Wednesday, September 15, 2010

Microeconomics Comprehensive Exam

2. Some airlines are charging separate fees for various aspects of their services, such as checking luggage and meal service.
a) What advantages exist for the airlines of doing so?  (What are the impacts on their producer surplus, profits and competitiveness?)
b) What are the impacts of such service-differentiated pricing on consumers?  (Distinguish two different consumer groups – one that does not demand the service for which the separate fee is leveraged and one that does.  How will demand and consumer surplus of each group be affected?)

In response to a separate fee on checked luggage, many travelers decide to increase the amount of luggage they carry on an airplane.
c) How can and should the negative externalities of excessive carry-on luggage be internalized?
d) What are the welfare implications of such internalization of externalities?


Microeconomics Comprehensive Exam
Fall 2010


2. Some airlines are charging for separate fees for various aspects of their services, such as checking luggage and meal service.
a) What advantages exist for the airlines doing so? (What are the impacts on their producer surplus, profits, and competitiveness?)
**For this question, I’m assuming that people do not need to check luggage or need to be provided with meal service. When they buy a plane ticket, the good they are buying is simply transportation. This is a reasonable assumption, because it is unlikely that most people would choose not to travel only because they will not be served a meal, or because they have to pack more efficiently. In this case, presenting these additional services as choices to people acts simply as a way for consumers to signal to airlines their willingness to pay.
**I’m also assuming that the airlines have a fixed cost per person for flying, which is not meaningfully affected by whether by whether or not a person has luggage or eats a meal.  (The alternative would be to say that the cost of passenger to the airline changes, so that a person with no luggage, or who does not consume a meal, would induce a lower cost to the airline.)
**I’m assuming that the airline market is in monopolistic competition. Airlines are price-makers, buyers are price takers, the airlines do not behave strategically, and entry into the market is free.

Price discrimination: One reason airlines may want to charge separate fees for various aspects of airline services is to engage in price discrimination (charging different consumers different prices for the same good). Firms engage in price discrimination because people typically differ in their willingness to pay, and the firm would like to charge a high price to the people willing to pay the higher price, but they don’t want to lose customers not willing to pay that high price.

A charge on checked luggage or meal service is a type of second-degree price discrimination. This is where a price schedule is offered to all buyers and they sort themselves through self-selection. In this case the action taken by the consumer (to purchase these additional airline services or not) serves as a signal of the underlying characteristic on which the firm really would like to base its price.

Price discrimination is possible because airlines are price-makers in the monopolistic competition market, and because the consumers cannot engage in arbitrage. Also, the firms can identify consumers with different demands for its product through screening.

Competitiveness: The effect on competitiveness of the airline that starts charging fees depends on three things. First, it may depend on what other airlines do (whether they charge the same fees, or not). If they do all charge the same fees, then airlines maintain the same relative competitiveness as before the fees.

Second, the effect on competitiveness will depend on the degree to which airline flights are heterogeneous and can be differentiated by consumers.  This aligns with the assumption of monopolistic competition made above. If airline flights are heterogeneous, then people will not choose to change airlines just because of the price change, and the airline can remain competitive. For this question, I’m assuming that airlines are heterogeneous and that all airlines are using the same fee structure. [This is a model of a market in monopolistic competition, where all airlines happen to have chosen to use fees.]

[If (before price discrimination occurs) the airline market was in pure competition, and airline transportation was homogeneous (it’s just as good to take Delta from DC-Boston as it is to take United), then the airline that imposes the additional fees will lose consumers to other airlines (its competitiveness will decrease, it will lose customers, and its producer surplus and profit would fall).]

(In reality, transportation is somewhat heterogeneous, since people have particular airlines that they prefer and are willing to pay more to fly on, so while some customers may be lost due to service fees, not all of them are. Also, it seems that airlines have been coordinated in their choice to impose additional fees, so each airline has remained competitive.)

Third, the effect on competitiveness will depend on whether there are close substitutes for air travel. If there were, then if airlines create fees, people may switch to a substitute – train or car travel, for example. However, if there are not close substitutes, then the airline fees will not cause people to switch to a substitute. (In reality, for most flights, airplane travel is much faster than traveling by car and train, so there are not close substitutes.) For this question, I’ll assume that there are no close substitutes for air travel.

Producer Surplus and Profit: In the case of airline fees, taking into account my two assumptions above, then second-degree price discrimination raises the seller’s profit and producer surplus.

Simplified Example: A simplified example can help illustrate this point. Say that the airline originally sold tickets from DC to Boston for $100, with all services included. There 10 customers (type 1) who are willing to pay $150 for the flight, but they want to be served a meal, if they are not going to be served a meal, then they’re willing to pay only $40. Another group of 90 customers (type 2) are willing to pay $100 for the flight, and they really don’t care whether they get a meal or not (airplane food isn’t very tasty, and the probably wouldn’t have eaten it anyway). In this case, the airline would like to charge $150 to type 1 customers, but if they charge $150 for a flight with a meal, then the type 2 customers will no longer fly, and their total revenue would be only 10*$150=$1500. If they charge $100 for a flight with a meal, then everyone will fly, and their total revenue would be 100*$100=$10,000. However, the airline could increase its profit if it could offer flights at a price of $100 to people who don’t care about meals, and $150 to people who do. Then its profit would be 10*$150+90*$100=$10,500.  This is an increase in profit of $500. The airline can achieve this outcome through screening by offering the same price schedule to everyone - $100 for a flight only, and $150 for a flight with a meal (a.k.a $50 charge for a meal). Then the individuals will self-select and reveal their willingness to pay. The type 2 people would be happy with the cheaper, $100 flight, since they didn’t want a meal anyway. The type 1 people would choose the $150 option. In this case, the increase in producer surplus is a transfer to the producer from the consumers that had a higher willingness to pay.

General: Even if we don’t make the simplifying assumption in the example, we can still assume that by using price discrimination, the producer can increase profit and producer surplus using second-degree price discrimination.

b) What are the impacts of such service-differentiated pricing on consumers? (Distinguish two different consumer groups – one that does not demand the service for which the separate fee is leveraged and one that does. How will demand and consumer surplus of each group be affected?)
(There should be no change in demand – i.e. shift of the demand curve – due to price discrimination, because the only change is in the price of the good itself. There are no changes in individuals’ income, prices of related goods, or tastes and preferences. Only quantity demanded may change.)

Simplified Example – Two types of people
Quantity Demanded: Under the assumptions made above (that all airlines adopt the same fee structure and/or that airline flights are considered heterogeneous), and that there are only two types of people (type 1 and type 2), there is no effect on the quantity of flights demanded. The only change is the increased ability of the airlines to take advantage of differences in individual’s willingness to pay.

Consumer Surplus
People who are willing to pay for meals (type 1): Under the assumptions made above, this group of consumers will lose consumer surplus – some of their consumer surplus will be transferred to the airline, now that it has identified their higher willingness to pay for flights with additional airline services.

People who are not willing to pay for meals (type 2): Under the assumptions made above, this group of consumers will still get to fly at the same price, so their consumer surplus doesn’t change. However, there could be some welfare losses because the person now has to spend more time to pack more efficiently, or has to exert extra effort to carry all their belongings on the plane, rather than checking.

Consumer Surplus: However, the assumption that there are only two types of people, with such simple demand curves is somewhat unrealistic.  In reality, the effects on consumers of second-degree price discrimination are difficult to determine. First, price discrimination will result in some of the consumer surplus being transferred to the producer, and in this way, consumer surplus goes down. Some consumer surplus could go up, if people that previously would have been priced out of the market are able to enter, and if they pay less than their full willingness-to-pay. However, consumer surplus could also be reduced because of the inconveniences associated with the new restrictions on flights (i.e., they have to carry on luggage, or bring food from home.)

Quantity Demanded: The effect on the quantity demanded depends on the price that would have been offered if there was no price discrimination. For example, if the original (non-discriminating) price was between the two prices offered with price discrimination, then there will be some individuals who wouldn’t have been able to afford to fly at all, who are now able to fly, due to the lower price being offered.

In response to a separate fee on checked luggage, many travelers decide to increase the amount of luggage they carry on an airplane.
c) How can and should the negative externalities of excessive carry-on luggage be internalized?
An externality is the direct effect of the actions of one person or firm on the welfare of another person or firm, in a way that is not transmitted by market prices. In the case of airlines, the externalities or bringing excessive carry-on baggage may include slower loading times for the plane and a lack of space for some people’s things in the overhead bins (so that they must put them under the seat and have less leg room).

Charge fees for carry-ons: To ensure that people recognize the social cost of bringing a large carry-on, the airline may decide to charge a fee for carry-on luggage. Ideally, this fee would be equal to the difference between the private marginal cost to the individual of bringing the carry-on luggage onboard and the social marginal cost of this action. This would be similar to a Pigouvian tax, which is leveled on each unit of the externality in an amount just equal to the marginal damage (MD) it inflicts upon society at the efficient level. In the case of carry-on luggage, this fee might be simply for the number of pieces of luggage, or it could be assessed by size or weight. (The airline would have to consider the costs of these different methods – it is likely much simpler to charge a fixed price per piece of luggage, rather than forcing everyone to weigh their carry-on and then pay a fee.)

