be Kaldorf-Hicks efficient if, in principle, the party who gains can compensate the party that loses and still be better off from the move tax distortion occurs when it artificially alters a price, it “distorts” or alters the optimal allocation of income, the tax makes consumers act as though some activity or product or service is more costly to supply to society than it really is, distortions almost always confer deadweight loss a tax on a good imposes no distortion when the demand elasticity is zero tax revenue is depicted by area B (which equals $17), while the deadweight loss is depicted by area C (which equals $8) and can be calculated by considering 3 logical steps: consumer surplus can be evaluated using an individual’s demand curve, the market demand curve merely reflects the surplus of each individual demand curve, the often have estimates of market demand curves price is Po per unit, while total quantity demanded at this price is Qo, based on this equilibrium, total consumer surplus is measured by the sum of areas A, B and C, tax revenue equals the tax rate t, times the quantity of goods demanded after the tax Qt, while consumers loose area C, area C is referred to as deadweight loss, welfare loss or triangle loss, area A denotes the consumer surplus Delta Q Rule: deadweight loss comes about because market output is different from the efficient solution, also called change in output ΔQ , the deadweight loss is a triangle located above it efficiency of an excise tax the cost of an excise tax equals the ratio of deadweight losses to tax revenues, it is easy to show that confiscatory tax one designed to affect behaviour, not raise revenue, in the limit, the tax is so high that it generates zero tax revenue, which means that the value of ξ above approaches infinity, that is, the entire amount of consumer surplus is eliminated and tax revenue 2. Demand curve and consumer surplus 6 this ratio can be expressed by this formula where |ητ| is the absolute elasticity of demand at the price inclusive of the tax falls to zero alongside consumption nondistortionary tax one that generates revenue but induces no change in behaviour, the ratio ξ above is zero, this results if the demand curve is perfectly vertical over the relevant range ξ = DW/TAXREV = 0.5∣ητ ∣τ 3. Supply curves and flow of resources 3 marginal cost assumption (MC) start of marginal cost of production + increase per unit * q where q is the quantity of output in this case the marginal cost assumption is MC=$150+$5q the supply schedule in our example is going to be equal to the marginal cost assumption as every producer maximises surplus by choosing an output where the marginal cost of production equals market price (MC=P) which means that if there are 10 firms all in the same market, all with the same marginal cost then market supply is just their horizontal summation which is sufficient to determine market price, but is this price sustainable? then we have average variable costs, which are the sum of the marginal costs of producing x units divided by x, it is always less than the marginal cost at any output, because cheaper units that were produced prior to the marginal unit influence the average average variable cost (ACV) if the marginal cost increases with output, than AVC is less than MC at every unit of output next let’s consider average fixed costs these are overhead items that need to be covered regardless of output level, because otherwise it is not profitable to enter the business fixed costs: those that do not change with output level average fixed cost (AFC) as output levels become high, AFC fall towards zero economic costs are those which includes all expenses, including salaries of overhead employees, interest payments, competitive wages and competitive rate of return to investors economic cost and economic profit: economic cost include competitive rates of return on investments made in the firm, hence a zero-profits equilibrium condition means that the firm earns a competitive return on its investment economic profit, also referred to as excess returns, excess profits or abnormal profits, are those that exceeded the competitive rate of return on investments average total cost is the vertical summation of average variable cost and average fixed cost, it has a U shaped curve which conveys the fact that as firms grow they take advantage of the economies of scale (which gives them some cost advantage), but size also means that maintaining quality over the product becomes increasingly expensive average total cost (ATC) total costs (TC) MC = ACV = (MCi +MCii + ... +MCq) ÷ q AFC = FC/q ATC = AFC +AVC TC = ATC ∗ q 3. Supply curves and flow of resources 4 marginal cost intersects the average total cost exactly at the minimum, which is not an accident! if the marginal cost of adding one more unit is lower in comparison to prior units, then it exercises a downward pull on the average cost curve, once the marginal cost curve exceeds the average of all prior units, then an additional unit of output must increase average costs the marginal cost curve (MC) intersects the average total cost (ATC) curve at exactly the minimum of ATC MC = minATC the average total cost curve is the one we need (so we can disregard its components for a while) so we can only consider ATC and MC, at which point we can consider the area of the fixed cost (total cost - variable cost) as a triangle (which means it is calculable as such) also we will consider the fact that the market price covers all costs, both marginal and fixed, and thus invites neither exit nor entry to this market sustainable price P: the price at which there are forces neither attracting entry to the market nor encouraging exit, it generates a competitive return on investments in the industry in question, it corresponds to the output level where average total cost equals marginal cost market equilibrium let’s consider a price of $300 and output level 30 (which was chosen because at that point marginal cost equals equals price) let’s say it is point c, at that point the firm is earning excess profits and the excess return earned by these producers beckons entrants but the process of entry works to expand industry output, which exerts a downward pressure on price, in this case the firm chooses output 10 because it corresponds to the point were price equal marginal cost, so reinvestments in this industry will diminish and some firms will depart, this exit process works to reduce supply in the industry pulling up the price let’s suppose there are 75 firms, all with the same cost curves, this makes the market supply 75 times the output of one firm, so if the cost curve is MC=10+5q, we can find the quantity that the firm would supply at each price (since P=MC) and we can multiply that by 75 to reach market supply market supply derived step 1: set marginal cost equal to price per one firm MC=P step 2: substitute the expression for marginal cost 150+5q=P step 3: solve per quantity in terms of price q=0.2P-30 step 4: multiply individual quantities supplied by n Q=nq=n(0.2P-30) suppose now that demand increases to D2, therefore market price increases to $370 and output increases to 3.300 units, considering individual marginal cost curve MC=150+5q, the price should be $370 and the quantity of each individual firm 44 so when the market learns that there is excess profit in an industry other firms enter in an attempt to also earn excess profits, but his makes the 3. Supply curves and flow of resources 5 market supply curve shift to the right, this only stops when market supply and demand are equal, in this case at price $250 profit as signal an excess profits condition in an industry attracts entry, creating a force to reduce price and reestablish a competitive return on investment, negative excess profits create the opposite force, the market is sustainable when excess profits are zero by working through the dynamics of disequilibrium price, we have segued into the notion of long run supply, as we saw before the sustainable price idea tells us that the market will re-regulate itself if the price strays from P* either through entry or exit, from this concept we can infer how a long run supply will work long run supply as long as the expansion or contraction of the industry does not affect input prices, the long-run supply curve is a horizontal line at the sustainable price, this is also sometimes know as constant cost industry producer surplus, long and short run and economic rent so we have an equilibrium at $250, and we have established that producer surplus does not exist in the long run, by looking at it in a different way you could say that the firm has committed to a fixed cost because it wants to reap as much excess over marginal cost as possible, even if the gains are not enough to pay the fixed cost, surplus is still useful as it reduces loss producer surplus in the short-run sense even at sustainable price, the accumulation of price over marginal costs for any level of output is surplus in the short run sense, this means that since fixed costs already have been incurred, the firm is willing to supply the product according to its marginal cost curve, any excess is surplus in this limited sense still true producer surplus can arise in a longer-run sense if the underlying input prices increase with the level of market demand: if the supply of inputs to an industry is increasing in price, then there is a separate sustainable price for every level of demand let’s suppose that law firms want to maximise the return on their investments and as lawyers are an important output into this market the supply curve of lawyers is going to be upsloping, still different people will value their work more and some less, thus a rising supply schedule reflects the underlying differences in lawyers’ willingness to tolerate the requirements of litigation work to provide a concrete example, I assume a particular supply curve of lawyers L(s)=10W, so for every $10 increase in wage, the supply of lawyers increases by 100, then we can suppose that so if the wage is $150 then the marginal cost to the law firm that produces 20 units will cost $250, obviously the demand for litigation lawyers is tied directly to litigation services and if the firm operates at minimum total average cost it 3. Supply curves and flow of resources 8 a deadweight loss arises because at the distorted price caused by the tax, consumers act as though it is more costly for society to produce the product than it really is short-run impact of a tax on good x quantity demanded falls, price paid by the consumer increases and price received by the producer falls; the government collects a tax revenue equal to the tax rate times the quantity demanded at the new price; consumer and producer surplus fall by more than the amount of tax revenue, thereby creating a deadweight loss regarding long run impact the final equilibrium can be found where the supply price inclusive of tax intersects the demand curve at P0+t, consumers now pay the full tax while producers absorb none of the burden long run impact of a tax on good x if a unit tax is imposed on some product then the price paid by the consumer increases by the full amount of the tax; quantity demanded falls by more than in the short run; price received by producers is the same as before the tax was imposed; government revenue is smaller in the long run and fewer firms exist (with fewer workers) on the other hand a subsidy operates just like a tax, but negative, in the short run it vertically reduces the supply curve by absolute amount t (producers get higher prices but society devotes resources valued above $5 to create output valued less than $5), in the long run effect entry is created and the supply curve remains stable at $5 so that producers get zero profit and consumers receive the entire benefit of the subsidy a few miscellaneous cost issues SUNK COST ex ante refers to the period prior to a decision to commit to an action, ex post refers to the period after a commitment has been made, ex post decisions are usually confined by ex ante ones sunk cost used interchangeably with ‘past cost’, they are those incurred regardless of a decision that must be made prospectively, decisions made prior to incurring any costs take into account all costs (including fixed ones) after an irrevocable commitment has been made to incur expenses, they are no longer relevant to future decisions the decision to be made is to select a level of output where marginal cost equals price, independent of any cost incurred in the past so the key principle of sunk cost therefore is once a commitment has been made to incur a fixed cost, it becomes an irrelevancy to any decision to move forward let’s say you accept a case in a law firm and the standard remuneration is soon after a precedent is established against you, this puts your chances at winning at 40% (1/4) making the revenue now $133.333, so at 3. Supply curves and flow of resources 9 1/3 of any judgement, which in this case would be 1 million making the firm’s share $333.333, the chances you win are 75% which makes the possible remuneration $250.000 (75% of $333.333) by calculating the expected costs (fixed investment of $100.000 + $10.000 per month, for 10 months) this would make the actual