Riassunto del libro "Economics for Lawyers" di R. Ippolito per Economia Politica in inglese, UniTn, prof. Maggioni, Dispense di Economia

Scarica Riassunto del libro "Economics for Lawyers" di R. Ippolito per Economia Politica in inglese, UniTn, prof. Maggioni e più Dispense in PDF di Economia solo su Docsity! Indifference Curve Satiation: if a basket A contains any bigger quantity than the quantity in basket B, A must be preferred. 
 “The more of a good one possesses the less one is willing to give up in order to get more of it”. Non-satiation: if there’s a basket but I don’t need its content, I won’t choose it. It is often preferred a basket which has less quantity of more goods, than one with more quantity of less goods Indifference Curve: it is a functions that tells the various combinations of goods that make a particular consumer indifferent. They always slope downward and follow the axiom “more is better”. Characteristics: 1. They are convex to the origin due to the diminishing marginal utility (higher value to the first units of consumption and less when he has abundance of them) 2. There are an infinite number of indifference curves 3. They never cross each other → if in one A = B and in another A = C, B should be indifferent to C, but it can’t be possible because they contain a different amount of goods even though they are both parallel to one or the other axis. 4. Different consumers have different indifference curves. They are personal for everyone. 
 Edgeworth diagram: depict the curve of one part normally and the curves of the other part in reverse, creating a “cigar” shape. 
 The “cigar-shaped” area created by the intersection of the two indifference curves is the area where both members of society can reach a position where they are both better off. Pareto superior: when one is better and the other is not worse off, but at least remains in the same position.
 Pareto optimal solution: when the two indifference curves are tangent; where both are best off and if they change something for something else, at least one of them will be worse off.
 The pareto are infinite. 
 Contract line: the connection of all the points where two functions are tangent. Budget line: I=PxX+PyY
 The budget constraint tells us how many units of the two goods the consumer can obtain if he spends all his money in one or the other good. The optimal solution is where the indifference curve is tangent to the budget constraint. Marginal Rate of Substitution (MRS): it is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility. At equilibrium consumption levels (assuming no externalities), marginal rates of substitution are identical. MRS indicates the slope of the indifference curve. If the curve is a line, MRS=k, otherwise it changes from point to point. Compensation principle Compensation principle: a change in utility brought about by either a change in price or other interference to the market can be translated into a dollar value by searching for the increment in income that restores the original utility. 1 Substitution effect / price effect: the choice moves on the same curve – the price of a good falls relative to the other, meaning that the consumer’s new optimum allocation will be more favourable to that good that to the other. Price effect is always negative. Income effect: the less the price, the higher the utility – more goods are purchased. Anatomy of price change: If the price of X falls, then, owing to the substitution effect (also called the price effect), the quantity of X consumed increases. The price effect is always negative. Owing to the income effect, ruling out exceptions, more of X is purchased as well as more of everything else. Mums and tulips Using compensation principle to calculate damages: 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. [cfr. 26/09 §§1ss.] Zero substitution: Two goods have zero substitution when, in a compensated sense, the consumer always chooses the same bundle of these two goods regardless of price. It is indicated by the Leontief function, called “L” function due to its shape. U=min[X,Y] First lesson about reputation value: There is a cost to reneging on a contract because it builds a reputation for unreliability. The benefits of dealing with an unreliable person are lower than those of dealing with someone with a reputation for honesty and trustworthiness. Corner solution: When considering two goods, a corner solution occurs 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. Demand Curves and Consumer Surplus Demand Curve: it depicts the relationship between price and quantity consumed, holding constant utility and other prices. They are always downsloping and quantity demanded increases. Compensated demand curve: The relationship between price and the optimal quantity consumed for some good, holding constant the consumer’s income (really, level of utility) and other prices – utility is constant. Uncompensated demand curve: The price-quantity relationship not subtracting out the income effect. Utility levels increase along the uncompensated demand curve – cost of optimal basket is constant. A Demand Curve: Two Perspectives Viewed along 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. Viewed along the vertical axis, the demand curve represents the maximum price that a consumer is willing to pay for each additional unit of consumption. This perspective is sometimes referred to as the “inverse demand curve”. The demand curve is downsloping because of the diminishing marginal utility of further consumption. On the margin: The consumer is willing to pay more for the 1st unit of clothing than he is for the 2nd or 3rd, and thus, it is important to distinguish that we are referring to value for the marginal unit. When we talk about the “value the consumer attaches to clothing consumption on the margin,” it means the value he attaches to his last (or marginal) unit of consumption. 2 3. Third, this is a fortunate outcome because we never observe indifference curves and seldom observe individual demand curves but often have estimates of market demand curves. Ergo, we can measure surplus from observable demand curves, and we can put these estimates in dollar terms. Surplus is the dollar value of “utils.” We can use the compensation principle to attach a dollar value to changes in utility. Tax revenue TR equals the tax rate, t, times the quantity of the good demanded after the tax, Qt . ∆Q Rule: Deadweight losses come about because market output is different from the efficient solution. Call this change in output Q. The deadweight loss is a triangle located directly above Q. 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 this ratio can be expressed by a simple formula: 