Make a rule: The airline could also simply make a rule that no carry-on bags are allowed, a rule to restrict the number of carry-on bags per person, or a rule to restrict the size of carry-on bags to items that will fit under the seat. Some rules about carry-on size and number already exist, and these simply be adjusted. (It is important to note that while the rule may eliminate the externality, it does not actually cause the externality to be internalized by the individual.)

The more efficient method of dealing with the externalities of carry-on bags is to charge a fee for them. In this way, people are able to decide for themselves whether they are willing to pay to have their luggage with them or whether they would prefer to check the luggage or fly without it.

d) What are the welfare implications of such internalization of externalities?
The implications of charging a fee for carry-on luggage would be to increase the cost to individuals of bring carry-on bags. Individuals would choose to pay to carry-on luggage up to the point where their private marginal cost plus the fee (which represents the difference between the private marginal cost and the social marginal cost) was equal to the individual’s marginal revenue. This would probably result in most people cutting back on the amount of carry-on luggage that they bring on-board.

The fee that they pay would be a transfer from consumers to producers (the airlines).

In addition to the changes mentioned above, everyone is better off because the externality has been eliminated (due to its being internalized). Now they can board the airplane more easily and have more leg room.

Overall, by internalizing the externality and moving to the efficient level of carry-on luggage, there will be a net welfare benefit to society. (Area A on the graph below)

Microeconomics: Chapter 18 Externalities and Public Goods

MicroeconomicsChapter 18 Externalities and Public Goods
An externality is the direct effect of the actions of one person or firm on the welfare of another person or firm, in a way that is not transmitted by market prices.

18.1 Externalities and Efficiency
Missing Markets
If the market for a commodity is missing, we cannot rely on market forces to provide it efficiently. The “missing market” interpretation of an externality is important because it allows us to focus on the reason why externalities can lead to inefficiencies. No one owns the air, and therefore people can use it for free. If someone owned clean air and could charge a price for its use, then a market for it would emerge and there would be no efficiency problem.

These are four characteristics of externalities:
1. They can be produced by individuals as well as firms.
2. There is an important reciprocal aspect to externalities. (Person 1 feels it is their “right” to smoke indoors, while Person 2 feels they have a “right” to smoke-free air.)
3. Externalities can be positive or negative. You may plant a flower garden that is a positive externality for others.
4. Zero pollution is not, as a general rule, socially desirable.

Private Cost versus Social Cost
The social marginal cost is the incremental cost of production which includes the opportunity cost of scare resources, whether priced or not.

In the absence of any intervention, the output is at the intersection of the demand and supply curves. However, because the externality leads to marginal damages, the social marginal cost is greater than the private marginal cost (which is embodied in the supply curve). Efficiency requires that a lower amount be produced at a higher price (equal to where the social marginal cost curve crosses demand).

18.2 Responses to Externalities
Private Responses
One way to solve the problems posed by an externality is to “internalize” it by combining the involved parties. If two firms causing externalities on each other worked together, than the overall benefits would be higher – when the decisions are brought under one firm, these benefits can be gained.

Social Conventions
School children are taught that littering is not “nice.” People are taught the golden rule – “do unto others as you would have others do unto you.” These moral precepts help to internalize externalities that individual behavior may create.

Bargaining and the Coase Theorem
As long as the amount that Firm A is willing to pay Firm B (marginal damages – MD) exceeds the cost to Firm B of not producing (marginal revenue minus private marginal cost), then the opportunity for a bargain exists.

The Coase Theorem states that assuming there are no bargaining costs, once ownership rights to a resource are established, individuals with bargain their way to an efficient use of the resource.

Reasons for Failure of Negotiations
Costs of Bargaining: When many people are the victims of pollution, there may be a problem of free-riders when a negotiation would take place. We can use the tools of game theory to explore this phenomenon. Each person can decide to either negotiate or not – if person 1 does not negotiate, but person 2 does, then person 1 gets all of the benefits of negotiation with none of the costs (free-riding). The dominant solution for any individual is not to participate in negotiations.

Difficulty in Identifying Sources of Damages: It can be hard to identify the source of the damages to property and to legally prevent damages.

Asymmetric Information: When everyone’s preferences and opportunities are common knowledge, negotiations can lead to an efficient solution. If this is not the case, bargaining may be expensive, take a long time, and ultimately be unsuccessful.

Government Responses to Externalities
If individuals’ marginal benefit schedules differ, then a regulation requiring that everyone cut back by the same amount is inefficient.

Corrective Taxes
A Pigouvian tax is a tax levied upon each unit of pollution in an amount just equal to the marginal damage it inflicts upon society at the efficient level of output.

A Pigouvian tax forces firms to take into account the costs of the externality that they generate, and hence induces them to produce efficiently. However, it requires the answers to several potentially difficult questions: Which activities produce pollutants? Which pollutants do harm? What is the value of the damage done?

Creating a Market 
An effluent fee is the price paid for permission to pollute. When the government auctions off pollution rights, the supply curve is perfectly inelastic. Firms that are not willing to buy permission to pollute at this price must either cut output or change their technology.

18.3 Public Goods
A public good is a commodity that is non-rival in consumption. The fact that one household partakes in the good does not diminish the benefits received by other households. (e.g. National defense)

Efficient Provision of Public Goods
Group willingness to pay for a public good is found by vertical summation of demand curves. At the efficient level of the public good, the sum of the marginal rates of substitution equals the marginal rate of transformation.

Because everybody must consume the same amount of the public good, its efficient provision requires that the total valuation they place on the last unit provided – the sum of the MRSs – equal the increment cost of society producing it – the MRT.

Impure Public Goods
An impure public good is a commodity that is somewhat nonrival in consumption. (Reading room of a library, highways that get congested.)

Market Provision of Public Goods
A nonexcludable good is a good for which preventing consumption is prohibitively expensive. A nonexcludable public good is simply a kind of positive externality. Because of the opportunity to free-ride, there is a good chance that the market will fall short of providing the efficient amount of the public good.

Even if a public good is excludable, private provision is likely to lead to efficiency problems. This is because full discrimination is not possible – therefore the same price has to be charged to everyone. Some people with low, but positive values on the good will not be able to buy it.

Responses to the Public-Good Problem
People do not always act as free riders. People donate money to many different causes.

Simply because a commodity is provided by the public sector, does not mean it meets the definition of a “public good.” There are many cases of publicly provided private goods – rival commodities that are provided by governments. Examples are housing and medical services.

Microeconomics: Chapter 17 Asymmetric Information

Chapter 17 Asymmetric Information
Asymmetric information is a situation in which one side of an economic relationship has better information than the other.

Hidden characteristics are things that one side of a transaction knows about itself that the other side would like to know but does not.

Hidden actions are actions taken by one side of an economic relationship that the other side of the relationship cannot observe.

17.1 Signaling and Screening
Another Look at Price Discrimination
Three conditions must be satisfied for price discrimination to be profitable:
1. The firm must be a price maker.
2. The firm must be able to identify customers with different demands for its product.
3. The consumers must not be able to engage in arbitrage.

Companies may use a signal, an observable indicator of a hidden characteristic, to determine a person’s willingness to pay.

A self-selection device is a mechanism in which an informed party in an economic relationship is offered a set of options, and the choice made by the informed party reveals his or her hidden characteristic. (For example, charging higher prices for flights that don’t include a weekend results in business people revealing themselves.)

Screening is an uninformed party’s attempt to sort the informed parties.

Normative Analysis of Second-Degree Price Discrimination
Second-degree price discrimination can raise the seller’s profit. The effect on consumers is mixed – it’s good for the consumer who would have been priced out of the market, but now can purchase a the good, but bad for a person who would have gotten a lower price, but now pays something higher.

Real-World Screening
Screening occurs in the real world in airline ticket pricing, as described in the text book example. The same was true of train tickets in the 1850’s.

Competitive Market Signaling
It could be argued that going to college is merely a signal for employers that the student is a highly skilled individual, rather than college being useful because of the skills that are learned there. This signal works because workers differ in their taste for education in a way that is systematically related to ability.

Normative Analysis of Education as a Signal
The only effect of signaling is to change the distribution of income across workers of different types. High and low- ability workers can be differentiated. It has a positive effect on the educated individuals’ income, but a negative effect on other workers’ income. Overall, workers are worse off by the full cost of education.

Is Education Really Just a Signal?
There is considerable anecdotal evidence that the screening model of education has some validity. However, there is also evidence that education is not solely a deadweight loss. The human capital model of education cannot be dismissed.

17.2 Adverse Selection
Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it (i.e. it gets an adverse selection of the informed parties.)

More on Insurance Markets
Two people may have different needs for insurance (e.g. different probabilities of being sued), and their personal probabilities/risks are known to themselves, but not to the insurance agents.

The Full-Information Equilibrium
Under full information, the insurance premium for a high-risk person would be higher than that for a person with lower risks.

The Asymmetric-Information Equilibrium
The equilibrium price under these conditions will be based on the average fair odds line for all people in the market. For those with high risk, the equilibrium price is actuarially unfair in their favor, and they buy as much insurance as they can (complete insurance). Those with less risk face an equilibrium price that is actuarially unfair, not in their favor, so they buy less than full insurance.