revenue $50.000, therefore you incur the initial cost of $100.000 this point the firm can choose to abandon the case or not, but it would be smart to continue: by comparing the expected revenue and the costs yet to incur there is still profit to be had (the $100.000 are irretrievable and therefore count as sunk cost and are irrelevant) after 6 months of costs another precedent is established against you, this puts your chances at 10% (1/10) making your expected revenue $33.333, which is less that the expected expenses for the next four months, which means it would be better for the form to abandon the case OPPORTUNITY COST by keeping in mind the basic tenet of economics that something is never free, even when it is, one can understand that even by doing something you incur the cost of not doing something that would be a better use of your resources opportunity cost the value of the next best use of time and money used in the activity we choose or the product we purchase TRANSACTION COST transaction costs are costs that are those that are incidental to a good or service from which one derives utility, they can also be thought of as production costs so the resource costs required to create a good or service that gives rise to utility still, while production costs do not vary based on the identity to the buyer, transaction costs do, they also do not increase utility, but just reduce surplus transaction costs those which are ancillary to a market transaction that gives rise to utility, production costs give rise to a product or service which increases utility, transaction costs do not increase utility but merely reduce consumer surplus they usually include the time and out-of-pocket expenses incurred to accumulate and evaluate information and to effect the desired outcome 4. The use of demand and supply to evaluate policies 1 4. The use of demand and supply to evaluate policies shifts in demand and supply curves when one refers to an increase in demand and supply I refer to a horizontal or rightward shifts, and similarly for decreases in demands and supply, so what happens when there is a combination of both? every combination of demand and supply results in a new equilibrium price and quantity in one of four quadrants impact of a maximum price: the case of gasoline the power of the market to allocate goods and services to the highest-value users can be diverted by governmental forces, but its presence still makes itself known in some way and there is no better example than the price cap on gasoline in the US in 1974 by President Ford and in 1979 by President Carter let’s take the original supply curve of gasoline in the US in the short run (in a more complete analysis we could also portray a long term supply which lies flatter, which reflects the fact that at higher prices oil companies will drill more wells or search more oil) without interference the market clearing price is $5 and the quantity 5 million gallons, at which point the presidents decide to set a maximum regulated price at $3 per gallon the problem created by the regulation is apparent: at price $3 there is a demand for 7 million gallons of gasoline while only 3 gallons are supplied which means that the market clearing price is $7, these types of actions are usually taken with the idea that it would benefit consumers as both presidents try to assign the surplus of the producer assigned by area D to consumers, but this ends up dissipating the area of surplus C as well it is noteworthy to acknowledge that the individuals on the upper part of the demand curve are the highest value consumers (attach a higher worth to it), most individuals will attach lots of value to the first units of gasoline they get) but how do the high-value users squeeze out the low-value users? the answer is queues (like actual real life queues) let’s suppose that a gas station owner has 1.000 gallons to sell and that all consumers attach a price on their time of $20 per hour, let us also consider a consumer who is willing to pay $10 per gasoline but finds $3 and therefore receives $7 of surplus per gallon full price a term that normally arises when there is some cost beyond the out of pocket price of some item of service (in this case the shifts in demand and supply curves impact of a maximum price: the case of gasoline the economics of the minimum wage price supports 4. The use of demand and supply to evaluate policies 4 this effort competition affects worker’s supply prices: a worker’s supply price depends in part on how hard one works on the job, the more work required the higher the required wage, therefore workers require a compensating differential to accommodate the higher work on the job, in the end the low rest guys are out, the high rest guys are in and the boss only reaps the benefits compensating differential the additional composition required to accept less desirable working conditions, as jobs require harder work, potential hires require a wage to accept these jobs, this concept is an application of the compensation principle (the disutility of the job requiring harder work is translated into a higher asking wage) equilibrium is discovered when workers put enough effort, the net results would end up being the following: the deadweight loss caused by unemployment effect, the additional disutility of harder work and some value offsetting the cost, at the end only high value workers are employed third effect of the minimum wage high rent workers out-hustle low rent workers and secure all minimum wage jobs, the higher effort increases value added which attenuates the employment effect, in the end, some unskilled workers are unemployed, the rest have more money income but less income unions also prop up wages above the competitive level, this means that fewer workers are employed but that the additional rent gained by the others is significant, however this rent can be eroded, this is the reason because the union also creates contract that don’t allow some workers from a given class to earn more no matter how hard they work or that make it harder for companies to fire workers, overall unions frown on workers doing anything beyond their job definition price supports price supports are the ‘cousin’ of the minimum wage except that they refer to output markets suppose that the government operates this system by coordinating farmers through cooperatives which assign quotas so that the farmers will assign only 3 million tons of wheat (the quotas are transferrable so that farmer 1 can sell his quota to farmer 2) the actual solution is nothing special: a deadweight loss ensues (area A+B) develop because the quantity supplied falls by 2 million tons, the price rises to $7.000, farmers’ rent increase by C and fall by B (C should exceed B, otherwise it would be useless) and consumers are worse off not only because they impact of a price support with sufficient output allotments price increases, quantity falls, consumers transfer surplus to farmers; total rent to farmers increases; a deadweight loss is imposed. the solution is the same at the government awarding farmers the property rights to tax revenue 4. The use of demand and supply to evaluate policies 5 transfer their surplus measured by area A but also because they transfer their surplus measured by area C to producers generated by attaching a $4.000 tax per ton of wheat another option is for the government to support price $7.000 and allow farmers to produce any amount they want and let market price be determined by demand conditions, at the support price farmers produce 7 million tons while consumers are only willing to absorb this quantity at $3.000 (which means that the market-clearing price falls by $2.000) this distortion happens because there is too much wheat (and the consumers do not attach to it a price higher that the marginal cost of production) the total amount of waste is measure by the vertical distance between the supply schedule and the demand curve for every unit of production between 5 and 7 million tons of output impact of a price support with no restriction on supply price falls, output increases, and consumer and producer surplus increases, a deadweight loss develops from an inefficient expansion of production (this solution is the same as the government offering a subsidy of $4.000 per ton 5. Economics of monopoly 1 5. Economics of monopoly assumptions about costs for simplicity, I make the assumption that the firm’s marginal cost curve is flat and fixed costs are 0, we can think of schedule as the long run marginal cost curve in an industry that is characterised by certain costs the price decision unlike a perfect competitor in a free market, who accepts the price given by market forces a monopolist recognises that he can set the price, this price needs to found along the demand curve that maximises the difference between revenues and costs, which defines excess profits assumptions demand curve: P=$20-Q → Q=$20-P marginal cost: C=$4 there are two methods to calculate optimal output: 1. look for the highest profits profits equal the difference between total revenue and total costs, let’s remember that maximum revenues occur at midpoint of the demand curve, when demand elasticity equals unity, this output corresponds to 10 units here, therefore if you want to sell more units of a good you need to lower the price as revenues grow more than costs because of the falling demand elasticity, the amount by which revenue increases becomes smaller for each incremental unit until it is zero at ten units the change in revenue from each unit of output is called marginal revenue marginal revenue the change in total revenue from a one-unit increase in output a firm in a competitive market cannot affect price, and so his market revenue from an additional unit of output is the market price, a monopolist is the only supplier and thus can control the price, he also takes into account that while a higher output alone works to increase revenue, it also causes price to fall which produces revenue 2. set the marginal revenue equal to marginal cost more convenient in application as it involves fewer calculations and takes advantages of the marginal principle, this is because a monopolist will choose an output level exactly where marginal revenue equals marginal cost so there are two ways to solve the problem the price decision the social cost of monopoly monopoly price discrimination price discrimination in competitive markets competition of the few (cartels) 5. Economics of monopoly 4 expense which means that there is a defacto monopoly price with other competitors makes it so that it ends up being a market) this whole process ends up creating rent erosion let’s suppose that Congress only awards one monopoly for period and that producers are willing to spend $64 in resources for lobbying, let us also suppose that due to ethics rules Congress should not take more than $8 from any lobbying efforts, this means that in exchange for spending $8 in lobbying they might receive a benefit of $64 let’s say there are two producers, both attach a max value of $64 and can spend only up to $8 in lobbying, if you look at it like a casino bet, they both have a 50/50 chance at winning which are excellent odds, if there’s three of them there is a chance of 33%, which is still quite good, for 4 of them a 25% chance, still good rent erosion a term of art that refers to the process by which surplus is eroded by resource cost, the erosion occurs as a result of competition to secure the property rights to the rent you can go on like this until a certain point, as expected profits from playing disappear only when eight players are in on it, but why? the chance of winning is 1 out of N and entry occurs until when expected profits from this activity are zero so if N industries play, then each has the chance 1/N to win the amount PRIZE, therefore expected winnings are 1/N x PRIZE this means that with 8 players the expected return is competitive because there is no expected profit from investing equilibrium condition in the market for monopoly the number of would be monopolists, N determines the chance that any one gains the rights to monopoly profits, anticipated excess profits are the PRIZE, assuming that each participant has an equal chance of winning, each has one chance in N to be the winner, making the probability of winning 1/N let us now reconsider the social price of monopoly pricing, whether one obtains a monopoly by lobbying, collusion or patents, the expected social cost of the monopoly equals both the deadweight loss and the excess remuneration, this rent erosion is one reason why antitrust laws exist, they deter wasteful activity and it also explains why society discourages property crime the social cost of monopoly equals the deadweight loss from the restriction in output plus the total amount of excess profits, the erosion is incomplete if some inputs to the market have a rising supply schedule, in which case some of the surplus will become economic rent monopoly price discrimination insofar we have assumed that the monopolist can charge only one price, but price discrimination the term used when a firm sells (1/N) ∗ PRIZE = CP 5. Economics of monopoly 5 in reality a monopolist can generate higher profits if he can set different prices to