NOTES_Microeconomics (John Hildred's Conflicted Copy 2013-11-27)

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Diplomatic Academy | 2010-2011 | 15. MAIS

Professor Dr. Werner Neudeck

International Economicscomplete notes by Max Meduna

! PRINCIPLES OF MICROECONOMICS

! MACROECONOMICS! INTERNATIONAL TRADE THEORY

! INTERNATIONAL MONETARY THEORY



Diplomatic Academy | 2010

Professor Dr. Werner Neudeck

Principles of

Microeconomicsnotes by Max Meduna



Principles of Microeconomics

Session 1 | 5.10.2010

Definition of Economics

Lord Robbins: “Economics is the science which studies human behaviour as a relationshipbetween ends and scarce means which have alternative uses.”

“Human behaviour” implies that we are dealing with a social science However, just oneaspect is being dealt with - humans defined by having aims. In order to achieve them, theyhave means. The trouble is that this means are scarce. And that is the economic problem.Therefore we have to economise - how can I achieve my aims in the best possible way, giventhe scarcity of means. Or, alternatively, how can I achieve a given aim with the use ofminimal means. This problem only becomes interesting, if choices are available (alternativeuses).

The economic methodology can be used in many different fields, not only the classiceconomic problems (Political Science: How do I mobilise voters, how do I bribe them? etc.Law: How do I formulate a certain punishment / the legal system, if I want to minimise thecost of achieving the reduction of murder? International Law: How can cooperation beachieved in the best possible way? How to formulate effective contracts, etc. How do I find aboy-/girlfriend, given my scarce financial, intellectual and physical means? - this is also aneconomic problem).

On the other hand, there are issues not dealt with in economics: Are the aims good, that

people want to achieve? Economics doesn’t question morality. The aims are given, notquestioned. The focus lies on the application of the given means.

Further main concepts, derived from the above definition:

Tradeoff (substitution)

I can substitute great holidays with buying a car, I cannot have both.

Cost (economic / opportunity cost)

If you do something, than you always have to give up something else. There is always a nextbest alternative. What you lose, is the opportunity cost. If a government buys military planes,the opportunity cost is: What could the invested money be alternatively used for?

Scarcity

Two basic aspects in overcoming scarcity:1. Production: transforming goods into other goods (eg. labour and steel into cars), in order

to achieve aims in a better way. Transformation of inputs into outputs.

2. Exchange: exchanging scarce goods in order to reduce scarcity and achieve aims.Exchange ratios are called prices (one tie against five pens, 100 currency units - product) -relative price (exchange) vs. absolute price (money).

Principles of Microeconomics | Prof. Neudeck 2010 -11

notes by Max Meduna 1



Mathematical modelling

A model is an abstraction, a simplification of reality. It is impossible to describe reality (allaims) realistically, objectively. Therefore, we have to make simplifications, strongassumptions - otherwise we couldn’t say anything. The mathematical formulation follows

from the economic premise: a maximisation (aims, ends) under a constrain (resources, scarcemeans). The science of international relations has become much more formalised and“economised” over the years. The economic problem itself is a mathematical problem.

ceteris paribus assumption (all other things equal)

Example: My happiness depends on many things (my consumption of wine, my wife’s mood,the health of my children, etc.). So let’s assume, that all other circumstances do not change -let’s only observe how the consumption of a glass of wine influences your mood, reducingthe model to a limited number of variables (so called partial analysis).

Every economic model has many other assumptions. The idea is to simplify reality in order tosay something about reality. A good model makes assumptions, that are not central to theresult. All the given economic models are logically correct (if A then B), however, it is quitepossible that the assumptions are stupid - then the results are irrelevant. Many classicalmodels assume, that unemployment cannot exist (equal supply and demand for labour). Suchmodels cannot explain unemployment, since the problem is already defined a priori. ManyKeynesian models assume that prices are fixed, which is nonsense.

marginal analysis concept

Accidentally discovered in Vienna in the 1970s. Some economic decisions are all or nothing (marrying or not, abstention from alcohol, MAIS or ETIA, etc.), but these are very rare. Theusual decisions are gradual or marginal (drink more or less alcohol).

Example: How will your happiness change, if I give you wine? What is the additional happiness I derive from an additional glass of wine?