The Efficiency Effects of Adverse Selection
In the asymmetric situation, risk averse people are forced to bear risk. Further, asymmetry of information, not just the lack of information, is the key to the problem.

Market Responses to Adverse Selection
Insurance and Testing for AIDS: Some insurance companies want to test for AIDS in order to prevent these people from purchasing insurance (or charge them a higher premium) – testing would identify these high-risk customers, and this would reduce insurance premiums for others.

Group Health Plans: Having automatic enrollment in an employee or other group health plan helps the insurance company to avoid adverse selection, because everyone has to join – not just those likely to have high health-care expenses.

Targeted Insurance Rates: Some companies offer higher rates to teenage drivers, or people who have been in accidents, for example.

Other Markets in Which Adverse Selection is Important
Labor Markets
Efficiency wages refers to the practice of raising wages to improve the productivity of the work force. The idea is that by paying a higher wage, a firm gets workers who are on average more productive, which makes the wage increase profitable to the firm. (With low wages, only low-ability workers would apply for the job.)

The Market for Human Blood
If hospitals pay for blood donations, people argue that the people who are driven by profit to donate blood are more likely to have medical issues with their blood than voluntary donors.

Government Responses to Hidden Characteristics
Many Western industrialized nations rely on programs that don’t allow self-selection, such as Social Security – everyone is a part of it. Governments may also help avoid adverse reaction by using information policies – they don’t allow false advertising – which hurts companies with bad products and helps good products, because firms can tell the truth without being suspected of lying.

17.3 Hidden Actions
In situations of hidden actions, the problem is that you cannot observe someone’s actions. You can hire a worker, but you can’t constantly monitor how hard they’re working. These situations exemplify the principle-agent relationship, in which the principle hires a second party, the agent, to perform some task on the principle’s behalf. These situations have three important features:
1. One side of the economic relationship, the agent, takes an action that affects the other side, the principle.
2. The principle cannot observe the action taken by the agent.
3. The principle and the agent disagree on what action is best for the agent to take. (The agent would rather relax, but the principle wants them to work.)

Moral Hazard in Insurance Markets
Moral hazard is another name given to situations of hidden action, because in such cases, the informed side may take the “wrong” action.

Fire Prevention in the Absence of Insurance
Without insurance, a rational decision maker would purchase care (fire proof linens, detectors, etc.) just up to the point where marginal benefit and marginal cost are equal.

Moral Hazard and the Effects of Insurance
When the homeowner purchases insurance, the marginal benefit of care shifts downward. With insurance, the homeowner’s marginal benefit of care is equal to the cost of care at a much lower level – the homeowner undertakes less care when insured.

Efficiency Effects of Moral Hazard
The problem is that the insurance does nothing to reduce the total cost of a fire to society as a whole – total surplus falls because the homeowner takes too little care to prevent the fire.

Co-Insurance and Deductibles
Co-insurance is a provision in insurance policies under which the policy picks up some percentage of the bill for damages when there is a claim. A deductible is a provision in an insurance policy under which the person buying insurance has to pay the initial damages up to some set limit. Co-insurance, or a co-payment, increases the value of investing in care for the homeowner.

Employer-Employee Relationships
The employee’s welfare rises as he shirks more, but the employer’s profit falls – the more the employee shirks, the less effort he devotes to running the firm and maximizing its profit.

Observable Shirking
The owners’ income is equal to the vertical distance between the profit curve and the employees indifference curve. When the amount of shirking is observable, the owners choose the level of shirking at which this distance is greatest. At this level of shirking, the owners are paying the employee the lowest amount possible to keep him from quitting his job.

Unobservable Shirking
A Flat Salary: If the employee receives a flat salary, the opportunity cost of shirking in terms of foregone consumption of all other goods is zero. The only limit on the amount of time spent shirking is the amount of time spent at work.

Performance-Based Compensation: A residual claimant is a party to a contract who gets all of the leftover, or “residual,” profit. The result in the residual claimant is the same one that arises when effort is observable.

Two Puzzles
(1) Why do people paid on salary do any work? Not everyone considers shirking an economic good – they may take pride in their jobs. Also, there may be some monitoring of employees, or some type of performance pay (at least in raises).

(2) If residual claimant contracts have such good incentive properties, why aren’t all contracts of this form? This has to do mostly with the level of risk that individuals are willing to take on. However, some firms do use incentive pay. A piece rate is a pay scheme under which an employee gets paid a fixed amount for each unit of output (“piece”) that he produces.

Moral Hazard in Product Markets
It’s possible to have moral hazard problems by firms – for example, you pay for a movie without knowing its quality (while the film-makers are aware of quality).

Reputation as a Hostage
One of the most important market responses to the problems of moral hazard is the development of reputations and brand names.

For the threatened loss of reputation to be an effective deterrent to cheating, having a good reputation must allow the firm to earn positive economic profits on future sales.

Tuesday, September 14, 2010

Microeconomics: Chapter 16 Game Theory

MicroeconomicsChapter 16 Game Theory
A game is a situation in which strategic behavior is an important part of decision making.

Non-cooperative game theory is a set of tools for analyzing decision making in situations where strategic behavior is important.

16.1 Some Fundamentals of Game Theory
The players are the decision makers in a game. A strategy is a player’s plan of action in a game. Actions are the particular things that are done according to a player’s strategy for a game. Payoffs are the rewards enjoyed by a player at the end of a game.

Game Trees: Decision Trees for Strategic Decisions
A game tree is an extension of a decision tree that provides a graphical representation of a strategic situation.

A decision rule is a strategy that specifies what action will be taken conditional on what happens earlier in the game. E.g. If Firm A produces “high,” then I will produce “low,” and if Firm A produces “low,” then I will produce “high.”

Dominant Strategy Equilibrium
A dominant strategy is a strategy that works at least as well as any other one, no matter what any one player does.

A dominant strategy equilibrium is an output in a game in which each player follows a dominant strategy. E.g. Firm B should produce “high” no matter what firm A does, and Firm A produces “high” no matter what firm A does.

Perfect Equilibrium
A perfect equilibrium is a set of strategies that satisfies both the Nash condition and the credibility condition. (The Nash equilibrium states that each firm is choosing the strategy that maximizes its profit, given the strategies of the other firms in the market.)

16.2 Applying Game Theory: Oligopoly with Entry
When the incumbent has the ability to collude with the entrant in post-entry output levels, that ability may make the incumbent worse off. The reason is that the potential entrant will take the possibility (and profitability) of collusion into account when deciding whether to come into the market. Knowing that the post-entry equilibrium will be a collusive one makes entry attractive. Even under the fully collusive duopoly outcome, however, the incumbent earns less than it would if it had retained its monopoly position.

Credible Threats and Commitment
Commitment is the process whereby a player irreversibly alters its payoffs in advance so that it will be in the player’s self-interest to carry out a threatened (or promised) action when the time comes. (In a decision tree for the entry game, this adds another decision to the beginning of the game in which the incumbent, for example, decides whether to make a large capital investment – build a large plant – or a small capital investment – build a small plant.) Though the incumbent would prefer a small plan in the case that entry doesn’t occur, it is logical to build the plant in order to keep the entrant out.

More on Strategic Investment in Oligopoly
The firm may also rely on the “strategic effects” of R&D investment. In both an oligopolistic market and a market with a single firm facing the threat of entry, strategic investment can commit a firm to act more aggressively, which then makes its rivals retreat.

16.3 Games of Imperfect and Incomplete Information
A game of imperfect information is a game in which some player must make a move but is unable to observe the earlier or simultaneous move of some other player. (e.g. Prisoner’s dilemma)

A game of incomplete information is a game in which some player is unsure about some of the underlying characteristics of the game, such as another player’s payoffs. (i.e. You don’t know where you are in the decision tree.)

The Prisoners' Dilemma: A Game of Imperfect Information
Two prisoners are taken in and must simultaneously decide to confess or remain silent. In this game, confess is the dominant strategy for both players. (Even though if both had remained silent, they would each have had less time in jail.)

The prisoners’ dilemma is a strategic situation in which two players each have a dominant strategy, but playing this pair of strategies leads to an outcome in which both sides are worse off than they would be if they cooperated by playing alternative strategies.

Mixed Strategies
A pure strategy is a strategy that specifies a specific action at each decision point. A mixed strategy is a strategy that allows for randomization among actions at some or all decision points.

An example of where a mixed strategy might be used is in the case of a free kick in soccer. The goalie always wants to go the same way as the kicker, but the kicker always wants to go in the opposite direction from the goalie. Hence, there is no equilibrium in pure strategies. There is, however, an equilibrium in mixed strategies: Each player randomly goes left half of the time and right the other half. Neither player can make himself better off by switching his strategy, given the strategy being played by his opponent.

A Bargaining Game of Incomplete Information
An example of incomplete information would be a case in which a seller didn’t know how highly a buyer values a particular good. The seller’s uncertainty about the buyer’s valuation of the good is captured in the decision tree by having Nature make an unobservable move to pick the buyer’s valuation of the good. We can say that Nature chooses a particular outcome with probability B. The seller cannot see the move that Nature has made, and instead he will calculate the expected value based only on the probabilities and his own payoff.