different consumers, to do this he obviously needs to separate the markets by preventing consumers who pay a lower price to reselling it to someone paying a higher price the same product to different consumers at different prices, which is not explained by a difference in the cost of making it available to these markets let’s consider a town where there is only one ice cream vendor and that one cone’s marginal cost is $4, there is a nursing home where ten elderly women are willing to pay $8 a cone (but the rules of the nursing home forbids food items from entering or exiting aside from vendors’) the rest of the town is willing to pay $12, there can be two possibilities: a single price is allowed the city council puts a restriction on the monopoly this means that the vendor could either put a single price of $12 for everyone, but doing so he would forego the opportunity to sell ice cream to the women at the nursing home, or put a single price of $8 and have both markets available, overall the second option would yield a higher profit two prices allowed this would yield an even higher profit compared to the first option, which means that a monopolist earns a higher profit by charging different prices to different consumers, separation of the markets is a prerequisite if a monopolist can separate markets based on different demand conditions, he can almost always earn higher profits by charging different prices it is quite useful to think about the most extreme case of price discrimination, what is the maximum profit to be earned from it? let’s suppose that the vendor knows the demand curve of each and every one of his customers, at which point he could charge the maximum price that each consumer is willing to pay for each ice cream cone this would convert all consumer surplus in excess remuneration also know as the perfect price discrimination it is also interesting to note that in a perfect price discrimination solution there is both no consumer surplus nor deadweight loss, but even if deadweight loss is zero, it does not follow that the social cost of monopoly is lower with perfect price discrimination compared to the one- price solution the higher excess profits are now subject to rent erosion, consumer surplus is converted to profit which is converted into social cost in the market for monopoly perfect price discrimination occurs when the seller knows each consumer’s demand curve and sells its product or service at a different price for every unit purchased by a consumer minus a penny the entirety of consumer surplus is converted into excess profits, unless substantial economic rents are earned by some inputs int eh market for monopoly, the social cost of monopoly is higher under perfect price discrimination as compared to a one- piece solution 5. Economics of monopoly 6 there are also other ways to extract consumer surplus tie-ins firms can require buyers of product A to also buy product B, so that all users pay prices in proportion to their intensity of use, this can allow a firm with market power to extract more consumer surplus (IMB example) auctions when it is legal producers or sellers can hold a secret bid, at which point everyone will be fearful that their bid is going to be too low to actually obtain the good they desire, and so they are willing to cut into their own consumer surplus, in this case the owner is unlikely to extract every penny of the surplus, he would certainly get a good deal out of it, this only works only in a market where there is one or few sellers (scalping tickets example) price discrimination in competitive markets one needs to remember that if a firm charges two prices it doesn’t necessarily mean that it has monopoly power: as long as there are fixed costs to production, price discrimination can occur in markets where there is no market power to illustrate we could use the example of the movie theatres: let’s say there are a 100 move theatres in a city, each has 100 seats which are all taken every night, the marginal cost for customer service is zero but there is a fixed cost to operating the theatre of $1.000 daily, by assuming that the tickets are $10 each and there is only one evening show a day, each theatre collects $1.000 a period (which makes $10 a sustainable price) let’s say that some enterprising theatre owner sees that there is a potential clientele going around in the afternoon doing nothing, she figures that many of these people would be willing to pay $4 to see a movie in the afternoon, since she’s the only one who offers this possibility and she only has 100 seats to fill, she easily makes $400 in excess profit (this is in addition to the $1.000) soon other theatre owners start to catch one and they open at afternoon too, but as they add the the supply of afternoon seats, the afternoon price must fall, so when all theatres open in the afternoon the market clearing price becomes $3 making the profit $300, so what happens next? entry does, excess profits attract entrants into the market who also want to earn excess profits the trick is to recognise that the total demand for each day is the vertical summation of evening and afternoon prices (not horizontal because the evening moviegoers do not preclude afternoon moviegoers) the equilibrium supply is given when the total daily revenue equals the sustainable price, zero profits are reestablished when an additional 100 theatres enter as there are 20.000 seats on the market 5. Economics of monopoly 9 conspirators’s innate propensity to cheat authorities are sure that consumers are not going to pay a high price for very long 6. Public goods and common resources 1 6. Public goods and common resources an introduction to private goods public goods have 3 fixed features: 1. its production is characterised by a large fixed cost 2. the ability of consumers to enjoy a product without inhibiting someone else’s enjoyment (morning -afternoon moviegoers) 3. an inability to charge users a fee so for example one could consider a fireworks show, to pay for it and solve the collection problem the government could decide to use tax revenues, but the implicit tax assessment might not directly match the beneficiaries of the show, for example some might attach a higher value to the show and pay too little, while some might attach too little a value and pay too much, but it is just a transfer from one citizen to another free rider one who reaps the benefit of someone else’s investment without paying for it, cannot work for a private good as one needs to pay for it in order to enjoy it, which means that the term free rider is usually found in the market for public goods because consumption an occur without a payment overral: vertical summation → consumption is not mutually exclusive horizontal summation → consumption is mutually exclusive technically to illustrate the optimal level of firework display we need to express the demand for each citizen and then add them vertically to arrive at the market demand curve which will tell us how much the citizens are willing to pay to see a fireworks display we also need to take into account both the fact that according to diminishing marginal utility, each user is willing to pay more for the initial unit than the second and that in the real world, rather than basing their calculations on the individual’s demand curve but rather their income tax market demand for public goods the vertical summation of individuals’ demand curves, each user can enjoy the good without revisiting the notion of transaction costs in the absence of transaction costs all public goods are private goods as long as property rights are clearly assigned, there is no need for the public provision an introduction to private goods innovations: classic public goods the common resource problem the source of rent erosion: poorly defined property rights 6. Public goods and common resources 2 interfering with others’ enjoyment of these goods, just that the government clearly assigns the property rights to its provider is government provision optimal? when assessing the benefits of government provisions of a public good, it is inappropriate to compare the perfect outcome the government can create with zero provisions of the goods in its absence, a better approach is to compare the under provision of public goods versus the imperfect outcome that government generates innovations: classic public goods there are many examples of public goods: everyone benefits from national defence and still each individual has an incentive to free ride on its benefits, still, there is another class of public goods where there are some prospects for collections but below the value added: the market for intellectual property rights it is a fact that ideas are public goods, but suppose that after I discover a combination of chemicals miraculous for headaches from which millions could benefit from, let’s also suppose that after incurring into $25 million of expenses the formula turns out to be something that can be easily implemented at home if innovations lead to idea that cannot be packaged int he form of a product, it is hard to envision how the private sector can profitably pursue the idea, but if the innovation can be packaged, then the prospects for collection become brighter and a patent can be awarded A. the solution in an ideal world a single new idea: let’s consider a three-period model, in period 0 the innovator engaged in R&D efforts leading to a new product, while in periods 1 and 2 innovators enjoy the benefits of the innovation, the demand of the headache pills is expressed through horizontal summation of individual demand curves the demand price captures the value that consumers attach to their effect, by supposing that the marginal cost of producing those pills is 0, it means that the R&D is the only real cost to recoup and that there is potential to realise as much as $400 ($200 in the first period and $200 in the second period) minus the cost of R&D representing 19 other new ideas: there is demand for 19 other drugs and that the demand curves for everyone look exactly like those above, if the marginal cost is zero, the total value added by society for each new idea is the area under the demand curves in both period ($200+$200) if I array these inventions side by side and against the headache remedy we see that each has the same height 6. Public goods and common resources 5 society is better off if it confers more monopoly profits to patent holders as it generates more innovations, this actually only leads to more rent erosion, more surplus is better, not more innovations E. other ides about patents no patent system: some innovations would allow the owner to exploit the new idea for some significant period anyway, as it would take copycats some time to figure out how to replicate the idea auction patent rights: if there was enough information available, we could eliminate some of the rent erosion by auctioning the rights to pursue innovations before any R&D costs are expended, in this scenario there would be no rent erosion because property rights are awarded ex ante not ex post, there is still DWL allow for price discrimination: one could also allow monopoly pricing for only one period, but allow the patent monopolist to practice perfect price discrimination, this would leave us with $200 in profits, 8 inventions to get to an equilibrium and R&D costs plus rent erosion would be the same as the two-period scenario the common resource problem the common resource problem the overuse of a valuable asset that has ill-defined property rights, if no one has property rights to an asset ex ante, then its value is driven towards zero because competitors erode resources as they try to attain the rights tot he assets ex-post let us consider the oil ship in distress problem: a ship which has whale oil on board worth $100 runs into some rocks, the weight of the oil makes it impossible for the ship to get out of the situation and, unless the weight is relieved (possible only through a rescue ship), the waves will tear apart the boat, which is worth $300 a rescue ship shows up and, upon seeing the situation, asks the captain if he would like to negotiate a price for the oil, given the situation, the captain is willing to give it up for free, and furthermore, he is willing to pay $300 more to save the boat, at which point the boat is rescued when they arrive in port the owner refuses to pay the $300 and wants his oil back, even though he signed the contract voluntarily holdup/opportunistic behaviour the advantageous taking from other, even if not done at the point of a gun, it often arises after one actor irrevocably commits an action, leaving himself vulnerable to subsequent exploitation, fear of a holdup gives rise to contracts enumerating each party’s obligations when the circumstances arise 6. Public goods and common resources 6 the ship under distress problem - it costs $40 to float a rescue ship for a season - each season, 100 ships pass through and exactly one always runs up on rocks - the oil is worth $100 and the ship is worth $300, and both are lost if the oil is not pumped out quickly - if there is only 1 rescue ship at sea, there is a 50% chance it will find the boat on time, if there are 2 the chance is 75%, if there is a 3rd its a 90% chance and if