This value is called marginal utility .

u

( u t i l i t y )

w (wine)



!w

!u



The utility (u) is dependend on different values: u(x1, x2, x3, ..., xn, w), however, in our modelwe assume that the values (x) - (xn) do not change (ceteris paribus!) and consider only thevariable wine (w).

The additional happiness (benefit) I derive from an additional glass of wine is the so calledminimum marginal utility . The first glass adds to my happiness, the second also, but less, the12th glass makes me sick and reduces my happiness. While my overall (average) happinessincreases, my marginal utility inclines at that point. The marginal utility is the slope of thecurve; at some point the marginal utility becomes negative. The “law” of diminishingmarginal utility is a very common economic feature.

!u / !w = muw (the marginal utility of wine) “!” is the sign for change.

In most cases only marginal decisions matter (more or less wine), not the absolute ones (todrink or not to drink).

How do economic models achieve the optimum? - i.e. how much wine should I consume?

marginal utility: The additional benefit I get from drinking a glass of wine.cost of drinking wine: a) how much do I have to pay b) health costs, etc.

The marginal cost is a) + b)

So I compare my marginal benefit (mb) with my marginal cost (mc). If the marginal benefit ishigher, I drink another glass.

If we assume, that the steps are very small (i.e. drops instead of glasses), than I should stop atthe point at which the marginal benefit equals the marginal costs. This is the typical result ofmicroeconomics - the optimum is where the marginal x is equal to the marginal y.

a m o u n t o f ( m c ) a n d ( m b )

marginal utility (mu)



stop drinking!

mc

mb



Now let’s go back two steps and take a look at economics in general.

Microeconomics looks at individual goods and their contribution to alleviate the economicproblem (how much wine should I drink, how should cars be produced, etc.). Yet there areeconomic questions, which deal not with individual goods but aggregates (such as capital,

GDP, unemployment rate, labour & capital income, inflation). These are macroeconomicquestions. A government for example has micro- (individual good and people) andmacroeconomic functions (increase money supply, raise level of taxes).

International trade theory: application of microeconomics to the international sphereInternational monetary theory: application of macroeconomics to the international sphere

The main microeconomic questions concerning the allocation of scarce goods are:

- how much of the goods (which?) are/should be produced?- how are these goods produced?- who should get these goods?

The answers depend on the organisation of economy. Two paradigmatic ways are possible:

1. (centrally) planned economy2. market / exchange economy (ownership rights; the owners can decide what to do

with goods: exchange in the market, use for production, etc. - the outcome of thisexchange process decides the allocation)

A priori one would assume that the planned economy is more rational than the market

economy, which has no coordinating mechanism. That was the opinion after both worldwars. The idea was that national ownership is much more efficient and less dubious. Sincethen there has been a reaction against this. How does a market / exchange economy solvethe economic problem? If we can predict it (and we can), is the outcome good or bad (is itefficient)? What could the government do in instances where it is not efficient? Empiricalevidence shows that market economy usually performs better then planned economy in thelong run.

What’s the market?

The market is the place where supply and demand meet, where exchange takes place. Prof.

Neudeck is a demander for wine. What determines the supply of a good? And what cangenerally be said about the demand of goods?






Session 2 | 7.10.2010

Prof. Neudeck’s demand for wine (DW) depends on his income (Y), the price of wine (PW),

the price of other goods ( Pother) and his preferences (Pref).

DW (Y; PW; Pother; Pref)

Not all goods have this future, some products are consumed less when the income rises (e.g.cheap coffee substitute) - negative relationship between income and the demand for thisparticular good. These proportionally declining goods are called inferior goods.

The “law of demand” curve - relationship between price and demand.

substitution effect

I live in a world of scarcity. How should I use my scarce budget on the various goods that

give me pleasure? If the price of wine goes up (ceteris paribus), then wine becomes moreexpensive in relation to other goods. If I’m rational, I’ll switch from wine to other relativelycheaper substitutes.

income effect

We have assumed, that, as the price of wine goes up, my income remains the same. In realitymy real income goes down (relatively) when the price of wine rises, since I can buy less winewith the same income. This income effect will reinforce the substitution effect and lead to thefact that a higher price correlates with a lower demand.With inferior goods the income effect logically opposes the substitution effect. The goodsconcerned by this perverse effect are called Giffen goods. These are theoretically possible,but not realistic in the empirical world.