 ξ=DW/TAXREV=1/2|ητ|τ (NB: lower is better) ητ: -b·P/Q τ=%T/(P+t) If η=0 → no DW Sum-up Thus far, while we have covered a lot of ground, the critically important lessons that have been conveyed boil down to a precious few. Free choice. Free choice is an important feature of economics. The value of $100 in income is not as high if consumers are restricted from allocating these monies to maximise their utility. It matters whether mums and tulips are planted in a particular proportion. Gains from trade. Left to their own devices, if the net surplus from doing so is positive, then market participants will find ways to trade with each other. Think of the two consumers in the Edgewood box or consumers trading dollars for goods as long as surplus from marginal units is positive. This principle is general and shows up under various guises throughout economics. The compensation principle: Changes in utility can be approximated by dollar values. In principle, we can ask participants, “How much would it take to make you whole?” which teases out a dollar value of changes in utility. Distortions are costly. Anytime that free-market outcomes are distorted by either taxation, regulation, or monopoly pricing, a deadweight loss is imposed. Even though resources flow elsewhere to produce something else, we do not end up with the same utility from the production and income that are generated. The efficiency of those dollars has been reduced because we have imposed artificial distortions in consumer choice. This principle is a natural outgrowth of the first three points. Demand curves are downsloping. Consumers demand more of the product the lower its price. This fundamental reality, which stems naturally from the principle of diminishing marginal utility, limits revenues obtainable from artificial increases in price and is the underlying reason why “distortions” characterise most price changes that are unrelated to the cost of production. A shorthand description of demand conditions is given by demand elasticity. Supply curves and Flow of Resources Marginal cost curve: The schedule that denotes the cost of producing each unit on the margin. It is to be distinguished from the average cost of producing all units, because the latter concept is the average of marginal costs incurred in the production of each unit. Individual supply curve: A schedule of quantities offered as a function of price. It is the marginal cost curve. Market supply: The horizontal summation of marginal cost curves offered by each individual supplier at each price. Optimal output for each supplier: Each supplier determines output by setting price equal to its marginal cost of production P=MC. Any other output reduces its surplus. 5 Producer surplus: The difference between market price and the marginal cost of production. Hence, total producer surplus is the area above the supply curve but below market price over the range of output supplied. Equilibrium price: Equilibrium price is found where the supply schedule intersects with the demand schedule Qs=Qd. At any output lower than this, there are net gains to trade that can benefit both producers and consumers. At any output higher than this, consumers are unwilling to pay the marginal cost of bringing the marginal units to market. In equilibrium, all consumers are satisfied who are willing to pay the marginal cost of the last unit willingly supplied by producers. To learn more about a “sustainable price,” I need to consider two kinds of costs: - variable costs, which vary with the amount of output - fixed costs, which are independent of output. A firm’s revenues must be sufficient to pay for both variable and fixed costs Average variable costs. Average variable costs are the sum of the marginal costs of producing x units, divided by x. 
 Average variable cost (AVC): The average of all the marginal costs incurred in producing quantity q. AVCq=MC1 + MC2 +…+ MCq/q If the marginal cost increases with output, then AVC is less than MC at every unit of output. Fixed costs: Those that do not change with output level.
 Average fixed cost (AFC): Fixed cost, F, divided by quantity produced, q.
 AFCq=F/q
 As output levels become high, AFC falls toward zero. Economic cost and economic profit: Economic costs 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 profits, also referred to as excess returns, excess profits, or abnormal profits, are those that exceed the competitive rate of return on investments Average total costs. Average total cost is the vertical summation of average variable cost and average fixed cost Average total cost (ATC) equals variable plus fixed cost, divided by quantity supplied. To derive the ATC, add the average variable and average fixed costs vertically at each output level. To obtain total costs, TC, multiply average total cost times quantity. ATC = AFC + AVC 
 TC = ATC•q The marginal cost curve (MC) intersects the average total cost (ATC) curve exactly at the minimum of ATC → minATC=MC Sustainable price, P*: That price at which there are forces neither attracting entry into the market nor encouraging exit. A sustainable price is one that generates a competitive return on investments in this industry. It corresponds to the output level where average total cost equals marginal cost: Q@ATC=MC To understand equilibrium, it is useful to recall three rules we already know. 1. First, the supply curve for any firm is its marginal cost curve. 2. Second, industry supply is the horizontal summation of all the individual supply curves in the market. 3. Third, each firm determines its output by setting marginal cost equal to price. These market characteristics of the solution are not affected by the discussion of a sustainable price 6 Profits as a 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 price is sustainable when excess profits are zero. When π=0, P* By working through the dynamics of disequilibrium price, we have segued into the notion of long-run supply. In the short run, supply is the horizontal summation of all marginal cost curves in the industry. The idea of a sustainable price, say P*, tells us that if demand increases or decreases so that price wanders from P*, entry or exit will reestablish the zero-profits condition. 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. Sometimes this condition is referred to as a “constant cost industry.” Producer surplus, Long and Short Run, Economic Rent Producer surplus in the short-run sense: Even at the 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; hence, any excess is surplus in this limited sense. If the supply of inputs to an industry is increasing in price, then there is a separate sustainable price for every level of demand. Short-run: at least one of the production factors is kept fixed. Long-run: the time in which production factors can vary. Production cannot grow to infinity as there is at least one fixed factor, which makes impossible to the production to grow. Economic rent: The excess of price paid to some input over the price at which it is willingly supplied. Normally, the term rent is used to describe surplus in an input market, and producer surplus is used to describe surplus in a final market. But often, the terms are used interchangeably. The concept of rent has a permanence to it, in the sense that it is consistent with long-run equilibrium. The long-run supply price is a schedule that shows the combination of quantity supplied and sustainable prices at each quantity level. Review of Terms