there are 4, there is a 100% chance - a ‘me first’ ex post system of property rights is the one applied, once a rescue ship finds the boat, the others will not approach them A. honour the contract one could think that the $400 could be a direct transfer, but they would be wrong to do so, considering the problem above we could say that the expected gain from operating a rescue ship is (1/N PRIZE) making the expected value $100 ($400/4), considering the cost of $40 but at that point should a fifth ship go out? yes, as its expected value would be $80, and so on, in equilibrium, using our formula, we know that there will be 10 rescue ships floating at sea every season, which means that the social cost of this rule of law is high if this solution is applied there would be no surplus form having ships at sea the problem with enforcing contracts made under duress is that they encourage too many resources looking for a ‘ship in distress’ B. nullify the contract let’s consider the opposite possibility, where the court dictates that the owner only has to reimburse the $40, at which point even one rescue ship (which has a 50% chance of finding the boat) would only have an expected value of $20 so no rescue ships would go out at sea C. the optimal settlement rule the optimal reimbursement is one that delivers the socially optimal number of rescue ships at sea, which would be the 4th, which makes an expected value of $40 and additional ships add no value, therefore the social optimal number of rescue ships is determined by the quality of marginal value added and marginal cost, which mean that the socially optimal number of rescue ships is either 3 or 4 (the fourth expand as many resources as he expects to save, so it is a toss up of when he should go out at sea) socially optimal number of rescue ships is determined by the equality of the marginal value added to society from having one more rescue ship at sea and the marginal cost of floating one more ship, in this case the correct number is four, societal surplus is maximised (it turns out to be $240= $400-($40x4)) on the other hand the average value of N corresponds to the chance that any given rescue ship is the lucky winner (1/N) x the prize amount x the probability that all N rescue ships find the whale oil boat ( ), in case we get more than 4 ships looking for the boat (a AV = (1/N) ∗ PRIZE ∗ probability 6. Public goods and common resources 7 free-for-all or first-come-first-served solution) the extra ships add extra value and their presence is just wasted resources D. setting average value to marginal cost the problem that arises from setting average value benefits to marginal cost is general as it always leads to 0 surplus: let’s say that the price is $10 and you choose 10 units as in this quantity the marginal value of the tenth unit is $10, thus generating surplus A, on the other hand you could keep track of the average value and find out that the infra marginal units deliver more marginal value than $10 but setting the average value equal to price generates negative surplus that directly offsets the consumer surplus, making it 0 another version of the delta-Q rule anytime quantity is not determined by the quality between marginal benefits and marginal costs, look for a delta Q and the associated waste, in case of common resources, the losses are always to the right of the efficient solution E. another way to think of the problem why does the common resource problem generate such an inefficient solution? it is because each additional entrant who searches for the ship has two components to his perceived gain: the true social gain (from the higher probability of finding the ship) and that he takes part of the gains already garnered by those already searching for the ship the first ship has a private and social gain of $200, but when the second ship enters, it perceives its gain to be equal of the value of the boat to be found times the probability times the 1 in 2 chance, which makes the expected value $150 (=$400x0.75x1/2) the social gain of entry on the other hand is found by adding the changes in expected benefits for both ships (ship 1: $200→$150 loss of $50; ship 2: $0→$150 gain of $150: the net change in benefit is $100) if one person has the property rights to the rescue ship operation, he takes into account the effects of entry on the expected values of ships already at sea and treats those as transfers patents pt2 each patent entrant adds to the likelihood of finding the patent, but this just increases the overall likelihood that a prize will be found by someone, in the end the prize mount is burned up with the social costs of rescue ships the source of rent erosion: poorly defined property rights overall one could say that rent erosion is the result of a faulty approach to assigning property rights which can be solved though ex ante assignment of property rights which can take the form of a random assignment or an auction (see alternate solutions to the gas problem), often the common resource problem is referenced in environmental issues common resource an asset that confers property rights ex-post, that is, after market 7. Externalities 2 have to start talking about demand for a ‘bad’, twisting our demand concepts around horizontal axis as units of quiet the market for airport noise for simplicity let’s assume that 1 flight corresponds to 1 unit of noise and that units of quiet are read left to right and units of noise are read right to left model strategy when dealing with a bad set the horizontal axis so that it measures units of improvement, by implication, movements from right to left on the horizontal axis imply more ‘bad’ homeowner demand for quiet also is their supply of noise so the downwards sloping schedule from left to right measures the amount that homeowners, as a group, would be willing to pay to rid themselves of noise, the summation is vertical because noice reduction is a public good and one homeowner’s ability to enjoy quiet will not infer from another homeowner’s we can rad along the homeowner demand curve in 2 directions: from left to right, it is the amount that homeowners are willing to pay to obtain more units of quiet, from right to left, it is the minimum amount of money that homeowners require to allow noise, given there is a lot of noise at the zero axis, homeowners are willing to pay quite a lot B. there is no costless solution to an externality problem there is opportunity cost in the noise, no matter what policy is followed, if a zero noise solution is enforced homeowner receive surplus but airline passengers give up surplus from travel, the opposite policy yields the opposite result the is an opportunity cost imparted no matter what noise policy is followed, if airlines have free use of the airspace, their passengers gain surplus but at the expense of negative quiet externality C. the socially optimum level of externality using the rule: ‘a dollar is a dollar’, it is apparent that 40 units of quiet maximise total surplus of both parties:it does not make sense to cancel the 41st flight because passengers on this flight gain surplus from flying that exceeds the value that homeowners attach to one more unit of quiet socially optimum amount of noise occurs when the marginal benefit of more noise equals the marginal cost of permitting more noise, this is the level of noise that an all-knowing benevolent dictator permits in the airspace strategy find the socially optimum solution even if it is entirely unattainable, just assume that there is an all-knowing benevolent dictator who wants to maximise surplus, even though the result is unattainable it gives you a baseline to compare against the real world 7. Externalities 3 the Coase theorem in a famous paper, Ronald Coase shows that the market delivers the socially optimal amount of some externality without benefit of intervention under two conditions: transaction costs are zero and property rights are well defined he argues that is homeowners and airlines have costless access to full information, they can come together and bargain at zero cost, then the market will be characterised by 40 units of quiet, regardless of who owns the rights coase theorem if transaction costs are zero, and property rights are well defined, then the market delivers the socially optimal amount of an externality without outside intervention A. airline own noise rights if the airlines own noise rights, the first reaction would be to think that airlines would ignore the homeowners’ demand for quiet and simply make 100 units of noise to obtain the first 40 units of quiet, homeowner are willing to pay a sum equal to A+C, but it is only with C to airlines to make the noise so they could make a deal over it, it does not matter how the surplus is split, as long as airlines receive all of B at the very least and the homeowners retain some part of A notice that the homeowner’s power cannot go further than 40 units of quiet, beyond that, their availability to pay is exceeded by the amount required B. homeowners own noise rights if homeowners have the rights to quiet, would they insist on zero noise? in reality, in this situation too both parties would be better off by making a deal by area B, but the airline will not pay for the last 40 flights, because their availability to pay is less than required by the homeowners no matter who owns the property rights we end up with the same result, 40 units of quiet and 60 units of flights, the socially optimal solution results as long as transaction costs are zero and someone owns the property rights to the sound waves over the flight path equity issues are an irrelevancy in Coase it is not productive to address externality issues by appealing to equity concepts, the party awarded the property rights usually have more money in their pockets at the end of the problem C. what if transaction costs are not zero transaction costs real costs, but different in character from production costs, they increase or decrease the utility of a good or service and can be seen as resource expenditures that erode surplus in the context of externalities and public goods they are information gathering costs, and do not increase utility but are financed by a mutually beneficial deal 7. Externalities 4 the all-knowing benevolent dictator prerogative is paramount to announcing zero transactions, which means that all the surplus is realised, while in reality solutions are imperfect and we just need to look for the solution yielding the best outcome government solutions the Coase theorem itself suggests that a solution could be found if some group can act as an agent for the parties affected by the externalities, that the airlines would come to represent the passengers is obvious, but what about the homeowners? as a practical matter political representatives could play a role in drafting a deal and if their constituents are both homeowners and passengers, expected votes might generate a reasonable approximation of the optimum solution, but chances are that the solution will not be an efficient one, and if it were it would be by accident vertical integration vertical integration means that a producer buys an input into the process so noise is part of the production process of creating flights and the airport internalises the benefits of the noise for the passengers and the costs imposed on the home owners suppose that the airport owns the land along the flight path, they have 3 options: a. not build, b. build houses and produce 100 units of noise, c. build houses and produce 60 units of noise, the airport will choose the third option as it is the one that yields higher surplus vertical integration often motivated by the promise of reduced transaction costs, which in the context of the Coase theorem can offer a way to deliver the socially optimum amount of some externalities contractual solutions one could observe smaller-scale externality problems solved in contractual contexts (for example restriction on houses’ appearances can be made to preserve the ‘look’ of the neighbourhood and not devalue other houses, the contract could also include tie-in sales D. corrective taxes Arthus Pigou made the simple observation that, as long as the government needs to raise revenue, why not attach a tax on the bad, these corrective taxes are used to correct the bias of using too much of an apparently free resource corrective tax/Pigou tax brings the price closer to the social marginal cost of production and therefore improves welfare even with this tax the socially optimal solution is reached because beyond a certain level of noise the tax exceeds the value of making noise, the question is whether can a tax or a regulatory solution generate more surplus than the free market left to its own imperfections? the answer of necessity depends on the problem at hand 8. Pollution in the work place 1 8. Pollution in the work place compensation for exposure to air particles let’s consider the case of air pollution exclusively for workers in a coal mine: if the air particles are merely aesthetically unpleasant workers might ask for a premium, but what of potential health issues? as long as workers are informed about the hazards, the problem is resolved naturally through the emergence of a “compensating differential”, in which case the