P

( p r i c e )

Q (quantity)



D1 (demand) fornormal goods

D2 (demand) for

Giffen goods



Two economically important examples, where the income and the substitution effect alwayswork against each other:

1. The demand for leisure is the opposite of the supply of labour. The price of leisure is thewage. If wages go up, leisure becomes more expensive (the wage being the cost of leisure),

therefore people would demand less leisure and work more. However, there is also anincome effect. If wages go up, people get richer and demand more leisure.

2. Savings. The price of savings is the interest rate. If the interest rates goes up, thesubstitution effect tells you to save more. On the other hand the income effect tells youthat the higher interest rates contribute to your wealth and you spend more.

The important thing is not to forget the income effect. Apart from the Giffen effect, there maybe other reasons why the D2 curve looks so perverse. One of them is the so called

Veblen effect

Veblen realised that prestige in America does not depend on your academic degree or yourtitle but the amount of money you have. It is hence important to “show money” by buyingthings that are expensive. People buy more things the more expensive they become in orderto show off (expensive wines, accessories, clothing labels). Most goods are of course notVeblen goods, but they do exist. Something similar is called the snob effect - you buy morenot necessarily to show how rich you are, but primarily to be different .

In our model we implicitly assume that people know what the goods are they are buying, wethus exclude the variable that people believe that more expensive goods are automatically

better and are hence not perfectly informed.

A third factor affecting Prof. Neudeck’s demand for wine is the price of other goods. Willwine be a substitute or a complement? If the price of Sturm goes up, he will drink morewine. If it is a complement, on the other hand, that we consume together with other goods(cheese), the effect will be inverted - if the price of cheese goes up, the consumption of winewill decline.

Finally, the demand for wine is also affected by preferences (personal wishes, happiness andutility factors).

Now, what determines the supply of wine?

SW (Pw; Pinput; Tech)

Firstly, the costs of the inputs (Pinput - grapes, labour, machineries, other products). Further:The price of the wine (Pw) - at a higher price, the supplier is willing to sell more. Lastly, thetechnology (Tech). These are the only three factors influencing the supply of goods.





In the market, we are not interested in individual suppliers and demanders, but in all ofthem. If we combine all individual supply and demand functions, we get an aggregatemarket demand / supply function, that will depend on all mentioned components.

The market demand function derived from individual demand functions will look like thenormal demand function (since Veblen goods are rather rare, etc.). Analogically, the sum ofall individual supply functions will create the market supply function, creating a similarcurve. If we bring those aspects together, we have to make an assumption:

perfect competition

“If I shoot one of you, nothing changes”. The individual has no influence on the outcome -this is what we mean by competition (if one drinker drops out, that doesn’t change themarket). More specifically that means that everybody is a price-taker . The decision is how Ican buy the good, not how much I have to pay (normally we cannot bargain in thesupermarket). Similarly, the competitive supplier cannot influence the price. Whatever onedoes with his BP shares, he or she cannot influence the prices of BP goods. If everybody

takes prices as given, then the market demand curve should look exactly as the (normal)individual demand curve. So will the market supply curve. It only makes sense to draw thiscurves, if we have some form of competition (prices are given).

P

( p r i c e )

Q (quantity)



S (supply)



Classic demand-supply curve.

At the equilibrium point every demander buys exactly as much as he wants, and everysupplier supplies exactly as much as he wants. But what would happen, if the prices werelower? A bidding process will start, until the equilibrium point is reached. This will alsohappen when prices are too high. The equilibrium is stable, nobody has an incentive tochange his or hers demand / supply (Nash-equilibrium).The function of the price mechanism of the market is to coordinate millions of demandersand suppliers. The only thing relevant for the individual actor is: “How do I get my wine.”The market mechanisms answers in a consistent way our basic questions (how the allocation

happens):

What is produced? - All the goods, which are demanded and supplied.How much is produced? - The equilibrium quantity.How are they produced? - However the suppliers decide to produce them.Who gets the goods? - Those demanders willing to pay the market price (or more).

The most frequent mistake made in economics, not just by students is the difference betweenmoving along a curve and shifting a curve.