 Multiple sustainable prices in a long-run sense: Given a demand curve, there is a unique sustainable price that equates the forces for exit and entry in an industry. If the supply price of some input is upsloping, then the sustainable price is higher at a higher level of demand. Long-run supply curve: Describes a schedule of sustainable prices consistent with every possible level of demand. Producer surplus in a long-run sense: The area above the long-run supply curve but below price. It is rent collected by inputs that have an upward-sloping supply schedule. Increasing cost industry: cost for which the sustainable price increases with successive levels of demand. Constant cost industry: cost for which the sustainable price is unique regardless of the level of demand. Sometimes you will hear the phrase “assume constant cost over the relevant range.” This means that we want to abstract from the second-order consideration of a different sustainable price within some problem we are studying Short-run impact of a tax on good x: Quantity demanded falls, price paid by the consumer increases; price received by producers falls; the government collects tax revenue equal to the tax rate times the quantity demanded at the new price TR=tQ; consumer and producer surplus fall by more than the amount of tax revenue, thereby creating a deadweight loss Long-run impact of a tax on good x: If a unit tax is imposed on some product: price paid by the consumer increases by the full amount of the tax; quantity demanded falls by more 7 Monopolist Percentage Markup and Demand Elasticity The greater the (absolute) demand elasticity, the lower the monopoly percentage markup over competitive price. If M is the percentage markup, then we have: M=(-1/1+η)100 where -η>1 Where η is the elasticity of demand at the monopolist’s optimum quantity (remember that it is negative and greater than unity in absolute terms). If demand elasticity around the optimal price is 5, then the markup is 25 percent above competitive price, but if is 2 then the markup is 100 percent Some Rules About Monopoly Price A monopolist:
 1. Chooses either price or quantity, not both. 
 2. Chooses the profit-maximising price, not the highest price.
 3. Chooses an output where absolute demand elasticity exceeds 1 (elastic demand). 4. Sets a price that is closer to the competitive solution, the lower the absolute demand elasticity in the relevant range. The effects of monopoly pricing are akin to setting an excise tax that maximises tax revenues from some market. The result in either case is lower output and a “triangle loss.” There is, however, one further consideration: a private party (the monopolist) pockets the tax, which ultimately creates a market for monopoly Market for monopoly: Refers to natural forces in the market to expend resources to obtain a monopoly, either by lobbying government, trying to effectively collude with other firms, or perhaps by finding a patent. In the market for monopoly, we expect the same competitive return on investments as in any other market 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 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. Thus, the probability of winning is 1/N. A competitive market for monopoly is in equilibrium when there are sufficient participants so that the chance of winning the prize, times the prize amount, equals the cost of playing, CP=(1/N)PRIZE The social cost of monopoly: Equals the deadweight loss from the restriction in output plus the total amount of excess profits (ScM=DW+π). The erosion is incomplete if some inputs to the market for monopoly have a rising supply schedule, in which case some of the surplus will become economic rent. 10 Price discrimination: The term used when a firm sells 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 If a monopolist can separate markets based on different demand conditions, he almost always can earn higher profits by charging different prices 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 every consumer, less one penny. In this solution, the entirety of consumer surplus is converted into excess profits. Unless substantial economic rents are earned by some inputs in the market for monopoly, the social cost of monopoly is higher under perfect price discrimination as compared to a one-price solution Tie-in: A requirement to purchase product B as a condition of purchasing product A. Often a tie-in can help a firm with market power extract more consumer surplus Auctions extract surplus from buyers in markets in which there is either one or just a few sellers Price discrimination can exist in competitive markets under a variety of conditions as long as fixed costs are important relative to variable costs. Common examples include time-of-day or time-of-week price differences (as in movie theatres, restaurants, golf courses, and airline seating), perishable goods (ripe produce and near-old meat in grocery stores, an airline about to fly with an empty seat), or joint supply conditions (as in the allocation of common fixed expenses in grocery markets). Price discrimination in competitive markets always expands output and increases consumer surplus. Thinking about price discrimination. Price discrimination is a characteristic of markets where there is some element of monopoly pricing and in some markets that are perfectly competitive. In one case, the enhanced profits generated from separate pricing are “bad” because they generate higher profits and thus attract more rent erosion. In the other case, they are “good” in a Pareto sense because all consumers are better off and producers are no worse off. Hence, from a public policy perspective, price discrimination alone is insufficient to conclude that sellers have market power Cheating: The tendency of participants in a collusive scheme to violate their assigned output quota. While each hopes to earn more excess profits at the higher price, their collective action increases output and drives price back toward competitive levels Prisoner’s dilemma: The general finding that when unable to explicitly collude, criminals have a natural tendency to cheat on each other, a process that tends to give these participants the worst outcome as a group A public good has three properties: Its production is characterised by lots of fixed costs; its consumption by one person does not affect the ability of other consumers to enjoy the same product; and it is difficult to collect a fee from consumers who enjoy the benefits of the product. Fireworks shown at ground level inside a stadium satisfies the first two principles but not the third because the owner can charge admission. Fireworks shown one thousand feet in the sky above the stadium has all the characteristics of a public good. It can be enjoyed by a limitless number of people within sight of the fireworks without affecting the enjoyment of anyone else, and it is hard for the owner to collect a fee from all the individuals enjoying the show. Market demand for a public good is the vertical summation of individuals’ demand curves. Each user can enjoy the good without interfering with others’ enjoyment. An example is fireworks shown high in the sky. 11 The optimal amount of a public good is determined by the equality of the aggregate value that users attach to the good and the marginal social cost of providing it. Public Goods and Common Resources Rival goods: can be consumed by only one consumer each eg. Cup of ice cream can be consumed by me OR another.