firm internalises the total cost of the hazard and delivers the optimum amount of harm to workers, but what if workers are uninformed? information almost always is a substitute for intervention in the form of tort law, direct regulation or taxation lack of information is the underlying rationale for intervention in private contracts A. setting up the air particulate problem when dealing with a bad like air particulates we should redefine the problem so that the horizontal axis measures more units of a good, and thus, units of bad are read from right to left, on the other moving towards the right side we can think of particulates removed from the air or units of air cleaned B. the demand for clear air the demand curve for cleaner air at work measures the added compensation that fully informed workers require to accept the higher risk, it follows that firms that expose workers to polluted air must pay some premium to attract those same workers, the more polluted air the workers absorb, the higher is the compensation they require the demand curve for cleaner air at work measures the amount that fully informed workers not the job site require as compensation for absorbing each small increment of air particulate, the area under the demand curve is the total amount of compensation required if the firm gives workers Co units of clear air, then 100-Co units of pollution still exist and workers require compensation to absorb it C. the supply of clean air the upscoping schedule (MC) describes the marginal cost incurred by the firm to get rid particulates from the air, and therefore can be seen as the supply schedule for clean air, as it is the minimum cost of eliminating each unit of pollution so clean air is not free, firms must expend resources to eliminate air particles compensation for exposure to air particles how do we obtain the socially efficient solution? the compensation principle and economic damages negligence standards additional examples 8. Pollution in the work place 2 every action has an opportunity cost dirty air is costly to the firm as higher wages, clean air is costly because of abatement, the firm’s job is to find the solution with the least costs D. the socially optimal it is apparent that the socially optimal level of Co, worth cleaning the air to this point because over this range, workers attach a value to each marginal unit of clean in air in excess to the marginal cost of cleaning it, hence, relative to zero pollution abatement, the delivery of Co units of clear air reduces the social cost of pollution how do we obtain the socially efficient solution? A. a contract solution (buyer beware) how does the market deliver the optimal solution? if workers have the full information, there is no reason to believer that private contracts will result in a suboptimal equilibrium, under these conditions there is no need for intervention, this is known as the standard buyer beware buyer beware standard as long as parties to a transaction are fully informed, we can expect the market to deliver optimum levels of potential harm, there is no elected benefit from regulation or the judicial system in this example the competition in the labour market ensures that the compensating differential is such that the marginal worker is just indifferent to working at a lower wage in a clear environment or at a high wage in an unclean one B. regulatory solution the buyer beware standard serves to provide a benchmark for analysis, because most of the time workers are poorly informed about risk, and as such they offset the proper compensating differential a solution would be to see the Congress or the judiciary as agents of workers, if they are perfect they would effect the same solutions as fully informed workers, to do so various standards could be enacted zero-harm exposure standard: a regulation can be issued that prohibits any measurable level of pollution on a work site though prohibitive taxes zero-harm exposure standard workers and other market participants are unwilling to sell their exposure for a finite price C. strict liability standard suppose that workers are oblivious to health hazards of air particulates on the job, and therefore do not require compensation, even if firms try to do the right thing competition will drive the compensating differential to zero firms who do the right thing will be at a cost disadvantage to those who act as though they do they don’t care, and will ultimately be driven from the market, only firms that don’t care survive 8. Pollution in the work place 3 in this sense air pollution can be seen as an externality which makes the optimum solution affixing the costs to the party who can find and solve the problem at the lowest cost, so if firms can solve the issue more efficiently a strict liability standard should be applied strict liability standard requires the party responsible for supplying harm to compensate victims for damages, regardless of fault the standard appeal against party A is more likely to be optimal if 1. information is poor to the party, 2. it is cheaper for party A to discover harm, 3. the solution to harm is mostly in the hands of party A assuming that jurors hare perfect workers ex- ante: they award judgements to workers equal tot he amount that workers would have solicited from the firm if they had full information, this only works to a degree (in the same sense of externalities) beyond Co units it is better for the firm to pay damages judgements can therefore be a stand in for a compensating differential that the workers would have charged the firm, it is just received later on in the form of judgments strict liability can deliver a socially optimum result if juries award damages that replicate the compensation that workers would have charged if they had full information the compensation principle and economic damages in a way torts are merely on the flip side of contracts, because, when contract are not economic a tort solution can produce the same outcome ex post if it sets awards in the amount denoted by area C so torts merely accomplish ex post what would have been accomplished through contracting ex ante A. torts are on the flip side of contracts I reconsider the plant pollution problem with a few more specific assumptions: in the first period 100 workers are exposed to pollution and in period 2 they are either harmed or unharmed, in the first case they incur $25.000 in health expenses, on the other hand the cost of abating 1 unit of air pollution is of $1000 so the benefits hat workers attach to clean air are therefor a result of health expenses suppose that out of 100 workers exposed to 50 units of air pollution only one is harmed, while if the units of pollution double to 100, 4 workers are harmed, then the demand curve would look somewhat like this: MB=$2000-$20x (where x is clean air) the contracting solution this demand schedule is shown as downward sloping, suppose that each exposed worker is harmed with probability p, what the workers require to accept this compensating differential the amount that a fully-informed person requires to accept exposure to harm that has economic cost H times the probability the exposure produces harm P C = pH 8. Pollution in the work place 6 that poses a fatality risk must include the probability that the activity produces a fatality times the value of live of the exposed population the full cost of speeding depends on the value of the life of the exposed population and the probability that speeding results in a fatality 1. unbiased estimates put the value of life in the $5 million to $7 million range 2. regulatory agencies use value of life in evaluating costs and benefits of lifesaving regulations (the values used are not consistent through agencies) 3. courts do not use value of life concepts but look for countable damages negligence standards there is one case where the individual who had been exposed to risk is liable for their own damages: when one is negligent for their own acts A. efficient negligence standard on candidate for this type of situation is one where the marginal cost of reducing harm is less than corresponding benefits a principle embodied in the Learned Hand Formula, which is a rendition of marginal principles in economics so, as long as they deliver Co units of clean air, firms are not liable for any damages learned hand formula a person imposing potential harm is not negligent if he engages units of care such that the marginal cost of care equals the marginal cost of harm, therefore the standard is met as long as the firm offers Co units of clean air, so the optimum amount B. if workers can reduce harm themselves however strict liability standards can have a negative effect as they can discourage the market from finding cheaper solutions, in this particular example: masks! if for a given amount the workforce is willing to wear a cheap paper mask, the harm from exposure to 100-Co units of unclean air particulates falls, and so as long as the cost of wearing the mask exceeds the cost of total savings, this solution can work if workers are informed than a contractual solution delivers the optimum amount of pollution, but if workers are uninformed, than a strict liability standard delivers the optimal solution if the firm can cheaply monitor its workers to make sure they do wear the mask, however if monitoring workers is not possible and damages under strict liability reflect observed health damage without regard to any self-inflicted damage workers have no incentive to wear a mask C. contributory negligence courts can enforce a contributory negligence standard if workers can ‘combat’ harm more cheaply than the firm, thanks to which firms are not liable for harm so workers have an incentive to wear the masks and firms have an incentive to provide the efficient level of care 8. Pollution in the work place 7 D. comparative negligence and strict liability with contributory negligence this standard is used if both the firm and the worker are negligent as it tries to divvy up damages according to whose negligence created which portion of harm a solution can be found by combining strict liability with contributory negligence so that the firm is liable for all harm done by exposure to air pollution, but damages are limited to level delivered by a no negligent worker contributory negligence if the victim’s own carelessness contributes to the accident that creates the tort action, he is not entitled to damages comparative negligence if both parties to a tort are negligent, the harmed party s entitled to the difference between the actual damages and those that would have been sustained had he met his standard of care a strict liability standard can be combined with a contributory negligence standard to produce an efficient result in this approach the firm is liable for harm imposed on workers, but only up to the amount of damages that would have been incurred by a non negligent worker additional examples A. the decision to smoke and rules of law how do we model the smoking decision of smoking with and without information? first of all we need to subtract any possible externalities and any problems of addiction plus we need to assume all smokers are the same, then we need to assume a two-period, in the first period he smokes C cigarettes, and in the second he experiences significant health effects the out of pocket cost of cigarettes is Po and the health costs is Ph, if the smoker is not informed, the only perceived cost is Po, and therefore the smoker acts as a consequence, on the other hand with full information the smoker perceived the whole cost and finds an optimum smoking level the problem that arises is that policy advocates only observe individual smoking after information is available and thus cannot tell who is who a tax on cigarettes 8. Pollution in the work place 8 suppose that a tax is proposed, one equal to Ph, so if the smoker is uninformed it encourages him to reduce smoking and improves his welfare, on the other hand it only reduces welfare for the informed smoker strict liability an alternative solution is to refrain from a tax and invoke a strict liability rule ex ante tobacco companies, this is presuming that juries can identify smoking related health damages and award an amount equal to Ph so it only works under the assumption that juries can decide at zero cost the marginal health effects and calculate damages correctly ex post reneging usually courts apply a buyer-beware policy, because since the effects of smoking have been known since 1964, the fact that people continued to smoke suggested that they were willing to accept the possibility of lung cancer and even death on the other and if courts were to change the rules ex post, the smokers would have to pay a cost similar to a life insurance B. driving and accidents suppose that drivers are never pedestrians and vice versa, that there are 100.000 pedestrians and 1 million drivers and that one more unit of speed has a marginal benefit of MB=$120-S while the marginal increase in pedestrian fatalities is F=0.4S this is an externality problem as pedestrians and drivers are strangers who have no opportunity to meet ex ante by solving per V one can find the socially optimum level of speed 9. Lemon Markets and Adverse Selection 3 company and on the