The demand curve shows the relation between price and quantity ceteris paribus. As the

price of the good changes, we move along the demand curve (it increases or decrease). Whathappens, if one of the other factors does change (no more ceteris paribus - e.g. income rises,preferences change, prices of substitutes go up, complements [cheese] become cheaper)? Inthat case the demand curve will shift to the right towards more demand. That is true not onlyfor the demand curve, but for each and every curve. The same is true for supply. If technologyand input prices change, the curve shifts. This insight enables to predict certain developments(e.g. price tickets after 9/11 - was not clear, since the demand decreased, but the costsincreased (security measures). What was clear, was that the quantity declined).

P

( p r i c e )

Q (quantity)



S (supply)

D (demand)

equilibrium

Q*

too high prices

too low prices




Session 3 | 12.10.2010

When we draw the supply and demand curves, we find the intersection in the equilibriumpoint, where a demander can buy as much as he wants to buy and a supplier supplies as

much as he wants to. This only makes sense under the condition of competition, where youtake the prices as given and only decide how much you want to buy. The market answers allthe essential questions of allocation (cf. session 2).

•How do we derive supply and demand curves?•How do we measure it?

The derivation of demand is mathematically very tricky, yet logical and intuitive. The demandfunction is being derived by the application of the economic principle: maximisation underthe scarcity constraint. We all are the demanders - the person to be analysed is hence theindividual household . What do they maximise? Their “happiness” - i.e their utility . What are

the constraints, how do we explain scarcity? Primarily the budget constraint (income & pricesof the goods - which types of goods can we afford?). So we could derive the demand curveby defining the utility function depending on the goods they are able to buy under certainconstraints. It is not surprising, that if we do a maximisation process (utility under a budgetconstraint), the result will depend on preferences, prices, and income, which is also intuitive.If one price goes up, you may shift from one good to another, etc. - all this can bemathematically shown (cf. appendix of Mankiew’s book). This is close to the originaleconomic problem. As Adam Smith said: consumption is the sole purpose of production.

Supply is much more complicated. Demanders directly increase their happiness by buyinggoods. Suppliers on the other hand have to take much more complicated decisions. Firstly,they have to (a) produce the goods (cf. all the components), then thy can (b) sell it in themarket - it is a much more time consuming and more complicated process. Most goods arespecifically produced for our consumption. Because this process is more complex, we have

P

( p r i c e )

Q (quantity)



D1

D

S

S1



to make stronger simplifying assumptions. Who are the suppliers? We call usually them firms.Firms maximise a specific form of utility - i.e. profits (which is much more specific thanmaximising utility). The profit (!) is the monetary leftover after the decisions: revenue (R)minus costs (C). Revenue is the money that flows into the company from the sale of its goods,costs is the money they pay for the factors of their production.

!(Q) = "R(Q) - "C(Q)

Why is profit maximisation the reasonable assumption? In a market economy, the profits goto the owner of a firm, who is a decision maker. This makes sense. Once you have themoney, you can use it for whatever you want (increase utility / happiness).Secondly, if you don’t maximise you profits, you will very likely make losses, go bankruptand leave the market. This is only a simplification, a first approach.

What are the constraints of a firm? Most importantly, technology. What can be produced andhow difficult it is to produce a certain good. We can analyse the supply curve by startingwith the theory that a firm maximises profits under technological constraints. Before you cansell something, you have to have (produce) it. In order to know how to produce the good(wine), you need a production function. This function shows the relation between thequantity of output and the quantity of various inputs (land labour, machinery, etc.). Theproduction function represents the technology of production - a pure technical, functionalrelationship, no money involved. The same output can be produced with differentcombinations of inputs.

QO = F (Q1, Q12, Q13, .... QIN)

A few features of the production function: how can it typically be characterised?

1. Look at the marginal product, under the ceteris paribus assumption.

If you employ too many workers, they are a waste and the overall output declines (assumingthat all other inputs don’t change). The marginal product MPIN1 (represented by the slope of

Q [ O ] ( q u a n t i t y o f o u t p

u t , i . e . w i n e )

Q[IN1] (quantity of input 1, i.e. labour)



"QIN1

"QO



the curve) is the additional output (in wine) that can be achieved by an additional unit of theinput.