 Non-rival goods: can be consumed by some consumers at the same time eg. Radio signal. Excludable goods: someone can be excluded by their use eg. apple.
 Non-excludable goods: no-one can exclude somebody from their use eg. oxygen A public good has three properties: Its production is characterised by lots of fixed costs; its consumption by one person does not affect the ability of other consumers to enjoy the same product (production is not mutually exclusive); and it is difficult to collect a fee from consumers who enjoy the benefits of the product Free rider: One who reaps the benefits of someone else’s investment without paying for it. 
 One cannot free ride on the purchase of a private good like an ear of corn because one needs to pay for it to have the opportunity to enjoy it. Market demand for a public good is the vertical summation of individuals’ demand curves. Each user can enjoy the good without interfering with others’ enjoyment. An example is fireworks shown high in the sky. The optimal amount of a public good is determined by the equality of the aggregate value that users attach to the good and the marginal social cost of providing it (SMB=SMC) A patent is the award of property rights to a new idea for a limited period. It allows the holder to set a price like a monopolist, the idea being that the excess profits can provide a way for the innovator to recoup its R&D costs. A patent does not solve all public good problems, just those that can be embodied in a product that cannot easily be reproduced outside the factory. If a person holds a patent on fireworks, he still cannot collect fees from everyone who enjoys his display. Record companies have been losing their ability to recoup their investments in songs because new technology facilitates copying music outside the factory. The value of a patent is proportional to the value added by the idea. Thus, consumer valuation is the driving force in the market for new ideas. This is the main attraction of the private production of new ideas The social costs of a patent monopoly equal the usual triangle welfare loss owing to restricted output, plus monopoly profits. These profits equal R&D expenses incurred by the winners and losers in the patent race. Social cost of the patent = Deadweight loss + π If society is too generous in paying for new ideas, it encourages the erosion of more of the surplus from innovations in the form of wasteful competition. If it pays too little, it risks losing lots of innovations that confer large amounts of surplus to society. Owing to lack of information, we do not know which level of generosity toward innovators generates the most surplus. 12 Goods Excludable Non-excludable Rival PRIVATE GOOD COMMON RESOURCE Non-rival ARTIFICIALLY SCARSE GOODS PUBLIC GOODS Transactions costs in the context of public goods and externalities usually are information-gathering costs. The information is the relevant set required to strike a deal When transactions costs are zero, all the surplus from the optimum deal is realised Solutions to allocate rights to the social optimum: 1. Benevolent dictator (50/50) 2. Regulation of the government 3. Vertical integration: it means that a producer buys an input into its process. Vertical integration often is motivated by the promise of reduced transactions costs, which in the context of the Coase theorem can offer a way to deliver the socially optimum amount of some externality. 4. Contractual solutions such as tie-in sales 5. Rights (to make noise or else) and internalisation 6. Corrective taxation aka Pigouvian tax: it is one that brings price closer to the social marginal cost of production and hence improves welfare. The introduction of a tax can change the people’s behaviour and reach the social optimum. The introduction of noise abatement equipment changes the optimal amount of noise. It pays to expand the number of flights and reduce the total number of noisy flights If the tax on a noisy flight is set to MCA plus a penny, airlines will put mufflers on 80 of their flights, including the first 33 flights because it is cheaper than paying the tax on noise. This outcome creates waste measured by area G in panel (b). If the tax is set to MCA minus a penny, then the airlines will not attach any mufflers because paying the tax on noise is cheaper than eliminating it. Pollution in the Workplace Information almost always is a substitute for intervention in the form of either tort law or direct regulation or taxation. “Lack of information” is the underlying rationale for intervention in private contracts; that is, the information problem is what triggers reactions like those observed when parties impose harm on a stranger The “demand curve” for cleaner air at work measures the amount that fully informed workers on the job site, as a group, require as compensation for absorbing each small increment of air particulate. The area under the demand curve over the range of pollution that exists on the work site is the total amount of compensation required by workers to tolerate it Every action has an opportunity cost. Dirty air is costly to the firm in the form of higher wages. Clean air is costly to the firm in the form of pollution abatement costs. The firm’s task is to find the solution with the least cost How to obtain the socially efficient solution: 1. Contract: 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 expected benefit from regulation or the judicial process. Harm is just another commodity that trades at a market-clearing price 
 The buyer could not recover damages from the seller for defects on the property that rendered the property unfit for ordinary purposes. The only exception was if the seller actively concealed latent defects or otherwise made material misrepresentations amounting to fraud 2. Regulation and Taxation: The buyer beware standard serves to provide a benchmark for analysis. In reality, workers may be poorly informed about risk and thus may have difficulty formulating the proper compensating differential required to offset the health risks. The information argument is often invoked in these cases to justify government intervention. 