Limiting Pricing: A Game of Incomplete Information
Limit pricing is the practice of setting a high output level, or a low price, to deter entry.

16.4 Repeated Games
There are many situations in which players find themselves repeatedly making the same decisions. One type of agreement that does make use of repeated interaction is known as the grim-trigger strategy. Firms may agree to charge a price, p, each day, as long as no one has cheated in the past. If anyone cheats, the firms “agree” to punish the cheater by setting all future prices at marginal cost. The strategy gets its name from the fact that detection of cheating “triggers” an infinitely long punishment (a “grim” prospect).

Finitely Repeated Games
Finitely repeated games are solved by using backward induction. When there is a unique Nash equilibrium of the stage game, the unique perfect equilibrium of the finitely repeated game is simply the one-shot equilibrium repeated in every period.

Microeconomics: Chapter 15 Oligopoly and Strategic Behavior

MicroeconomicsChapter 15 Oligopoly and Strategic Behavior
Mutual interdependence occurs when the price or output of choices made by any one firm affects the profits of all.

The Fundamental Assumptions
1. Sellers are price makers.
2. Sellers behave strategically.
3. The conditions of entry may range from completely blocked to perfectly free.
4. Buyers are price takers.

The Appropriate Market Structure
1. The size and number of buyers. We are interested in markets with many buyers, no one of whom is large enough to exert any influence on price.
2. The size and number of sellers. We are interested in markets with relatively few (but more than one) firms in the industry. In this case, they are likely to recognize their mutual interdependence.
3. The degree of substitutability of different sellers’ products. This can range from perfect substitutes to goods that are highly differentiated. However, producers must be able to recognize their influence on one another.
4. The extent to which buyers are informed about prices and available alternatives. The model can encompass both well-informed and poorly informed consumers.
5. The conditions of entry. Oligopoly allows for conditions of entry ranging from blocked to completely free.

15.1 Quantity-Seeking Oligopolists
These are the assumptions for considering the model:
1. There are two firms in the industry. A market in which there are only two suppliers is referred to as a duopoly.
2. Further entry into the market is completely blocked. (We only need to worry about the behavior of the two firms.)
3. The firms produce homogeneous products.
4. The firms have identical, constant marginal costs equal to c. This implies that if the firm’s output level is x, then its total cost is c*x.

Market Equilibrium
A self-enforcing agreement is one in which each firm finds that abiding by the agreement is in its self interest, given that the other firms do so too.

A tacit agreement is a situation in which firms have come to a common understanding about how they should behave in a market without actually discussing it among themselves. Usually firms use tacit agreements rather than explicit agreements, because explicit agreements are often illegal.

Equilibrium Defined
The best response is a decision maker’s best course of action, given what the other decision makers are doing.

A market is at a Nash equilibrium when each firm is choosing the strategy that maximizes its profit, given the strategies of the other firms in the market.

A Cournot equilibrium (or Cournot-Nash equilibrium) is a Nash equilibrium in a market in which each firm’s strategy consists of its choice of output level. For example:
1. Given that Firm B sells z units, Firm A’s profit is maximized by selling y units.
2. Given that Firm A sells y units, Firm B’s profit is maximized by selling z units.

Finding a Cournot Equilibrium
Deriving the Best-Response Functions
The residual demand curve is the firm-specific demand curve faced by the supplier, given the price or output strategies chosen by its rivals. The axes of this graph are output (x-axis) and cost (y-axis). Assuming a particular level of output for the rival(s), the firm can then determine how to maximize its own output – i.e. its best response to the other firm’s action.

The best-response curve (or reaction curve) is a schedule showing a decision maker’s best course of action for each set of choices made by other decision makers. The axes of this graph are Firm A’s output (x-axis) and Firm B’s output (y-axis). The reaction curve tells us Firm B’s profit-maximizing output choice for any given output level by firm A.

Using Reaction Curves to Find the Cournot Equilibrium
To be in equilibrium, each firm must be at a point on its reaction curve. The point where the reaction curves cross represents the conditions in which each firm is best responding to the other. The Cournot-Nash equilibrium is found at the intersection of the two reaction curves.

Comparison of Cournot, Monopoly, and Perfect Competition
Viability of the Full Cartel Agreements
Cournot duopolists collectively produce more output than would a monopolist.

Are We Back to Perfect Competition?
Under the Nash-Cournot equilibrium, the level of industry output is greater than the joint-profit maximizing level and less than the competitive level.

An Algebraic Example of Cournot Equilibrium
This section provides the derivation of the mathematical solution to this problem. (See text book)

Comparative Statics
1. A firm’s profit falls when its own cost rises.
2. A firm’s profit rises when its rival’s cost rises.

Comparison of Cournot Duopoly, Competition, and Monopoly
The monopolist produces the least output followed by the Cournot Duopoly, followed by perfect competition, which results in the greatest output.

The monopolist has the highest prices, followed by the Cournot Duopoly market, and the market in perfect competition has the lowest prices.

15.2 Price-Setting Oligopolists
Bertrand Competition
A Bertrand equilibrium (or Bertrand-Nash equilibrium) is a Nash equilibrium in a market in which each firm’s strategy consists of its choice of the price at which to sell its output. For example:
1. Given that Firm B charges pB per ticket, Firm A’s profit is maximized by charging pA per ticket, and
2. Given that Firm A charges pA per ticket, Firm B’s profit is maximized by charging pB per ticket.

Finding the Bertrand Equilibrium
The market curves for each firm depend on the other:
1. If Firm A charges a higher price than Firm B, then all customers buy from firm B.
2. If Firm A charges a lower price than Firm B, then all customers buy from firm A.
3. If Firm A and Firm B chare the same price, then customers buy half of the amount demanded from A and the other half from B.

When all firms have marginal costs that are equal at c, the Bertrand equilibrium entails all firms setting their prices equal to c.

Cournot or Bertrand?
Why Are Bertrand and Cournot Duopolies So Different?
When dealing with the Cournot equilibrium, cheating on the number of units sold causes the price to fall for both firms. The fact that Firm A’s price falls in response to B’s cheating means that B does not get the whole market just by lowering its price a little.

In the Bertrand firms, if Firm B decides to cheat by lowering its price slightly, Firm A does not change its price to match (it’s prices are stuck), and Beta could get the whole market at almost the same price. The incentive to cheat under these conditions is much larger than under Cournot.

Which Model Should We Use?
We want to focus on the choices to which the firm has to stick. In most markets, prices can be adjusted more quickly than quantities (it’s just a matter of changing price lists), while changing quantities means the firm actually has to change its production operations. Therefore, the quantity-setting Cournot model is often more appropriate.

In a Cournot market, both firms would set quantity at a level that was difficult to change. If one firm cheats (and produces more), the other firm can quickly change its price, but it can’t change its output level.

In a Bertrand market, both firms would set prices that would be difficult to change (mail order catalogues, or bids on a project). If Firm A cheated and set a lower price, Firm B would not be able to adjust their price quick enough, and Firm A would take the entire market.

15.3 Cooperation and Punishment
A more realistic model must take into account that firms make choices repeatedly. In this case, firms can make decisions based on actions that have taken place in the past. If one firm cheats on the deal today, the other firm may punish it in the future.

A Model of Repeated Interaction
If Firm B takes T days to detect Firm A’s cheating, then cheating allows firm A to earn an extra profit. (The extra profit is equal to its profit per day if it cheats minus the profit per day if it sticks to the agreement.) Once Firm A has been caught cheating, it suffers a net punishment per day. (This is the profit if it had stuck to the agreement minus the profit it will earn if it is being punished.) This punishment takes place from the T+1st day.

General Predictions
1. The longer it takes to catch a cheater, the greater the incentive to cheat.
2. The less likely it is that a cheater will be caught, the greater the incentive to cheat.
3. The harsher the punishment that a cheater faces, the lower the incentive to cheat on an agreement. However, a threat or promise by a firm is credible only if it would be in the firm’s self-interest to carry out the threat or promise if called upon to do so.
4. The more complex the collusive agreement has to be, the less likely it is to succeed.

Market Structure and Collusion
1. The more that the firms’ costs differ, the less likely is cooperation, all else equal.
2. The more that demand varies from period to period, the less likely is cooperation, all else equal. This is because changing demand makes the collusive argument more complex.
3. The easier it is for firms to monitor their rival’s output levels, the more likely is cooperation, all else equal. This is because it is easier to catch the cheater.
4. Product differentiation may increase or decrease the likelihood of cooperation, all else equal. Since not all customers will choose based on price, the gains to cheating are lower. However, punishment is more difficult because changing output may not affect the other firm – you are not a strong credible threat.
5. When prices are negotiated with each customer separately, collusion is less likely to be successful, all else equal.
6. When individual orders are large relative to the overall market, collusion is less likely to be successful, all else equal. When the stakes of one order are high, firms may ignore the future.
7. The more firms in a market, the less likely is cooperation, all else equal. More firms make collusion more complicated and cheating harder to detect.

Microeconomics: Chapter 14 More on Price-Making Firms

MicroeconomicsChapter 14 More on Price-Making Firms
A price-making buyer is a buyer whose purchase quantity affects the price that it has to pay.