MPIN1 = !QO / !QIN1

2. What happens, if we increase (double) all the inputs (land, labour, etc.)? There are severalpossibilities:

a. all outputs doubles too. This is what we call constant returns to scale (scale doesn’t reallymatter). Very often we assume this, and the rationale for it is quite straightforward:duplication. All macroeconomic growth models use this assumption.

b. Theoretically, it would also be possible that doubling the inputs leads to more than doubleoutputs. This is what we call increasing returns to scale or economies of scale. Forexample, I do not need a second design office if I re-produce a type of car.

c. Of course it would also be possible that doubling all inputs will less then double theoutputs (decrease return to scale or diseconomies of scale).

The second thing the producer knows, is the price of the inputs. Your production decision isbasically based on costs. In economy, costs means opportunity costs. In this model, wesimplify costs to money (how much do I have to pay for my inputs to produce the wine?). Forthat I have to derive the costs function.

What firms try to do first, is to minimise the costs. No firm, which does not minimise itscosts, achieves profits. The cost function depends on the technology and on the price of theinputs. What is the minimum of costs for each quantity you want to produce? This is alreadya very difficult decision process: I can produce different quantities of wine with differentqualities (varying quantity of vineyards, workers, land, etc.). There are many ways to producethe same quantity of wine, the cost function tells me the cheapest way to do so (e.g. if labouris expensive, I apply more machinery and vice versa). The cost function is already the resultof this maximisation / minimisation procedure. Whereas the production function is a purelytechnical relationship, the cost function is already an economic relationship. Fixed costs (CF)are basic costs I have, even if do not produce anything yet. The more I want to produce (the

C ( c

o s t s o f t h e i n p u

t s )

Qw (quantity of wine)



!C

!Q



higher the output), the higher the costs - variable costs (CV). The marginal costs is theadditional cost of one additional produced unit: MC = !C / !Q.

Why is this plausible? At the beginning, producing the first units, there are almost alwayseconomies at scale at work (the marginal cost is declining). But why are marginal costs risingat the end? The reason is scarcity . As you extend production, factors become scare, thusexpensive - i.e. you will have to pay higher wages the more difficult it becomes to findworkers, you will have to higher additional managers, even the raw materials will becomemore expensive (you will have to buy from more expensive suppliers). Other possible costfunctions would be:

M C ( m a r g i n a l c o s t s )

Q (quantity)

if: then:

C

Q

M C

Q

C

Q

M C

Q



MC



Given the cost function, how much output will a firm supply at each price? Deriving thesupply curve. Let’s start with deriving it mathematically. What is an optimal output supply?

!(Q) = R(Q) - C (Q)

To maximise this function, we have to set the first derivative equal to zero. The first derivativeis the marginal profit:

!’(Q) = MR - MC’ = 0 MR = MC

This is the typical maximisation requirement. If the marginal revenue is higher then themarginal cost, it makes sense to increase production, otherwise you should reduceproduction. Let’s apply this to a competitive market.

How much do I want to supply at a given price (P, this is of course also true for any otherprice)? What is the additional revenue you get, when you sell one more unit? It is the price ofthe unit. The optimal quantity of supply is where the price-line hits the marginal cost curve.The supply curve is nothing else than the rising part of the marginal cost curve above the

average cost curve!

Now we want tot define average costs (AC). The marginal costs are the costs of the last unit just produced. In contrast, the average cost is: AC = C / Q. The last unit is always the cheapestunit, the average cost will thus be higher than the marginal cost. As long as the marginal cost(last unit) is cheaper then the average cost, the average cost will be falling.

Let’s go back to the supply curve. Average profit (AP) is average revenue (R) minus averagecost (C). At a price level of P3 I would leave the market.

P

( p r i c e )

Q (quantity)



MC

P1

AC

P2 (AP=0)

P3

su l curve !!




Session 4 | 14.10.2010

So far we have only looked at qualitative relationships: demand depends negatively on price,

supply positively. However, we need to measure how supply and demand reacts.

Absolute change: how many units are less demanded, if the price goes up by 1!. But thisdepends on what the size of the good is (cf. chewing gum vs. Rolls Royce, in the latter casethe demand will not change if the price goes up by 1!). Therefore, it depends also on the

level of the price. We use hence a relative measure, called elasticity (! - always in %). Theprice elasticity of demand tells us how output demand changes (by how many %), if the pricechanges (by 1%).