 If information is costly, we can think of workers hiring agents in the form of either Congress (or the 15 regulatory agencies that administer legislation) or the judiciary to find the optimum solution.
 Zero-harm exposure standard assumes that workers and other market participants are unwilling to sell their exposure for a finite price. But this outcome is likely only in the most extreme cases 
 In consideration of a sufficiently higher wage, most workers will accept some health risk and other risk of harm. 3. Liability: strict liability standard requires the party responsible for supplying harm to compensate victims for damages, regardless of fault.
 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. 
 Liability standards are substitutes for compensating differentials. Assuming that courts can accurately calculate damages, then tort awards to harmed workers are the equivalent of a stream of compensating wage differentials. The standard can improve efficiency only if workers are uninformed. 
 Under strict liability, there is no requirement to prove fault, negligence or intention. Strict liability is the imposition of liability on a party without a finding of fault (such as negligence or tortious intent). The claimant need only prove that the tort occurred and that the defendant was responsible. The law imputes strict liability to situations it considers to be inherently dangerous. It discourages reckless behavior and needless loss by forcing potential defendants to take every possible precaution. It also has the effect of simplifying and thereby expediting court decisions in these cases. The compensating differential is the amount that a fully informed person requires to accept exposure to harm that has economic cost, H, times the probability that exposure produces harm, p: CD=pH Torts accomplish ex post what is infeasible to accomplish ex ante through contracting Awarding economic damages in a tort is akin to paying off the health insurance policy that each exposed victim in principle could have purchased ex ante with the compensating differential they would have received in a contract A liability standard can deliver the optimum amount of harm as long as it delivers economic damages Economic Damages
 The economic cost of harm equals the compensating differential that a harmed person would have required ex ante to accept exposure (if he were fully informed), divided by the probability that exposure produces harm, p: H = CD/p The probability of harm equals the number of episodes of harm, n, divided by the number of exposed workers, N. Thus, an equivalent formula is: H = CD/p ; p=n/N thus H=CD/(n/N)=CD·N/n → H=CD·N/n which says that economic damages per episode of harm equal the compensating differential times the number of exposed persons, divided by the number of harm episodes expected for this population of exposures If we know the compensating differential for accepting risk and the probability that exposure yields harm, then we can infer the economic cost of harm. If we do not know the compensating differential, then we can only try to replicate the components that exposed parties would have included in their calculus, had they been fully informed. Presumably, these components include medical costs, forgone wages, forgone leisure, pain and suffering, and so on If Courts award more than the economic damages: firms abate too much pollution even though workers can bare the same pollution at lower wages.