other the value of the security so assets are split into two categories: physical assets are everything we can observe, count and attach a price to, while intangible assets or goodwill are assets we cannot see or measure, often called reputation value the ownership claims on the other hand are either bonds or stocks reputation value/brand name capital refers to the asset value of the company’s name and implies that the firm has somehow created a credible commitment to deliver high- quality products that consumers expect of the firm reputation is a bond if the company reneges on the deliver of promised quality, its reputation suffers, which reduces stock value and makes the shareholder suffer consequences in proportion to the firm’s reputation value B. quality assurance premium: where does reputation value come from? most large firms have a reputation value, and how it is produced is quite interesting, to understand it properly we should take as an example McDonalds historically hamburger joints had difficulty establishing a good reputation, and so when McDonald (which had created a more expensive production function) was created it had some difficulty too which is why the quality-assurance premium (an idea by Carl Shapiro) was adopted the idea of quality-assurance premium is quite simple: McDonalds did not ry to make customers pay for high quality goods but initially charged low-quality prices for high-quality goods, so that, when word of mouth spreads the losses sustained in the first period are compensated by the ‘excess profits’ of the second period so the company is entitled to a premium only after it demonstrates through experience that it is a high quality supplier the high price in the second period is referred to as a quality assurance, as it is a bond: if the company reneges on its promise, consumers will walk away quality assurance bonds are substituted for contracts quality assurance premium refers to an increment in price that a company is entitled to charge above the marginal cost to compensate its earlier investment, this means that the premium is a bond whose value will be lost upon reneging on the continued deliver of high quality goods C. specialised investments another idea to bond quality are specialised capital investments, let’s take again the case of McDonalds who invests substantial additional money in its Golden Arches and other characteristics connoting the idea of announcing ‘the store is here’ these things take on additional significance once one notices, they have zero use to any potential user of the site 9. Lemon Markets and Adverse Selection 4 specialised capital investments quality assurance bonds as their value automatically falls when the company reneges on the deliver of the promised quality what information is conveyed when a company invests substantial additional money to erect a structure that obviously is of little use to any other occupant? it shows that the company is confident they are not going to fail D. advertising advertising is a special form of interment as it is firm-specific, the decision of whether or not to engage in advertising sends a signal on whether the movie is of high quality, so ads have a double purpose, they let the customers know of the product and its quality because if the customers are disappointed, the advertising expenditures will be lost, also this solution provides a selection function, as firms can choose which goods to publicise (eg movies) advertising can be viewed in part as a quality assurance bond because if the product is not as good as promised, the seller cannot recoup its advertising investments E. warranties warranties are a more recognisable way to bond quality as they must be credible to convey value to the market, they do send a signal of high quality because if the good needs to be repaired or replaced additional costs are going to be incurred warranties bind high quality because if the company reneges on quality it absorbs large repair costs, they have value if they are issued by reputable companies F. other examples of contractual bonds penalty clauses → usually invoke an automatic financial loss upon failure to live up to standards performance issues → a bonus is paid upon successful delivery of promised quality nonrefundable deposits → the penalty clause is posted ex ante to guarantee performance problems when the seller is uninformed: adverse selection adverse selection occurs when the buyer select in on a basis that in creases the cost of providing the offer, because while sellers might be able to observe some characteristics that affect costs, others are unobservable, making it difficult for some individuals to the other side of asymmetric information is when the buyer knows more than the seller, because, while in most cases the identity of the buyer is of no matter to the seller, in some instances it is particularly important, especially if the cost of the service depends in in part on the characteristics of the consumer 9. Lemon Markets and Adverse Selection 5 find the product at a price attractive to them A. temporal adverse selection temporal adverse selection arises most often in insurance and occurs when individuals purchase the insurance after they have the certainty that the insured event is going to happen, this is not actual insurance but an attempt to advantage of those who have been paying the premium to insure against the possibility of incurring an insurable event suppose that there are 2000 people, 20 of which are going to be sick, half of them buy insurance, as 10 of them are going to be sick and total costs are expected to be $1 million, each pay $1000, the other half do not buy insurance, except from the 10 who find out their diagnosis, which makes the six people 20 and raises the insurance price once it becomes evident that you can jump it after your diagnosis, then all insured have the incentive to become uninsured and jump in after a diagnosis, so only 20 people purchase the insurance and the insurer needs to raise the price to $100.000 (the price of cures): the temporal adverse selection has completed degenerated the insurance function making it so that there is no actual insurance anymore temporal adverse selection refers to individuals from a similar risk group entering an insurance risk pool after either receiving an adverse diagnosis or otherwise receiving information that increases the odds of having the malady that is the subject of the insurance a common contractual solution is to carve out a preexisting conditions clause in the contract, but this would work only if the firm can cheaply find out any conditions of the buyers long term contracting: two alternative life insurances policies are considered, term insurance and term renewable insurance, term life insurance can be operative for only a short period and the buyer need to undergo health evaluations to renew it term renewable life insurance: one that keeps the insurance in force automatically as long as the insured continues to pay premiums, these cannot be increased, if the individual is diagnosed but can reflect general increases in rates charged by the insurance company to all its life insurance policyholders some solutions to temporal adverse selection insurance companies: protect themselves against temporal adverse selection by invoking preexisting conditions into their policies that rule out payments for maladies that have been diagnosed prior to joining the risk pool B. cross-section selection 9. Lemon Markets and Adverse Selection 8 change societal surplus, however it makes both high risks and low risks better off (the first pay less and the seconds have insurance) cross subsidy low risk insureds pay more than it costs to service them and high risks obtain coverage at a lower price than the cost that they impose on the system, sometimes they are the only feasible solution when there is poor information (often used in insurances and taxes for natural disasters) how to find the change in social welfare from a change in policy: - social gains vs resource cost: identify the value that consumers attach to any changes in quality and compare them to the resource costs of delivering those same values - delta-Q rule: find the change in quantities that result from the change in policy, find the triangle gain or loss - summing up rule: leave the transfers int eh figure, add up all the changes in welfare for each group affected by the change (including pluses and minuses) the result is the net change in welfare adverse selection in the job market adverse selection is just as troublesome in the labour market, after all firms hire workers on the expectation that they will stay with the company for a reasonable period, yer worker quality is not observable at the time of hire as worker look like blank slates as job applicants, their rescue tells them their training but some things cannot be found in a resume, plus honest evaluations have no payoff and create a lot of potential exposure networking one common solution is the concept of networking, as an employer is more likely to receive honest information about an applicant if they know the past employer personally hire at entry level adverse selection is reduced at entry level, the fact that no one is in the market because they left their job tilts the odds in favour of a good hire, plus if the firm makes a mistake in a junior hire it can simply delay promotions and give the person undesirable assignments until they quit therefore an early departure from the initial job evokes a self-selection suspicion, which is why students try to find a job at an institution they think will work out for the long run signaling workers know that adverse selection characterises the market and expect employers to be looking for clues the answer the ‘why on the market questions 9. Lemon Markets and Adverse Selection 9 10. Asymmetric information 1 10. Asymmetric information sorting is a mechanism that allows market participants to discover information before they engage in a transaction; often it’s the seller who has the advantage over the buyer, but this is not always the case, still, bot parties can set up a ‘sort’ to divulge information and make a better choice if the sorting is effective it does not matter who originally had the information or if they know the information is pried from them, anytime market participant make a choice, a sorting function is performed and convoyed example: law firm consider a market for new lawyers, who all think they would like a high paying job but do not realise the amount of work they would have to put in the firm initially chooses them based on performance in school and other factors, and then force them to work way more then required, asking them to solve myriads of cases, work during nights or weeds etc etc junior associates who cannot or do not want to handle the rhythm self select for a early departure from the firm those who stay comprise higher concentrations of highly committed workers choice implies sorting every time a choice is made, a sort occurs and information is conveyed sorting mechanism encourages a productive separation of individuals on the basis of hidden attributes sort always produce self-selection those who do not want this pace of work self-select out of the firm individuals subject to a sort always send signals, either knowingly or not bonds that also perform sorting: the Becker-Stigler Police Model many sorting models are found in the labour market as information there is often poor and the consequences of bad matches between firms and workers can be considerable, for example the Becker-Stigler police model can show how a carefully constructed pension plan can reduce malfeasance A. a Beckler-Stigler pension bond Beckler-Stigler bond the value of a deferred pension for law enforcement workers: upon being caught in malfeasance during his career, a policeman looses his pension, this bond is intended in a way that alters behaviour and create a situation in which crime does not pay policemen are subject to the temptation to engage into crime so, a typical police compensation package includes a modest cash wage, bonds that also perform sorting: the Becker-Stigler Police Model the Spence model of sorting other sorting devices more examples of sorts and bonds 10. Asymmetric information 4 to monitoring older officers efficiency wage a premium that an employer deliberately pays to workers to give them an incentive to stay in employment and to perform according to specifications in the employment contract corollary in an efficiency wage arrangement, the firm cannot hire more skilled workers at the higher wage, otherwise the ‘bonus’ from the perspective of workers disappears E. putting the two bonds together a third solution would be to combine the two bonds, in this case there is no indenture premium as the cash wage matches the alternative wage, the entire efficiency wage is paid in the form of a pension in this example the police department offers compensation equal to $15.000 a year, $5.000 of which is in the form of a pension a solution that pays the efficiency wage in the form of a higher pension trumps a pre efficiency wage solution as it gives a higher bond at all tenure levels without imposing additional costs the Spence model of sorting A. the idea in