14.1 Cartels
A cartel is an arrangement under which suppliers band together to restrict output and raise the market price.

Cartels in Product Markets
The Full Cartel Outcome
The full cartel outcome is the price and quantity at which suppliers’ joint profit is maximized.

Cheating on Cartel Agreements
The firms gain collectively from adherence to a cartel agreement does not mean that each firm will find adherence to the cartel agreement to be in its individual self-interest.

Entry as a Limit on Cartel Success
As a cartel limits output and increases prices, it will attract new firms to the market. This make the cartel break down.

Regulation as Cartel Enforcement
Government rules and regulations sometimes restrict both price and entry. This was true with the Civil Aeronautics Board limited air fare increases and blocked attempts to lower fares.

The Welfare Cost of Monopoly Reconsidered
Rent seeking refers to activities aimed at obtaining or preserving economic profits.

Labor Unions
Labor unions are an extremely important type of cartel in the U.S. economy. By acting together, workers may be able to collectively to behave like a price-making monopolist.

14.2 Monopolistic Competition
The Fundamental Assumptions
1. Sellers are price makers
2. Sellers do not behave strategically
3. Entry into the market is free
4. Buyers are price takers

The Appropriate Market Structure
1. The size and number of buyers. There must be many buyers so not one is large enough to influence the price.
2. The size and number of sellers. Monopolistic competition best applies to markets with many suppliers – this makes them more likely to be nonstrategic.
3. The degree of substitutability of different sellers’ products. Monopolistic competition includes price-making sellers, so the structure is one in which products are imperfect substitutes.  The products are heterogeneous (differentiated) – consumers view the products of the various producers as being somewhat different from one another.
4. The extent to which buyers are informed about prices and available alternatives. The monopolistic competition model encompasses both well-informed and poorly informed consumers.
5. The conditions of entry. The model assumes that entry is free.

Short-Run Equilibrium
Like any profit-maximizing firm, when a monopolistic competitor chooses not to shut down, it produces output where marginal revenue is equal to marginal cost.

Long-Run Equilibrium
Under monopolistic competition, entry into the industry is free and new firms enter as long as there is profit to be made.  In the long-run equilibrium, a representative firm produces an output level at which the demand curve and the average cost curve are tangent.

Normative Analysis of Monopolistic Competition
When the production of a good is characterized by economies of scale, variety is costly.

The So-Called Excess Capacity Theorem
The excess capacity theorem suggests that there may be too many firms in the market under long-run, monopolistically competitive equilibrium. A downward-sloping demand curve tells us that variety is costly, but it doesn’t explain how those costs compare with the benefits of variety.

The Market Equilibrium Compared with the Efficient Outcome
The long-run monopolistically competitive equilibrium may have too many or too few firms, depending on the cost and demand conditions.

14.3 Monopsony
The Fundamental Assumptions
1. Sellers are price takers.
2. Sellers do not behave strategically
3. The conditions of entry into industry supply may range from completely blocked to perfectly free.
4. Buyers are price makers.

The Appropriate Market Structure
1. The size and number of buyers. One buyer.
2. The size and number of sellers in the industry. Many sellers, no one of which is large relative to the overall market.
3. The degree of substitutability of different sellers’ products. The outputs of different sellers are homogeneous.
4.The extent to which buyers are informed about prices and availability. Buyer is well informed about the offerings of competing suppliers.
5. The conditions of entry. Technological and legal barriers to entry may or may not exist.

The Monopsonistic Equilibrium
The factor hiring rules states: A profit-maximizing firm should hire a factor up to the point at which its marginal revenue product is equal to its marginal factor cost (MRP=MFC).

Remember that marinal revenue product of a factor is equal to the factor’s marginal physical product (MPP) times the firm’s marginal revenue of output. If the monopsonist is a price maker, than it simply finds its marginal revenue curve the same way as a monopolist. The difference between a monopsonist and an input price taker comes in terms of the marginal factor cost.

Marginal Factor Cost for a Monopsonist
The monopsonist’s marginal factor cost curve is derived from the corresponding average revenue curve (demand curve). The monopsonist’s marginal factor cost (MFC) can be represented in terms of the price elasticity of supply for the input that the firm buys: MFC=p(1+1/εS)

The smaller the price elasticity of supply, the larger the monopsonist’s marginal factor cost. When supply is highly inelastic, it takes a large price increase to induce producers to supply a little bit more output, and the monopsonist counts this large price increase as a cost. In the extreme case of infinitely elastic supply, there is no loss on inframarginal units, the firm is a price taker, and MFC is equal to the price of the factor.

Because the factor supply curve facing a monopsonist slopes upward, the marginal factor cost curve lies above the supply curve.

Applying the factor hiring rule, a profit-maximizing firm purchases units up to the quantity at which the marginal factor cost is equal to the marginal revenue product. The equilibrium price is found by going down from this spot to the corresponding point on the supply curve.

A price-making buyer purchases less than would a price-taking buyer facing the same supply curve and having the same marginal revenue product curve.

Normative Analysis of a Monopsony
The change from price-taking to monopsony leads to a lower equilibrium factor price. This reduces the surplus of suppliers in the market. The buyer benefits from its ability to influence the price of the input. The monopsonist produces less of the final output. If the firm is a price-taker as a seller in the final market, then the price to consumers is unaffected. If it is a price-maker, then the price of the product to consumers rises, and consumers are worse off.

Partial Equilibrium Analysis: From an efficiency perspective, the monopsonist purchases too little of the input. The loss in total surplus that arises because a monopsonist purchases less than the total-surplus-maximizing amount of an output is referred to as the deadweight loss of monopsony.

General Equilibrium Analysis: Given the level of output that it chooses, a profit-maximizing monopsonist chooses a socially inefficient means of production. (The firm does not set the marginal rate of technical substitution equal to the ratio of the price of labor and capital, since it is a price-maker in the capital market.)

Buyer Cartels: Amateur and Professional Athletes
Numerous studies of professional sports have found that these buyers’ cartels have significant effects. Baseball players (in 1974) were paid far below their marginal revenue products. This is because there were reserve clauses in contracts that forced each professional baseball player to deal with only one team.

The most effective buyer cartel has been the one run by universities. They pay players only a tiny fraction of the revenues that these players generate for their schools. (In football, the university cartel gets help from the NFL, who won’t hire players until they’ve graduated from college.)

Microeconomics: Chapter 13 Monopoly

Chapter 13 Monopoly
A price maker is an economic decision maker that recognizes that its quantity choice has an influence on the price at which it buys or sells a good.

Market power is another name for the firm’s ability to influence price.

13.1 The Basic Monopoly Model
The Fundamental Assumptions
1. Sellers are price makers
2. Sellers do not behave strategically
3. Entry into industry is completely blocked. No new suppliers can join the industry.
4. Buyers are price takers.

The Appropriate Market Structure
1. The size and number of buyers: We require many buyers, no one large enough to influence price.
2. The size and number of sellers: There is only one firm in the industry, so the firm is a price maker, and there is no scope for strategic behavior.
3. The degree of substitutability of different sellers’ products. Assume buyers are prefectly informed – i.e. all buyers know about the monopolist’s price and the characteristics of its product.
4. Conditions of entry: This model applies to markets into which entry by new firms is completely blocked by either technological or legal barriers.

A monopolist must meet the marginal output rule (produce at an output where marginal revenue is equal to marginal cost) and the shut-down rule( if at every choice of output level the firm’s average revenue is less than its average economic cost, then the firm should shut down).

Marginal Revenue for a Monopolist
When a monopoly increases its output by one unit there are two effects on revenue. Revenue rises by the extra amount of output times the price at which it’s sold. Revenue falls by the decrease in price times the number of units sold.

Inframarginal units are the units of output that the price could have sold at the old price, but now must sell at the new, lower price that prevails when it increases its output level.

If the firm is a price-maker, the marginal revenue curve lies below the demand curve everywhere except at an output of zero. At zero output, there are no inframarginal units on which to suffer losses, so the two curves coincide.

When demand is highly inelastic (close to vertical), the loss on the inframarginal units is large. When demand is relatively elastic, the loss on inframarginal units is relatively small.

Like any profit-maximizing firm, the monopolist chooses the output level at which marginal revenue is equal to marginal cost. The equilibrium price is found by looking at the price associated with this level of output on the demand curve.

Applying the Rules for Profit Maximization
A monopolist charges an equilibrium price that is greater than marginal cost.

Price Elasticity and Profit Maximization
The only way marginal revenue can be positive is for the price elasticity of demand to be greater than 1. Demand must be elastic at the monopolist’s equilibrium price and output levels.

The Long and the Short of Monopoly
The distinction between short run and long run is less important for monopoly than it is with perfect competition, because under perfect competition, firms can enter or leave the market in the long run. In a monopolized market, further entry is locked. Because it does not face the threat of entry, a monopolist may earn positive economic profit in the long run.

Monopoly Compared to Perfect Competition
A multi-plant monopolist produces less output than would perfect competitors facing the same industry demand.

Taxing a Monopolist
Even though the firm raises its price in response to a unit tax, a monopolist’s profit falls when a unit tax is imposed on it.