 If Courts award less than economics damages: firms abate too little pollution and the environment is too polluted. In the absence of transactions costs, there are no torts, only contracts. Zero transactions costs means that all parties to exposed risk are fully informed, that payments are made ex ante from those imposing risks to 16 those at risk, and that there are no costs to any of these transactions nor any costs of enforcing these agreements Value of life: That number, V, which when multiplied by the probability of death, p, gives us the observed premium required by informed participants to accept some risk of death, c: c=pV
 The value of c is the supply price of fatality risk, p. The value of life in a tort setting exceeds the value in a contract setting. In the case of contracts, only those with the lowest supply prices work in risky activities, whereas in torts, exposure is involuntary and thus includes a cross section of individuals with supply prices higher than those who contract for risks The full cost of any activity that poses fatality risk must include the probability that the activity produces a fatality, times the average value of life of the exposed population FC=pV Two liability standards: buyer beware and strict liability. In one case, the individual exposed to risk is liable for his own injuries → buyer beware. In the other, the one who supplies the exposure is liable for damages → strict liability A third standard introduces the notion of negligence. One who poses dangers is liable for damages from injury only if he is “negligent” in his acts 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: MCcare=MCharm If workers can reduce harm, the CD is lower: the amount of pollution is bigger because workers wear a mask. This technology allows the employer to obtain savings. Contributory negligence: If a 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 is entitled to the difference between actual damages and those that would have been sustained had he met his standard of care. Examples of incremental damages include harm from an auto accident that stems from the harmed person failing to use a seat belt, head injuries that result because a motorcycle rider did not wear a helmet, a smoker who develops health problems because she continues her habit after the government announced health warnings, and so on. 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. Thus, a driver that runs into another car for any reason is held liable for damages to the occupants of the car he hits, save for those incremental damages attributable to the occupants’ failure to wear seat belts. Lemon Markets and Adverse Selection Asymmetric information means that one party to a market transaction knows more than the other. For example, in the market for used cars, the seller usually knows more about the quality of a car than the buyer. In the case of health insurance, the buyer of the policy often knows more about his or her health than the insurance company selling the policy Lemons market: Describes equilibrium in a market where mostly poor-quality goods are sold at commensurately low prices. This situation arises when product quality is not apparent at the point of sale and sellers cannot find an economic way to show that they are offering high quality and thus deserving of a “high-quality” price The central question: How does the market deliver a high-quality product at a high-quality price in any market that is characterised by widespread ignorance among buyers about the technical competence of the product? Customers could enter into purchases with lawyers at their side to write customised contracts that articulate expectations and specify remedies in the event that promised quality is not forthcoming Market for informations can be achieved with: 17 If junior hires turn out to be exceptional, then it is predictable that the firm does whatever is required to retain them. Hiring predominantly at the entry level diminishes selection problems 3. Signaling: employers wonder what kind of worker selects himself out of the workforce for long periods of time. And so it goes. A better signal is one that carries a bond for quality. Sorting as a solution to Asymmetric information To get an efficient solution, firms often set up sorts on commitment early on. Those not cut out for this kind of life self-select for early departure from the firm. Those who stay comprise higher concentrations of highly committed workers who form the pool eligible for high-level positions. The voluntary nature of the departures ensures little litigation exposure Sorting: Choice implies sorting. Every time a choice is made, a sort occurs and information is conveyed. A sorting mechanism encourages a productive separation of individuals on the basis of hidden attributes. A sort always produces self-selection. If a law firm creates demanding jobs for new lawyers, 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. A Becker-Stigler bond is the value of a deferred pension for law enforcement workers. Upon being caught in malfeasance during his career, a police officer loses the pension. The bond is intended to alter behavior— that is, to create a situation in which crime does not pay. But it also sets up a sort: given the pay structure, dishonest individuals self-select out of the queue of applicants A defined benefit pension pays a lifetime annuity starting at retirement age based on salary and service. A police pension pays a lifetime annuity often equal to 50 percent of final wage after twenty years of service. It vests at twenty years, meaning that police officers gain the property rights to it only if they successfully complete twenty years of service. If they quit or are fired during their tenure, they lose their pension A Key Equation in the Economics of Crime Income-maximising potential offenders do not engage in crime if and only if crime doesn’t pay C<pB, where C is the payoff from crime, p is the probability of getting caught, and B is the loss imposed on the offender if caught. A profit-maximising offender engages in crime if the payoff from crime exceeds the expected costs. In Becker-Stigler, the only penalty is loss of pension. The equation abstracts from many complications and qualifications but gives the essence of the problem. The main point is that offenders are assumed to be driven by economic calculations and not by antisocial attributes If C>pB crime pays and people prefer crime to honest work. Indenture premium: A wage premium collected by workers because they have to wait until later in their careers to collect a large portion of their lifetime pay. The pay structure provides an incentive to stay in the police department for twenty years and to avoid episodes of malfeasance. It also attracts applicants who are most likely to stay with police work for the full twenty years If an honest person contemplates crime, he views the benefits as C but the cost as G. Assume that G exceeds C so that even without a bond, an honest person does not engage in crime. In contrast, suppose a dishonest person is characterised by a zero value of G. To see the value of setting a wage system that creates a desirable sort, let me first consider one that does not work. In fact, it creates a perverse incentive for honest individuals to avoid police work. Suppose that the income from crime, C, is $20,000. The police department pays a salary of $10,000 with no pension. If the chance of detection is zero, then which type would self-select into police officer jobs? Honest workers view the wage as $10,000. But dishonest workers view the wage as $10,000 plus the income