"Q(D) / Q(D)

="P / P

So usually we make three distinctions:

1. elastic demand (reacts strongly to price): if this elasticity is larger then 1, the quantitydemanded goes down by more than 1%,

2. inelastic demand (does not react strongly to price): if this elasticity is larger then 1, thequantity demanded goes down by less than 1% (e.g. 1/2),

3. completely inelastic demand: the demand does not change.

The relevant area is where the supply curve intersects the demand curve. Normally, the priceelasticity is negative, however, only the value is relevant. The price elasticity of supply worksanalogous. Or we could ask for the determinants of demands (other goods) - indirect orcross-price elasticity. If the price of cheese goes up, by how many % will the demand forwine change? This depends if wine is a substitute (positive) or a complement (negative). Wecan also determine the income elasticity of demand - if income grows by 1%, how does thedemand change (can be income-elastic or income-inelastic), with inferior goods it would, ofcourse, be negative.Usually, goods which are necessary (“necessities” - such as salt, etc.) have a low priceelasticity of demand, but also a low income elasticity. In contrast, luxury goods have a highincome elasticity (electronic gadgets) and also a high price elasticity. The concept of elasticityis essential.

Let’s go back to our analysis of markets. We have derived supply and demand for acompetitive market. Let’s look at situations, where the assumption of competitive marketcannot be attained. The classic example would be the case of monopoly , where just onesupplier exists. It makes no sense that the supplier is a price-taker (takes them as given), he isby definition a price-setter. How do monopolies come about?





1. The monopoly owner may be the owner of a scarce resource,

2. Much more common: state monopolist (when the states protects and guarantees themonopoly) - much of early economic theory was a fight against these monopolists, and

3. Natural monopolists. We have said that the supply curve is nothing else than the rising

part of the marginal cost curve above the average cost curve! In the case of naturalmonopolists marginal costs are falling (e.g. big economies of scale: designing a Jumbo

Jet - wouldn’t pay for two companies to do so), the largest firm is the one whichproduces cheapest, so eventually the small firms will be driven out by the largest.

Can the monopolist charge any price (s)he wants? No, because even for monopolists there isthe restriction of demand. However, a monopolist faces the entire demand curve - what is theoptimum price-quantity relationship? Where profit is highest. The condition for maximisingprofits is that marginal cost is equal to the marginal revenue (MC = MR). In a competitivecase marginal revenue is equal to the price, in a monopoly, however, the marginal revenue issmaller than the price. If you want to sell one addition unit, you will have to reduce the price(the price of all units I could have sold minus the price I get for the additional unit).

The so-called point of Cournot (C) is the optimal point on the demand curve

(monopolist outcome)

MC = MR < p

Let’s compare the competitive and the monopolistic outcome. Monopolists sell less andcharge a higher price; because they have an incentive to restrict output in order to achieve ahigher price.

Oligopoly

An oligopoly is a market form in-between. It has not one supplier, but several. Each supplieris strong enough, that his action would influence the market. If you shoot an oligopolist,things do change (which is not the case in a normal, pluralistic market situation). Oligopoly

P

( p r i c e )

Q (quantity)



D

MR

MC

competitive outcome

C



seems the most common assumption in many markets. The trouble is that it is also the mostdifficult one. In the monopolist case, there are no others, in the competitive case, they don’tmatter. Here you have always to assume what the actions of the others are, depending onyour assumption about the reaction function the model differs (there are thousands). Themethodology we are going to use is game theory .

Three stylised facts which show the problems, but also realistic situations:

1. Cartels: how can we together maximise our profits? In behaving like a monopolist(which is not always illegal). Oligopolies are inherently unstable. The point of anoligopoly is to reduce output to get a higher price (cf. OPEC). Each individualparticipant has an incentive to cheat.

2. If you can’t form a cartel with your fellow oligopolists, kill them (by bankrupting themwith very low prices - ruin competition). So very low prices may be a sign of anoligopolist trying to become a monopolist - too low prices may be as dangerous as toohigh prices.