Incentives to Innovate
Process innovation refers to an idea that lowers the cost of producing existing products. Product innovation refers to an idea that gives rise to a new good or service.

Process Innovation
As long as the innovation leads to lower production costs, the monopolist derives benefits from innovation, even if it means rendering existing plants and machinery obsolete.

Product Innovation
If a firm can apply for a patent, then the incentive to undertake R&D is the entire amount of monopoly profit that the firm will be able to earn once it obtains the patent.

13.2 Normative Analysis of Monopoly
Monopolization raises the firm’s profit and the income of the firm’s owners, and it lower the incomes of consumers. Whether or not this is desirable depends on our ethical judgments regarding how deserving the suppliers and consumers are.

A Partial Equilibrium Analysis
The deadweight loss of monopoly is the loss in total surplus that arises because a monopolist produces less than the total-surplus-maximizing amount of output.

Firm’s private incentive = Change in producer surplus
Social incentive = Change in producer surplus + Change in consumer surplus

A General Equilibrium Analysis
Production efficiency: [Marginal technical rate of substitution (MRTS) between any two inputs (capital and labor) is equal to their price ratio] A profit-maximizing firm that is a price maker in the output market, but a price taker in the input markets, makes an efficient input choice.

Consumption efficiency: [Every consumer must have the same marginal rate of substitution (MRS) between the monopolist’s good and any other good.] If other firms in the economy do not engage in price discrimination, then the equilibrium for a nondiscrimination monopolist entails an efficient allocation of output among consumers taking as given the total amount produced.

Allocation Efficiency: If all of the other goods in the economy are sold in perfectly competitive markets at prices equal to their marginal costs, then the monopolist violates the condition for allocation efficiency because it sets the price of its product greater than its marginal costs.

13.3 Public Policy toward Monopoly
Patent Policy
A patent allows a firm to have a monopoly, and this monopoly produces a smaller amount of total surplus than a competitive market. The government chooses to provide patents to ensure that the firm has the incentive to innovate and create new products.

Antitrust Policy
Antitrust Policy is the set of laws designed to prevent firms from exercising market power by the firms’ restricting output and engaging in anticompetitive behavior.

A conduct remedy is a government-imposed change in firm behavior (conduct) designed to make the market more competitive. A structural remedy is a government imposed change in the industry structure designed to make the market more competitive.

Determinants of Market Structure
Economies of Scale: When average cost declines over the entire range of output levels, the lowest-cost way to produce any given level of output is to have one firm responsible for all of the output; the industry in a natural monopoly. (A natural monopoly is an industry in which, over the range of relevant output levels, a single firm can produce the total industry output at less cost than can any greater number of firms.)

Barriers to Entry: In addition to economies of scale, the number of firms in an industry may be limited by barriers to entry. There are two types of barrier: technological and legal.

Product Differentiation: When firms’ products are differentiated, producers are not price takers even when there are many firms in the market.

It may be prohibitively costly, or even impossible, to create a competitive market structure in some industries.

Regulation of Monopolies
Regulation is the process by which the government engages in pervasive intervention in the operation of a market. Governments that decide to regulate the firm must realize that the regulated firm is a self-interested decision maker. This has three implications:
1. A regulated firm must be allowed to earn nonnegative profit.
2. A regulated firm will use its private information to its own advantage.
3. Regulatory controls may have unintended consequences

13.4 Price Discrimination
Price discrimination is the practice of charging different consumers different prices for the same good.

Conditions Necessary for Profitable Price Discrimination
1. The firm must be a price maker.
2. The firm must be able to identify which consumer is which.
3. Consumers must not be able to engage in arbitrage. Arbitrage is the process whereby customers whom the firm charges low prices make purchases that they then resell to customers who would otherwise have to pay high prices.

First-Degree Price Discrimination
First-degree price discrimination is the practice of selling each unit of output at a price just equal to the buyer’s maximal willingness to pay for that unit. Another name for this is perfect price discrimination.

Welfare Effects of First-Degree Price Discrimination
A perfectly discriminating profit-maximizing monopolist produces the total-surplus-maximizing amount of output.

Second Degree Price Discrimination
Second-degree price discrimination is price discrimination in which the same price schedule is offered to all buyers but they sort themselves through self-selection. Two-part tariffs (that include a fixed fee and a per-unit charge) are an example of second-degree price discrimination.

Welfare Effects of Second-Degree Price Discrimination
In the typical case in which demands can be ordered, the monopolist restricts output below the socially optimal level.

Third Degree Price Discrimination
Third-degree Price Discrimination is the practice of identifying separate groups of buyers of a good and charging different prices to these groups. An example is “ladies-night,” which uses sex as an indicator of a consumer’s willingness to pay.

Welfare Effects of Third-Degree Price Discrimination
When total output falls under third-degree price discrimination, so does total surplus – the output that is produced is allocated to consumers inefficiently and there is less of it. But hen total output rises, the welfare analysis is ambiguous – the output that is produced is allocated inefficiently, but there is more output. Consequently, total surplus may rise or fall, depending on the specific details of the market.

Microeconomics: Chapter 12 General Equilibrium and Welfare Economics

MicroeconomicsChapter 12: General Equilibrium and Welfare Economics
Partial equilibrium analysis is the study of equilibrium in one market in isolation. In contrast, general equilibrium analysis is the study of the equilibrium of all markets simultaneously.

12.1 General Equilibrium Analysis
Supply and Demand Curves
1. The markets for two goods are linked if the two items are “related” (substitutes or complements) or if one of them is an input into the production of the other. When markets are linked, a shift in the supply or demand curve in one market has consequences for the price and output in the second market. Thus, when policymakers consider intervention in one market (e.g. a tax or regulation), they should try to think about the effects in other markets as well.
2. Suppose that the commodities X and Y are related, and there is a shift in either the supply or demand curve of commodity X. A partial equilibrium analysis of the effect of the shift may be in error because of feedback effects from the market of Y. For example, if a tax raises the price of beer, then the demand for wine may increase (since it is a substitute), but this increase in demand causes the price of wine to increase, which in turn shifts the demand of beer up, and so on. Ultimately, the economy settles to a new general equilibrium.

General Equilibrium Analysis of the Minimum Wage
The partial equilibrium model shows that when a minimum wage is instituted, some workers gain and others lose. The winners are the workers who are lucky enough to get employment in the covered sector. Losers include workers who used to work in the covered sector and either become unemployed or take jobs with lower wages in the uncovered sector.

The general equilibrium model provides an important new insight. Just because a worker is initially employed in the uncovered sector does not mean that he or she is unaffected by the minimum wage. The losers from the minimum wage include workers in the uncovered sector, whose wages go down because of the influx of workers from the covered sector.

General Equilibrium in a Pure Exchange Economy
A pure exchange economy is an economy in which the quantities supplied of all goods are fixed; the only economic problem is to allocate amounts of the goods among consumers.

Edgeworth Box
An Edgeworth box can be used to depict the allocation of two goods between two people. The height of the box represents the total quantity available of Good 1, and the length of the box represents the total quantity available of Good 2. The amount of Good 1 allocated to Person 1 is measured by vertical distance from the bottom left corner to a designated point. The amount of Good 1 allocated to Person 2 is measured by the vertical distance from the top right corner to that same point. Any point in the Edgeworth box represents an allocation of commodities between two consumers.

In an Edgeworth box, for Person 1, higher levels of utility are represented by moves to the northeast; for Person 2, to the southwest.

Given an initial allocation, Person 1 and Person 2 can make mutually beneficial trades to maximize their respective utility. This occurs at a point where their indifference curves are tangent. (This occurs when both people set their MRSs equal to the price ratio.)

12.2 Welfare Economics
Welfare economics is the branch of economic theory concerned with the social desirability of alternative economic states.

Consumption Efficiency
An allocation is said to be consumption efficient if, given the total supplies of the commodities, the only way to make one person better off is to make another worse off.

The contract curve is the locus of all the consumption-efficient points in an Edgeworth box. (There can be many, depending on the starting point for allocations.) It is defined by the mutual tangencies between the two consumers' indifference curves.

Consumption Efficiency and Water Rationing
Water rationing can be examined using an Edgeworth box with sides representing water and a composite of all other goods. Allotting each person an equal share of water and forbidding its sale is inefficient if the allocation is not on the contract curve. A simple solution would be to provide tradable ration coupons, which would allow people to trade water for “all other goods” in order to reach the contract curve. This is not always done because officials feel it may be “unfair” for some people to end up with less water than others, particularly if those people were the poorest members of the community. Behind this position is the notion that people cannot be expected to make trades that are in their own interest, and hence must be protected by not allowing them to trade at all.

Production Efficiency
In an Edgeworth box for production, the length and width represent amounts of the respective inputs. Each point in the Edgeworth box shows the allocation of the inputs between the two outputs. Within the Edgeworth box, isoquants can be drawn for each commodity representing the various combinations of inputs that produce the same number of units of a particular commodity. (The equivalent of indifference curves for consumption.)

The allocation of inputs is production efficient if the only way to increase the output of one commodity is to decrease the output of another commodity. The locus of production-efficient points is defined by the mutual tangencies between the two sets of isoquants.