from crime, $20,000. Indeed, the dishonest applicants would be willing to work for a zero wage 20 because the $20,000 income from crime swamps the income from a non-police job ($10,000). Gradually, this competition for police work drives the wage to zero. The compensation system invites adverse selection of dishonest people for these jobs. Suppose alternatively that the police department defers part of the wage. It pays a $5,000 cash wage plus $5,000 in the form of a deferred pension. Assume for simplicity that the indenture premium is zero. Suppose also that the police department sets the bond and the probability of getting caught in any tenure year t so that the expected penalty from engaging in crime is zero even for dishonest applicants; that is, pt ·Bt=C. Crime does not pay for either honest or dishonest applicants. In this case, the dishonest people no longer dominate the applicant pool. Watch out that detection probability grows with the years of tenure. The probability of detection needed to deter malfeasance in the police force is inversely related to the bond. All else equal, older police officers require less monitoring than younger officers An alternative bond is 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 the specifications in the employment contract. In a police model, the contract calls for honest enforcement of the laws. Corollary: In an efficiency wage arrangement, the firm cannot hire more skilled workers at the higher wage; else, the “bonus” from the perspective of employees disappears. The efficiency wage solution has the odd feature that the firm (or police department) deliberately hires lesser qualified applicants in the queue Another way is to fuse the two bonds. The Spence education bond model is a sort of meritocracy and portrays schooling as a kind of hurdle system in which students are required to divulge information about the attributes that likely will affect their performance in the job market. More able individuals can clear these hurdles at lower cost than those who are less able. The system forces self-selection up front: more able students are more likely to select themselves into the pool of applicants Other sorting devices in the labour market: – Sick-leave: Paid sick leave is a sorting device. It sorts on the basis of reliability. Reliable workers pass up the opportunity to take “free” time off and thus send a signal of high quality to the firm; their continued abstention from using the time off creates a reputation for reliability. A 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, thereby creating a wage differential. In equilibrium, reliable workers work more and get paid more; unreliable workers take more time off and get paid less. Related Idioms You get what you pay for; There’s no such thing as a free lunch; When a deal seems too good to be true, it usually is – Discount rates: Low discounters attach value to consumption today and in the future (Today ≈ Tomorrow) → GOOD. They work hard because they can see the future benefits in terms of promotion and so on. They also are savers because they can perceive the importance of having resources to buy goods and services in the future, like a house, car, college education for their children, a secure retirement, and so on. High discounters attach disproportionate value to current consumption and leisure and care little about the future (Today > Tomorrow) → BAD. They do not work hard because they value taking it easy today more heavily than the repercussions on their career path in the future. Similarly, they save little because they attach more value to consumption now than higher consumption in the future. Put simply, they highly “discount” future values A “plain vanilla” defined contribution pension is one in which the firm contributes some percentage of pay into a worker’s account; the account accumulates interest. Upon vesting, which often is immediate, the worker 21 can take the value of the account upon quitting but must leave the account untouched until retirement if he stays A low discounter attaches equal value to the pension as he does to his cash wage because he values the future security implied by the pension. A high discounter attaches little value to the pension because it represents future spending, which he does not value. Other things equal, he wants to spend those monies now. The problem is that he cannot access monies in his pension while he is working for the company. There is one way in which the high discounter can access the balance in his account immediately: he can quit A defined contribution plan sorts on the basis of workers’ discount rates. By effectively forcing each worker to save some of his compensation in a pension account, the firm sets up a choice: either stay with the firm and continue to accumulate a larger pension account, or quit and obtain access to pension monies immediately. High discounters self-select for early departure from the firm, leaving the firm’s workforce dominated by low discounters – 401(K) pension plans: 401(k) plan is a special kind of defined contribution plan. Workers choose to contribute a portion of their pay, and often the employer matches these contributions up to some percentage of pay A 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 also to adjust their own pay on this basis. By divulging their lower quality, high discounters receive an immediate wage penalty The slotting fee bonds quality. The fee sorts on the basis of products’ attractiveness to store customers. Producers who have products that promise lots of sales self-select as candidates for shelf space. All others select themselves out of the queue for space. This solution is efficient because it ensures that the consumers get the products they most want and still economise on their shopping time, which carries an opportunity cost. Put differently, by assigning property rights to shelf space, the store prevents the creation of a common resource problem, with all the attendant waste generated by that solution Showing up for an interview in a dark suit sends a positive signal. If the applicant shows up in a dark suit and makes it apparent that he has read extensively about the company prior to the interview, he bonds his interest in the firm. By making it known that applicants make it into a partner’s office only if they bond their declarations of interest, the law firm sets up a sort that forces applicants to self-select on the basis of their interest and likely chances of hire in the firm Moral Hazard and agency Problems Moral hazard, agency costs, and externalities all are close cousins in the sense that they involve altered behavior of some party caused by the mispricing of a resource. Moral hazard and agency costs both arise in an implied or explicit contractual context when information is costly and often asymmetric. Externalities arise outside a contractual context—that is, when “strangers” are affected by the behavior of others. Sometimes, externality problems are rooted in information problems but often also reflect poor assignment of property rights. Moral hazard is the term of art used when behavior is altered when mispricing arises in a buyer-seller contract. It occurs when someone increases their exposure to risk when insured. This can happen, for example, when a person takes more risks because someone else bears the cost of those risks. It is a form of opportunistic post-contractual behavior which can lead people to pursue their own interests at the expense of the other party, trusting in the impossibility, for the latter, to verify the presence of intent, fraud or gross negligence.