brief Micheal Spence wrote an article in 1974 on the idea that higher education di not only confer learning but also acted as a sorting device, the general idea is that the market is looking for able individuals for important jobs and that successful college careers are a great way of discerning applicants in a way college students post bonds, a number of years of their lives, out of pocket expenses and the effort to go through with the whole thing, so only the most able students apply and finish college Spence education bond model schooling is a kind of hurdle system in which students are required to divulge information about the attributes that like will affect their performance on the job market, the system forces self-selection up front: more able students are more likely to select themselves into the pool of applicants B. application to law school we can view law school from Spence’s perspective as a series of hurdles, which students have to clear with various attributes valued by law firms among college students contemplating the cost of attending law school, the cost seems higher to those who have doubts or are generally unsuited for this amount of work, after all students are required to put substantial out-of pocket money and devote large amounts of time to study C. pursuing the model one step further law school essentially delivers a market a bottom line index which incorporates the end result of students attributes , both observable and not and ranks them in the form of grade sheets and class rankings 10. Asymmetric information 5 so prospective students who have the right attributes to perform well in a legal environment see lots of payoffs to a law degree with a high ranking while those who regard themselves as unlikely to attain a high ranking might see the cost as more than payoff the hurdle system improves the quality level of the incoming pool and helps ensure that within this pool, the proper hierarchy of success is conveyed to employer sorting continues though the grade system from the pool of promising entrants, law schools and other institutions sort among the able group to ensure a proper hierarchy, the ranking coveys information about relative performance to the market that helps ensure an efficient allocation of graduates to available jobs other sorting devices A. sick leave why do firms offer sick leave? usually people who take it use it as annual leave instead of sick leave, thus from the perspective of the employer, workers who are unreliable are less valuable then those who show up on a routine basis suppose that sick leave is not a free benefit, but a sorting device to encourage workers to show their propensity to take time off if it appears free, workers who use sick leave earn a reputation for unreliability, those who eschew it gain a reputation for reliability paid sick leave is a sorting device it sorts on the basis of reliability, as reliable workers pass up the opportunity to take free time off and thus send a signal of high quality to the firm reliability wage premium develops when firms fill more important jobs, they select candidates from the pool of reliable workers, leaving sick leave users in less important jobs, in an equilibrium, reliable workers work more and get paid more while unreliable workers take more time off and get paid less B. sorting on the basis of discount rates we could also sort on the basis of a worker’s discount rate, which is the degree to which workers value the future versus the present suppose there are two types of workers: high discounters, who care more more about leisure and consumption today and low discounters, who attach a lot of value to the future low discounters attach value to consumption today and in the future, they can see the future benefits in terms of promotions and such, they are savers high discounters attach disproportionate value to current consumption and leisure and care little about the future, they save little and highly discount future values so a firm values low discounters more than high discounters because it knows that low discounters are self motivated to work harder for the benefit of future promotions 10. Asymmetric information 6 plain vanilla defined contribution pension a pension plan in which the firm contributes some percentage of pay into a worker’s account which accumulates interest the balance does accrue interest with time and, as the worker has property rights on it, can take the balance of the account upon departure from the firm, if he stays, however, he cannot touch it however the difference between the two is not apparent when they are hired, and to differ between the two the firm could offer them a simple contribution pension plan in which the firm does not promise an annuity at retirement but build a tax-preferred savings account for the employee while a low discounter attaches a high value to the pension, a high discounter does not, and will quit to access the balance in his account immediately to have a clearer picture on can see discounters on a spectrum: the highest discounters will quit immediately, the second highest will wait a year, the third highest will wait 2 years and so on, sooner or later all the high discounters will select themselves out defined contribution plan sorts on the basis of worker’s discount rates by forcing each worker to same some of his compensation in a pension account the firm sets up a choice: either stay and accumulate or quit and obtain access immediately to a smaller amount high discounters tend to gravitate towards firms that have no pensions and that pay compensation directly in the form of cash wages, which means the compensation levels are lower C. 401(k) pension plans a 401(k) pension plan can also be used a sort for discount rates by giving workers the choice on whether to adhere to the plan which entails saving up x percent of pay in the pension to which the firm promises to match these contributions up to some percentage of the pay low discounters will accept the plan, save the 10 percent and receive the 5percent match as they attach substantial value to the match, on the other hand high discounters pass up the offer 401(k) pension plan is a sorting device by offering a matching amount on worker contributions to a pension plan, the firm encourages workers not only to divulge their discount rates, but to also add just their own pay to this basis D. a postscript on Becker-Stigler: the role of high discounters we could also revisit the Becker-Stigler model after having analysed high and low discounters: and consider the possibility: what if high discounters enter the police force? to them the pension payoff has approximately zero value! this is why it is important for the police cash wage to fall below alternative job options, because a high discounter will view the cash wage as disproportionately important, additionally if high discount rates present such a problem, the police department could seek out evidence of low discount rates (college, non smoker, etc) 11. Moral hazard and agency problems 2 chances of a fire, these are ‘units of care’ more units of care are used the more the marginal effects falls but it is not costless for homeowners to engage in care, especially if they go beyond basic units of care, without insurance, the homeowner would engage in C0 units of care, the point at which MC=MB care with insurance suppose that, out of concern that fire could degrade a large portion of their wealth, the homeowner decide to purchase fire insurance assuming a competitive insurance market, the premium for this policy covers the expected cost of fire, plus some assessment to cover the administrative cost of insurance, also the insurance is complete so that the full amount of the loss, H, is covered at this point the homeowner will not act with the same level of units of care as before, as now it imposes no cost, this situation creates a moral hazard, because homeowners act as though the benefits of care are zero, while the socially optimal level of care C0 is still optimal the insurance does not change the social benefits of care, but the private benefits the moral hazard of insurance insurance conveys value to consumers as it rids them of the worry of losing wealth to some event, but once insurance is in place, insured lose some incentive to exercise proper care and, doing so, increase the likelihood of the event, insureds act as though risk is costless even though it is not C. the free lunch example moral hazard can also be found in a mundane situation such as splitting equally restaurant checks, because in their case every food item on the menu that has a price Pi, now carries a value to each person of 1/n of Pi, because they perceive it so, but by behaving like this the total cost of the bill is driven up the larger the group, the more the bill will rise because the perceived price depends on n, number of diners, at which point some people will self select out of the event, in order not to pay more the moral hazard problem is distinct from adverse selection because when people change their behaviour due to the perceived or not underpricing of a resource it is moral hazard, but when the underpricing affects the composition of consumers it is adverse selection D. limits on moral hazards coinsurance moral hazards do not imply an absence of control over the ‘overuse problem, on the other hand, insurers often impose a coinsurance feature, for example, in the fire insurance example, the insurance will no longer cover the full damage H, but only two thirds of it, the rest will take the form of the inconvenience of staying in an hotel room or the loss of heirlooms, family photos and cash 11. Moral hazard and agency problems 3 now that the homeowner absorbs 1/3 of the cost he perceives the marginal benefit of engaging in the i unit of care as a third of the total benefit amount B, in a potential scheme of the situation the difference between the two downsloping figures show the benefits of care that accrue to the insurer which results in reduced premium to all insurers people still engage in too little care, but the cost of moral hazard is reduced pricing the insurance premium sometimes can be tailored to reflect different levels of risk exposure across insureds, the insurer forces covered individuals to internalise the benefits of more care maybe it would be helpful to consider situations in which differential risks are not priced, which come exclusively from the government, which will offer insurance (often for natural disasters) at prices that are less than expected losses, by subsidising the insurance the government encourages moral hazards so that people will inhabit places they normally would not as the government does not allow them to internalise the full cost of their decisions for example San Francisco is prone to earthquakes, but people still live there because US taxpayers as a whole absorb the costs int he form of an implied bailout in case of natural disaster, a moral hazard is introduced reputation value a more subtle control over moral hazard is reputation value: if a person shows they can restrain themselves from succumbing to moral hazard we can consider them trustworthy because we can depend on her to engage in an efficient level of care in a long run, moral hazard’s effects can diminish thanks to agents who act as though the price equals the social cost, if we see the sick leave example workers who do not take time off act as though they recognise the social cost of taking time off and by doing do gain positive asset value reputation value as a constraint on moral hazard market participants that repeatedly engage in socially optimal behaviour, even in the face of moral hazard gain a reputation for trustworthiness this idea is an application of quality assurance premiums, because by resisting the temptation of moral hazards, the high road types create a reputation for trustworthiness tie-ins tie in sales can also play a role in reducing moral hazards, as when purchases such as new cars come with a warranty moral hazards are present, which is why they tie in the cost of all servicing in the price of the car because the company knows that, when faced with a zero marginal cost customers will bring their car in for checkups more often 11. Moral hazard and agency problems 4 E. moral hazard will not necessarily stop the market the presence of moral hazards and adverse selections will not doom the market, the latter will still exist, it will just present some imperfections, for example, wile insurance policies do carry some level of moral hazards, the possibility that people will go out of their way to injure themselves to have the money is relatively low the market works this does not mean that the market confers maximum surplus obtainable with full information and no transaction costs, but that the market has found the optimum solution, given all the costs , also when information is costly it might be optimal to have some moral hazard when markets will not survive these problems it means that it is not optimal for that market to exist pre-commitment as solution to ex-post moral hazard: health insurance sometimes moral hazard is handled with a pre-commitment contract, and a good example of this is health insurance A. the moral hazard problem suppose that