Production Possibilities Curve
The production possibilities curve is the locus of production-efficient points, which is defined as the mutual tangencies between the two sets of isoquants. It can also be drawn on a graph with axis representing the number of units of Commodity 1 produced per year on one axis and the number of units of Commodity 2 produced per year on the other axis.

The marginal rate of transformation is the rate at which the economy can transform one output into another by shifting its resources; the negative of the slope of the production possibilities curve. MRT12=MC1/MC2 (The marginal rate of transformation for commodity 1 and commodity 2 is the ratio of their marginal costs.)

Pareto Efficiency
Allocations of commodities and inputs such that the only way to make one individual better off is to make another worse off are referred to as Pareto efficient. A Pareto efficient allocation must be consumption efficient (on the contract curve) and production efficient (on the production possibilities curve). A Pareto efficient outcome must be allocation efficient: MRT12=MRS12, i.e. the marginal rate of transformation between any two goods is equal to consumers' common value of the marginal rate of substitution between the two goods.

The utility possibilities frontier is a graph that shows the maximum amount of utility that one individual can obtain, given another's level of utility.

A Pareto improvement is a reallocation of resources that makes at least one person better off without making anyone else worse off.

The First Fundamental Theorem of Welfare Economics
First Welfare Theorem: As long as producers and consumers act as price takers and there is a market for every commodity, the equilibrium allocation of resources is Pareto efficient. That is, the economy operates at some point on the utility possibilities frontier.

Intuition behind the First Welfare Theorem
1. Consumption efficiency: If all people pay the same prices, then every person’s marginal rate of substitution (MRS) is equal to the price ratio. Thus, their MRSs must also be equal to each other. This is the requirement for consumption efficiency.
2. Production efficiency: If firms are price-takers in factor markets and output markets, then they all face the same price of labor (w) and price of capital (c). To minimize costs, the firm must set its marginal rate of technical substitution (MRTS) equal to the ratio of the prices of labor and capital. The same is true for any commodity. Therefore, every firm must have the same MRTS, which is the necessary condition for production efficiency.
3. Allocation efficiency: Now we have to show that the marginal rate of transformation between two commodities equals the marginal rate of substitution. We know that a profit-maximizing competitive firm produces output up to the point at which marginal cost is equal to price. Thus the marginal cost ratio of the firms is equal to the price ratio. The MRS of every person is also equal to the price ratio, so the MRS of every person is also equal to the marginal cost ratio of the two firms. We showed earlier that MRT is also equal to the ratio of marginal cost. Therefore, the MRS for each person is equal to the MRT for the two commodities.

Prices and Decentralization
An important implication of the First Welfare Theorem is that the price system allows Pareto efficiency to be achieved in a totally decentralized setting. Relative prices convey to people all of the information they need to know.

Are Competitive Prices Fair?
The first welfare theorem doesn’t say anything about fairness – it only refers to efficiency. You may or may not believe that the efficient prices are just or fair.

The Theory of the Second Best
The Theory of the Second Best states that if a first-best allocation is impossible to obtain, then a second-best allocation may involve the introduction of additional wedges between price and marginal cost.

This theory means that when one change has already been made, so that the solution is no longer Pareto efficient, it may be most efficient to make a second change. For example, normally it would be inefficient to put a tax on videotapes. However, if there is already a tax on movie tickets that cannot be removed, then adding a tax on videotapes might move consumption back towards the efficient level.

The First Welfare Theory and Total Surplus Analysis
What relationship does surplus analysis have to Pareto efficiency? Surplus maximization is consistent with a multiplicity of efficient applications. Depending on market conditions, there are a large number of possible Pareto-efficient allocations, each corresponding to a different distribution of real income.

The Second Fundamental Theory of Welfare Economics
Second Welfare Theorem: Provided that all indifference curves and isoquants are convex to the origin, for each Pareto efficient allocation of resources there is a set of prices that can attain that allocation as a general competitive equilibrium.

12.3 The Welfare Economics of Time and Uncertainty
Efficiency and Intertemporal Resource Allocation
Why don’t consumers and producers who are interested in high levels of consumption and profits now squander society’s resources so there will not be “enough” for the future? The anticipation of higher prices in the future induces owners of these resources not to dump them on the market for a quick profit.

Efficiency and Uncertainty
Markets allow people to reduce risk, because given the chance, people will trade or make deals with each other in order to reduce (or smooth) the risk they face. Another way in which market markets allow people to reduce risk is by providing opportunities for diversification. The stock market is crucial in this respect – it divides the risk of investment over a large number of people. In this way, private market may be better able than government to take on risky projects.

12.4 Welfare Economics and the Real World
Market Failure
Market Power
If some individuals are price makers (rather than price takers) then results will generally be allocated inefficiently. This is because a firm with market power may be able to raise prices above marginal cost by supplying less output than a competitor would. This can happen in a monopoly or oligopoly. It can also occur in a market with many firms, but where the product is differentiated (Calvin Klein jeans).

Nonexistence of Markets
If a market for a commodity doesn’t exist, we can’t expect the market to allocate it efficiently. Markets may be missing because of asymmetric information (one party in a transaction has information that is not available to another). One type of inefficiency due to the non-existence of a market is an externality. In the case of externalities social cost is not the same as private cost.

Market Failure and a Role for Government Intervention
Government intervention may lead to greater efficiency if it can help to solve these market failure problems.

The social welfare function is a function or schedule that shows how the welfare of society depends upon the utilities of its members. A particular Pareto-efficient allocation of resources need not be socially desirable.

Even if the economy generates a Pareto-efficient allocation of resources, government intervention may be necessary to achieve a “fair” distribution of utility.

Buying into Welfare Economics
The great advantage of welfare economics is that it provides a coherent framework for thinking about the desirability of alternative allocations of resources. Nevertheless, ideological factors that lie outside the realm of welfare economics can and do influence views on economic issues.

Microeconomics: Chapter 11 Equilibrium in Competitive Markets

MicroeconomicsChapter 11 Equilibrium in Competitive Markets
11.1 The Basic Model of Perfect Competition
Fundamental Assumptions
1. Sellers are price takers. Each supplier has a negligible impact on the market price and no impact on the collective actions of other suppliers.
2. Sellers do not behave strategically. The supplier doesn't anticipate any reaction by rival suppliers when it chooses its own actions.
3. Entry into the market is free. (A market is said to be characterized by free entry when new suppliers can enter the market without any restrictions on the process of entry. A market is said to be characterized by blocked entry when it is impossible for new suppliers to enter the market at any reasonable cost – may be legal or technological barriers.)
4. Buyers are price takers. They take the price as given.

The Appropriate Market Structure
Whether the previous assumptions are likely to be satisfied depends on the market structure – the economic environment in which buyers and sellers in an industry operate.

This is a list of the important dimensions and the conditions consistent with the assumption of perfect competition.
1. The size and number of buyers: The assumption of buyer price-taking is most appropriate when there are many buyers
2. The size and number of suppliers: The assumption both of price taking and of nonstrategic behavior by suppliers are most likely to be satisfied when there are many suppliers in the market.
3. The degree of substitutability of different sellers' products. (Homogeneous goods are perfect substitutes, and have a marginal rate of substitution of one. Homogeneous goods are considered identical by buyers.) Since perfect competition is a model of price-taking sellers, the most appropriate market structure is one in which the outputs of different suppliers are homogeneous products.
4. The extent to which buyers are informed about prices and available alternatives: For the assumption that sellers are price takers to be a sensible one, buyers must be well informed about the available alternatives.
5. The conditions of entry: No technological or legal barriers to entry is present in a perfectly competitive market.

Identifying a Competitive Market Structure
The competitive model also captures the behavior of many product and factor markets, even if it does not fit all of the assumption exactly.

Finding a Competitive Equilibrium
The equilibrium market price and quantity are found by using market demand and supply curves.

The Short Run
Market Supply by Firms
To find the short-run market supply curve, we horizontally sum the individual firm supply curves. (i.e. For a given price, we add up the number of units that each firm would be willing to supply at that price to get the total market supply.)

Market Demand
The assumption that buyers are price takers allows us to summarize buyer behavior in terms of a market demand curve. We horizontally sum the individual demand curves.

Market Equilibrium
A competitive market is in equilibrium when: (1) buyers are choosing their optimal output levels, given the prevailing market price; (2) sellers are choosing their optimal output levels, given the prevailing price; and (3) suppliers are willing to produce as much as buyers wish to purchase, and buyers are willing to purchase as much as suppliers choose to produce. The equilibrium price and quantity is found at the intersection of the market supply and market demand curves.

The Individual Supplier's Perspective
An individual supplier bases its decisions on its firm-specific demand curve. For a price-taking firm, the demand curve (and marginal revenue curve) is represented as a horizontal line at the market price. The firm's equilibrium quantity is where the firm-specific supply curve intersects with the firm-specific demand curve.

The Role of Price
In a competitive market, there is no one person who works to bring the quantity demanded in line with the quantity supplied – this is done by the impersonal forces of the market. The buyer does not need to know about technology, factor prices, or the number of suppliers. From the buyer's point of view, market conditions can be summarized entirely in terms of their market price.