 22 confidence about how player B will react. We also call this process strategic planning, conveying the idea of others’ reactions to our choices A dominant strategy is an action that always is optimal for one player no matter what the other player might do A cooperative game is one in which both parties find a solution through an agreement, either implied or contractual. A cooperative solution often yields a payoff to both players that is higher than what noncooperative solutions would yield. Most of the games I consider are noncooperative solutions. A noncooperative game is one in which the parties do not enter into formal agreement but rather make strategic moves based on their estimates of payoffs and rational decisions by the other player. In a noncooperative problem the players usually do not communicate with each other, but the problem can be modified to allow some signaling Some Key Game Characteristics
 Simultaneous or sequential decisions? Do both players make a decision at the same time or does one go first? In the latter case, the second mover has the information revealed from the first player’s move. One-time game or repeated game? If the game is played once, each player acts solely from knowledge of the payoff structure. If played many times, players can use information revealed in previous renditions. Know the payoffs or not? Often, it is assumed that each player knows the other’s payoff structure. The game, however, can be played with either imperfect knowledge or no knowledge of the other’s payoffs. In the latter case (no knowledge of payoffs), decisions are based on less information, but this problem can be attenuated if the games are repeated Nash equilibrium is one where neither party in a game has an incentive to move. Put somewhat differently, each party is doing the best it can, given the choice made by the other party in the game A coordination game is one in which neither player has a dominant strategy, and it pays both players to coordinate their actions to find an optimal solution A mixed strategy is one in which the player is best off by altering his actions unpredictably. It does not have to be a 50-50 strategy. It is to be distinguished from a pure strategy, in which one or the other action is optimal A cooperative solution is one in which the players arrange a way to end up in the cell with the highest total payoffs. In many cases, side payments are required to make it in everyone’s best interest to move from a Nash equilibrium to the cooperative solution A credible signal is one that is bonded. In the case of the job interview, both the applicant and the firm are wasting their resources unless they are interested in pursuing a job match A reservation wage to the seller is the minimum wage offer at which he is willing to strike a deal. A reservation wage to the buyer is the maximum wage at which she is willing to strike a deal Maximin strategy: A decision by a rational player that avoids the possibility of a large loss instead of one that generates a small gain. This solution often arises when there is an asymmetry between gains and losses and there is some chance that one player is not interpreting the other’s payoff matrix correctly. [Mafia solutions] Vigorish: A term of art that means a cut or a piece of the action collected by the house. It is the difference between monies paid in and monies received by suppliers of the product. It is the difference between amounts gambled and won in Las Vegas, the legal fee to write a contract, the broker’s fee for doing a stock trade. It is the proverbial middleman payment 25 [driver and cyclist problem] Game theory and monopoly: 1. Perfect discrimination: the monopolist has a dominant strategy: no matter what price is announced, he sets output to the point where his marginal cost equals price 2. Monopoly: there is only one player, which makes it unnatural to think about him playing a game. But consider the agglomeration of consumers as the “other party,” and think of the monopolist playing the “monopoly game,” which involves a strategic decision. He chooses price, taking into account the actions of his adversary (the consumer). In this case, the consumer’s reaction function is the demand curve. The monopolist has a dominant strategy: given any demand curve, set output where marginal cost equals marginal revenue. Since consumers cannot act in concert, they cannot coordinate an optimal response, which makes the game uninteresting 3. Cournot model: there are only two producers of some product and no possibility of entry. There are no fixed costs. Marginal cost of production is constant, but different, for each firm. Firm 1 holds a patent on a cheap process to produce some good. Firm 2 has figured out a different way of producing the product without infringing on firm 1’s patent, albeit at a higher marginal cost. 
 In consideration of antitrust laws, the firms cannot find a cooperative solution by merging or engaging in a contract that sets price and output. Assume that they do not communicate. They simply observe each other’s output and choose their own output based on the other firm’s choice. Ergo this a noncooperative game.
 Linear demand curve and constant marginal cost schedules. The key assumption in the Cournot problem is that each firm takes the other firm’s output as a given. He then considers himself a monopolist with respect to the market that remains. He takes into account the effects of his output on market price and chooses his optimal output, assuming that the other firm does not change its output.
 The easiest way to find the Nash equilibrium is to eliminate all the cells that cannot be the solution. We can have a Nash equilibrium if neither firm has an incentive to move Sequential decisions: First-mover advantage refers to any solution in which the first to make a decision nets some advantage over the second. In Stackelberg, there is a first-mover advantage. This is not always the case in game theory models Tit-for-tat decisions: An agent using this strategy will be a collaborator in the first period, then he’ll use the same strategy as the counterpart: if he has been a collaborator, he’ll be collaborative, else he’ll be not. Firm 1 may anticipate firm 2’s actions and find a different strategy other than one that accommodates firm 2 in hopes of altering firm 2’s behavior. Moreover, there is a tendency for these strategies to unravel when the end point of the game can be anticipated, as in my patent case. For example, in the final year of patent protection, firm 1 does not care what firm 2 does in the following year, and so firm 1 will act in a way that ignores firm 2’s reaction. But knowing what happens in the last year can affect the optimal decisions in the penultimate year of patent protection, and so on. 26