all patients in Firm X have the same preferences in decisions on medical care and that the odds of someone being diagnosed with a serious illness make it so that 100 out of 10.000 employees are going to be diagnosed with a life threatening illness from the table notice that the process of deciding of willingness to pay for higher probabilities of living yields information about the value of life so workers should decide whether they want a policy that covers one, two, three, four or five procedures, this decision depends on expected medical outcomes and the premiums to determine premiums one can cumulate the cost of sequential treatments and divide by participants, in making this decision workers implicitly decide to limit the amount they spend to reduce the probability of dying B. consumer surplus demand for health care to show this solution one must convert the information to optimum care in reality, many incremental units of medical care could be undertaken not only 11. Moral hazard and agency problems 7 agency cost also arise in the context of brokerage services: after all if brokers earn commissions when they trade, they have an incentive to trade stocks too much, acting contrary to the commissioner’s best interests, if, on the other hand, brokers are paid a flat fee, they have an incentive to trade too little, the whole situation is created from a lack of information firm ownership another venue of agency costs are corporate finance literature: as shareholders may be many, it can become difficult for them to ensure that managers are maximising stock value and that are not taking advantage of moral hazard, the crux here is asymmetric information, which is why stock options are given to high officers, so that if the company looses money they do to this solution can however create a secondary problem: managers can just create short term wealth, this can however be corrected through the notion of reputation, if someone has the reputation of being reliable then there is more chance of the board approving of him a royalty problem another problem could be a patent for a new idea: a manufacturer might set the marginal cost as marginal revenue, but doing so they reduce the inventor’s profits by setting the price higher to the inventor’s marginal cost, a principal- agent problem is created this could be solved by the innovator selling the idea to the highest bidder or enforcing a minimum output restriction, but in reality, if the idea is not hat important, a royalty is the only way to go agency costs and rent erosion: tort lawyers A. the reimbursement theory the relationship between tort lawyers and plaintiffs is also a good example of a classic agency problem, which is also characterised by rent erosion, so let’s consider the usual example of lawyers incurring the costs of the suit and that they are compensated by 1/3 of the judgement they win, let’s also assume that there are no fixed cost to running a law firm the lawyer must decide the quantity of the legal service, as to say the units of care (care here is a homogenous measure of things to do to enhance the client’s chance at winning B. the principal-agent problem by looking at this with a schedule, it looks like the more care is expended on the case, both the judgement and the likelihood of winning increase, but at a diminishing rate (downwards slope), if the client had legal knowledge they would get the entire judgement, but they do not, they also don’t have enough information to know the necessary units of care or their benefits an agency cost arises: the lawyer maximises the firms profits by setting MC=MB/3 and as a result engages in too little care, their and the clients’ best interest are not aligned 11. Moral hazard and agency problems 8 C. implications of rent erosion if the tort lawyer expects to earn excess profits, this will create entry so law firms will compete for cases in an attempt to gain surplus, this competition can be seen as: firms that gain a reputation for winning more often improve their chances at getting more cases rent erosion works to diminish agency costs in the case of tort reimbursement and other shared payment schemes to win more cases, more units of care should be expanded, so competition drives units of care to a level that ensures zero profit, so even though rent erosion in most cases is seen as wasteful, in this case it can improve welfare if law firms have fixed costs than the prior solution is modified but the problem remains: if fixed costs are equal to rent erosion the units of care are in equilibrium, if fixed costs are lower, either competition or investment will increase the rest erosion 12. Game theory 1 12. Game theory game theory a tool that allows other players to improve their information by putting themselves in other player’s shoes and then choosing their optimal course of action basic concepts in game theory A. how the game works a dating game is a good example to illustrate game theory: Shawn and Mary like each other but do not want to reveal it, they could either hang out at the movies or at the bowling alley, Shawn attaches a value of 1 to the first and Mary attaches a value of 1 to the second the problem has two choices and fits into two- by-two decision matrix, this is usually called the normal form, in these problems one player is arrayed along the side and one is placed on top and the payoffs are written in each cell normal form of the game is a simple decision box used to illustrate the game in a simplified way, it is however not the only way to illustrate such a game since the two do not know each other’s preferences, the only payoffs that appear are those that reflect their own interests; Shawn prefers the movies regardless and Mary the bowling alley, they both have dominant strategies dominant strategy an action that is always optimal for one player no matter what the other does this is an uncooperative game, while in a cooperative game Mary and Shawn would talk to each other cooperative game one in which both parties find a solution through an agreement, either implied or contractual, it usually yields better results then uncooperative games noncooperative game a game in which the parties do not enter into formal agreement but make strategic moves based on their estimates of payoffs and rational decisions by other player the dating game is characterised by simultaneous decisions, on the other hand in a sequential game Shawn can make his move knowing Mary’s decision, this basic concepts in game theory practical applications institutions and cooperative outcomes how legal standards change the payoffs quasi monopoly markets 12. Game theory 4 there is going to be some negotiation to make it seem like that both have given away some surplus: deals are more likely to be killed if one or the other party insists on iterating to the edge of the contract curve if there are many buyers and one seller, then it is more likely that the deal will maximise the surplus of the buyer, but if there are only two parties chances are they want to leave the other with some surplus B. irrational behaviour wasted interview costs if in the game of the hiring process one of the two parties is irrational things can change because if the rational party estimates that the expected cost of irrationality (percentage) outweighs the benefit maximin strategy a decision by a rational player that avoids the possibility of a large loss instead of one that generate a little gain - the solution often arises when there is an asymmetry between gains and loss and when there is some chance that one player is not interpreting the other’s payoff correctly in general when there is a large asymmetry between the gain and loss from a decision, then sometimes a rational player will choose the strategy that maximises of incurring minimum cost from an error: maximin strategy C. the game in a mugging another Maximin example is a mugging, there are witnesses around the park, and depending on whether the victim thinks the mugger is reasonable, a sequential game ensues: if the victim thinks the mugger is reasonable the victim realises that the mugger will not shoot regardless of whether, this is inferred by the fact that the muggers’ payoffs are higher if he does not shoot therefore the thug has a dominant strategy: to not shoot as a consequence Dick says no and the mugger leaves empty handed if the victim thinks the mugger is not reasonable the victim figures that if he gives over the money, it is optimal for the mugger not to shoot, but if the victim says no, it is optimal for the thug to shoot Dick knows that there are two possible outcomes: he hands over the money and doesn’t get shot or he does not hand over the money and gets shot Dick prefers the first option and to obtain this result he says yes institutions and cooperative outcomes the role of institutions often is to change the rules of the game as for the players can attain the cooperative solution 12. Game theory 5 A. the prisoner’s dilemma the prisoner’s dilemma can be ‘solved’ by going to both of them confessing to neither of them confessing just by introducing an institution who can change the payoffs to make the ‘do not confess’ the most profitable option by adding to the cost of bot confessing B. common resource problem assuming there are only two suppliers competing for a project, either one of the two or both can hold up the contractor and getting all the money available, this result means that no developer will invest in a similar project the solution here is that an institution can arbitrarily allocate the shares in the holdup enterprise on an equitable basis, after all payments are made all players must cooperate to finish the project on time, the fee/share facilitating this transaction is called vigorish vigorish a term of art that means a cut or a piece of the action collected by the house, it is the difference between the monies paid in and the monies received by suppliers of the produce C. public goods problem suppose that an enforcement of protection of the neighbourhood is a public good, as such, once the enforcers are in the neighbourhood its inhabitants get the protection whether or not pay their share of the costs so no one pays and enforcement happens anyway the solution can happen through the involvement of the institutions who enforce the payment through extortion how legal standards change the payoffs A. level of care let’s consider drivers and cyclists, the first has the possibility to drive slow or fast and the second can wear a helmet or not, their decision on either option depends on the legal standard in place: drivers are considered blameless regardless → the dominant solution for the driver is to drive fast and the dominant solution for the cyclist is to wear helmet strict liability standard → the dominant solution for the cyclist is to not wear the helmet while the driver’s dominant solution is to go slow contributory negligence standard → the dominant strategy for the cyclist is to wear a helmet while the driver’s dominant solution is to go slow B. externalities if airlines are not held responsible for the noise, then a Nash equilibrium is some solutions could be: 12. Game theory 6 found in the solution in which mufflers are not installed by the airline and the homeowners install triple pane windows, this is not the socially optimal solution homeowners could install the mufflers themselves (cost is less then windows) a noise tax can be installed airlines can be held responsible for their negative noise externality quasi monopoly markets consider the role of game theory in the subsequent ‘special’ market types: perfect competition → each individual plays a game vis a vis the market and has a dominant strategy: no matter what price is announced, he sets output to the point where marginal cost equals price monopoly → if you can consider the agglomeration of consumers as the other party and the consumer’s reaction function as the demand curve, so the monopolist has a dominant strategy: given any demand curve set output where marginal cost equals marginal revenue A. the Cournot model game theory discussions of markets start with a presentations of the Cournot model, a simple model that determines market price and quantity in a market with 2 producers take two procedures of the same product and with no possibility of entry, there are no fixed costs, marginal cost of producing is constant but not the same between firms, and the demand curve is a line, there is also no communication, they observe each other’s output and choose their own based on this information because of the way it is structured the easiest way to find the Nash equilibrium is to eliminate all the scenarios that cannot be the solution (cooperating is not a possibility because of the tendency to cheat B. other models first mover advantage refers to any solution in which the first that makes a decision nets some advantage over the second, in the Stackelberg model, there is a first mover advantage, but it is not present in all models tit-for-tat strategy possible if the game lasts many periods, in it whatever output firm 1 chooses, firm 2 is going to choose the same output or at least a sufficient output to drive the price to zero, and so firm 1 is coerced to make a deal with firm 2 to split the profits 50/50