The Long Run
Over a long enough time period, new suppliers can enter the market and old suppliers can exit. As a result, the short and long-run equilibria of a market may be very different.

Market Supply
When entry is free, the long-run market quantity supplied is infinite for any price greater than the minimum of long-run average cost. The market quantity supplied is zero at any price less than the minimum of long-run cost. It follows that the firms collectively are willing to supply any quantity at a price of p*, the minimum of long-run average cost.

The long-run market supply curve is a horizontal line at a price equal to the minimum level of long-run average cost. An industry in which long-run average costs remain unchanged as industry output rises is said to be a constant-cost industry. The long-run average cost is p* no matter what the long-run quantity supplied is.

Market Demand
The market demand is likely to be more elastic in the long run, because people have more opportunities for substitution.

Market Equilibrium
The equilibrium price is at the intersection of the market supply and demand curves.

The Individual Supplier's Perspective
If the long-run equilibrium price is p*, then we know that each supplier faces a firm-specific demand curve that is horizontal at a price of p*. At this price, profit is maximized by producing x* units of output. Looking at the market equilibrium, we can see that the market equilibrium output is X1. We can use this to determine the number of firms in the market: N1=X1/x*

The Long Run is the Short Run Too
A long-run equilibrium is also a short-run equilibrium: each firm in the industry is producing at a point where price is equal to marginal cost and no firm that is operating could increase its profit by shutting down. However, it is not the case that every short-run equilibrium is a long-run equilibrium. To find a long-run equilibrium, there must be the right number of firms, and all firms must earn zero economic profit.

Input Price Taking by the Firm But Not by the Industry
A short-run supply curve may be upward sloping even when input prices paid by the firms are constant. In contrast, the long-run supply curve is flat when input prices paid by the firms are the same. When all suppliers are the same, any upward slope in the long-run supply curve is due to an industry-wide price effect. An increasing cost industry is an industry in which long-run average costs rise with the industry output level. An industry in which long-run average costs fall as the industry output rises are called a decreasing cost industry.

Heterogeneous Suppliers
Heterogeneous suppliers are producers of a single good who have different costs of production from one another. (e.g. There may be a limited number of 'good mines' where gold can be extracted cheaply, and a much larger number of 'bad mines' where it is more expensive to extract gold.)

Short-Run Analysis
Taking the horizontal sum of the individual supply curves, we find the market supply curve. The equilibrium price is given by the intersection of the industry supply and demand curves. Once we have found that price, we can use it to construct the firm-specific demand curve faced by each supplier.

Long-Run Analysis
When there are only four good mines and entry by a bad mine is free, the long-run industry supply curve initially is upward sloping and then becomes flat at the price equal to the minimal long-run average cost of a bad mine. Depending on the market demand curve, the equilibrium price may be equal to the minimal value of the long run average cost of a bad mine. At this price, bad mines earn zero economic profits, but good mines earn positive economic profits.

When there are ore deposits of many different qualities and there are just a few deposits of each quality, the long-run supply curve is upward sloping over a wide range. At price ps, the price of gold is so high that it is profitable to extract gold from sea water. Since the amount of gold that can be recovered this way is unlimited, this segment of the supply curve is a horizontal line.

Economic Rent
The mineral rights for a good mine sell for more than the mineral rights to a bad ore deposit by the amount equal to the additional profit that can be made from them (the producer surplus). In this case, the owner of the mine gets the economic rents, and the operator of the mine does not.

An economic rent is what the supplier of a good or service gets paid above and beyond what is needed to induce it to supply the output.

Four Steps to Finding an Equilibrium
1. Derive individual supply and demand curves.
2. Sum up individual curves to obtain market curves.
3. Find the equilibrium price and market output levels.
4. Find the individual production and consumption levels.

11.2 Using the Competitive Model
The Effect of Taxes
The statutory incidence of a tax - the economic agent who is legally responsible for the payment of the tax – is not always the same as the economic incidence of a tax – the change in the distribution of income brought about by the imposition of the tax. To determine who really pays the tax, we must look at the economic incidence of the tax.

Ad Valorem Tax: A tax whose amount depends on the value of the transaction being taxed. (e.g. 5% sales tax on clothing)

Unit Tax: A tax that is levied as a fixed amount per unit of the item subject to taxation. (e.g. 5 cents per gallon of gasoline, or $1 per pack of cigarettes)

The imposition of a unit tax paid by suppliers raises the supply schedule as perceived by consumers by exactly the amount of the tax. The economic incidence of the tax falls on both producers and consumers. The price paid by consumers rises (so it’s more expensive for consumers), but the price net of the tax falls (so producers make less than before the tax).

If the imposition of the tax is on the buyers, then from the perspective of the sellers, the after-tax demand curve, D' is equivalent to the before-tax demand curve shifted downward by exactly the amount of the tax. In this case, the price paid by consumers rises (so it’s more expensive for consumers), but the price net of the tax falls (so producers make less than before the tax).

In a competitive market, the economic incidence of a unit tax is independent of whether it is levied on consumers or producers.

Elasticities and Incidence
If demand is perfectly inelastic (demand curve is a vertical line), then the entire tax burden is borne by consumers. In general, the greater the elasticity of demand, the less the tax burden is borne by buyers, all else equal.

If supply is perfectly elastic (supply curve is a horizontal line), then the entire tax burden falls on consumers. In general, the greater the elasticity of supply (the percentage change in the quantity supplied divided by the percentage change in price), the less the tax burden is borne by suppliers, all else equal.

Who Pays for Social Security?
The payroll tax used to fund Social Security is a flat percentage of the employees’ gross wages up to some fixed amount. Half of the tax is paid by employers and half by employees. However, we may assume that the supply of labor is perfectly inelastic. (Empirically this is close to the truth.)

In this case, the employer tax shifts the effective demand curve downward. The employee tax shifts the effective supply curve upward by the amount of the tax (but if supply is perfectly inelastic, then this shift results in the same vertical line). After the imposition of the tax, the wage paid by employers to workers falls, while the full price for labor paid by employers (including wages and the tax payments) stays constant.

The Elasticity of Demand
There are a number of determinants of the price elasticity of demand.
1. The Elasticity of Demand for the Final Product: The demand for inputs by firms is derived from the demand for their output. The total output effect on factor demand increases as price elasticity of demand for the final product increases. (e.g. If the demand for cigarettes were perfectly inelastic, there would be no effect on the quantity of final output demanded when the cigarette suppliers raise their prices
2. The closeness of substitutes. The size of factor substitution effect clearly depends on the extent to which substitute factors are available.
3. The Time Frame Considered: The log-run price elasticity of market demand for the final product is likely to be greater than the short-run price elasticity. The longer the time frame, the more powerful the output effect on derived demand. Also, when the output effect (induced by the substitution made by the buyers of an output) and the factor substitution effect work in the same direction, the longer the time frame, the more elastic is the input demand.
4. The Importance of the Factor in Total Costs of Production: When a factor accounts for only a tiny fraction of the total cost of the output, a firm is unlikely to make a large adjustment in its level of output solely because the price of that factor has risen.

Steps to do comparative statics with the competitive market model
1. Sketch the original equilibrium that holds before there are any changes in the underlying market conditions.
2. Given a change in underlying market conditions, such as the imposition of a tax, figure out whether the supply curve or the demand curve is affected.
3. Determine the direction of the shift in the affected curve.
4. Find the new equilibrium at the intersection of the new supply and demand curves.

11.3 Normative Analysis of Perfect Competition
Total Surplus as a Measure of Performance 
Total Surplus is the sum of consumer and producer surplus. Total surplus is the greatest when the total output is at the competitive level.

Are Value Judgments Being Made
Maximizing total surplus leads to an outcome that is efficient, but not necessarily “fair.” The justification for this approach is that once total surplus is maximized, it can be redistributed later in accord with the communities notions of fairness – make the pie as big as possible, and then worry about dividing it.

Prices versus Quantities and Their roles in Attaining Efficiency
We have been comparing the level of total surplus under competitive equilibrium with the surplus levels that would arise at different market quantities, but we have said nothing about prices. In competitive markets, prices affect quantity decision and thus (indirectly) affect total surplus. For a given quantity, a change in the price merely results in a transfer of surplus, not a net creation or loss of surplus.

Evaluating Rent Control
In the absence of rent control, the equilibrium point is at the competitive level. With the imposition of a rent ceiling equal to a price lower than the competitive equilibrium price, the quantity of housing supplied is lowered, and the total surplus falls.

Producers are worse off with rent control because they have to rent apartments at a lower price. Some households are better off because of rent control – in particular, those who obtain apartments under rent control are better off by the amount equal to the reduction in rent times the number of units rented. Some households lose from rent control – in particular, those people who would have been willing to pay the competitive price, and who would have gotten an apartment in a free market, but who do not get apartments when rent control is imposed and the quantity of housing falls.

Normative Analysis of a Sales Tax
From the buyers' perspective, the tax on wine shifts the supply curve up by $3. The equilibrium shifts as well. As a result of the tax, the surplus falls – the loss is referred to as the excess burden of the tax.

The excess burden of a tax is the amount by which the loss of surplus suffered by consumers and producers exceeds the tax revenue collected. (aka Deadweight loss)