3. Price stickiness. Normally, if anything in supply or demand changes, prices will change.Very frequent price changes would be expected in both competitive and monopolistmodels. But often prices do not change (cf. newspaper) - in an oligopoly people havethe following expectation: If I raise my price, my fellow oligopolist will not follow (I’mgoing to lose a lot of demand), on the other hand, if I lower my price, my fellowoligopolist will lower their prices too and I don’t gain so much.

This leads to a ! kinked demand curve (developed by Sweezy ).

Game theory was developed in an economic context after the war by Oskar Morgenstern and John von Neumann to analyse strategic interactions (what you do, depends on whatothers do). In the simplest case there are only two players and each of them has a strategy.The pay-off matrix shows you the outcome for each player depending on the applied strategy.The most common example of a game is the Prisoner’s Dilemma, showing how theequilibrium concept works.

P

( p r i c e )

Q (quantity)





Two criminals, Bonnie and Clyde, are caught. If you witness against your co-criminal (andsecure the others conviction) then you will be let free. So you have a choice to confess ornot. In the case nobody confesses, there is not enough evidence for the major crime, only aminor one (one year imprisonment). What is going to be the equilibrium? This game has astrong solution, because there is a dominant strategy for both of them: whatever the otherdoes, it’s always better for me to follow the dominant strategy.

Bonnie:

Clyde:

8 years

8 years

Bonnie:

Clyde:

20 years

0 years

Bonnie:

Clyde:

0 years

20 years

Bonnie:

Clyde:

1 year

1 year

Dominant strategy equilibrium concept

If Clyde confesses, ! it is clearly better for Bonnie to confess too.If Clyde does not confess, ! Bonnie is still better of when she confesses.

Whatever Clyde does, it is always better for Bonnie to confess. This is her dominant strategy !Analogous, this is also true for Clyde’s strategy.

Secondly (and paradoxically), there would be a situation, where both would be better off bynot confessing. If they could have agreed not to confess, they would both be better off.

This dominant strategy produces a strong equilibrium, but is not advantageous to either party.

Applied on an oligopoly (duopoly in this case), the following question arises: should theyform a cartel? Should they cooperate or not? Cooperation in a cartel means to reduce theoutput in order to achieve the highest price.

firm A:

firm B:

3*

3*

firm A:

firm B:

4*

0*

firm A:

firm B:

0*

4*

firm A:

firm B:

1*

1*

* profits in million

If B cooperates, ! A will not (profit: 4).If B does not, ! A should also not cooperate (profit: 1)The same is of course also true for B. Thus the dominant strategy is to cheat .



C l y d e

Bonnie

confess | not confess

n o t

| c o n f e s s

n o t

|

c o o p .

cooperate | not cooperate

fi r m B

firm A



The dominant strategy predicts the breakdown of the cartel. This is why most oligopolies areunstable - there is an incentive to cheat. Following measures against this dilemma resultingfrom the strategy based on the incentive can be imagined: •external rules: if you cheat, you die;

• Aumann looked at repeated games (in all following games do what the partner did in thefirst game), which may lead to an optimal outcome.

The beautiful thing here is that we have an easy equilibrium concept. However, dominantstrategies are not that common. An example would be the most general equilibrium conceptin all economics: Let us assume, the actors are car firms. They can produce either small orbig cars (we assume that big cars bring higher profits). If A produces small cars and B bigcars, then there is not so much competition, so each can get higher profits. The optimum is to

produce whatever the other is not producing ! there is no dominant strategy!

firm A:

firm B:

1

1

firm A:

firm B:

5

4

firm A:

firm B:

4

5

firm A:

firm B:

2

2

The Nash-equilibrium (after John Nash) is a situation where there is no incentive to changethe strategy, if the others don’t change their strategy; i.e. if every single actor has no incentiveto change his or her behaviour, given that the others don’t change their behaviour.Competitive and oligopoly equilibria are Nash-equilibria.

If both would be producing small cars (or both big cars) the situation would not be a Nash-equilibrium. The trouble is that [A5,B4] and [A4,B5] are both Nash-equilibria, and we do notknow which one will take place. This is not predictable in a supply-demand model.



small cars | big car

b i g

|

s m a l l

firm A

fi r m B




Session 5 | 19.10.2010 [credits for the notes to Muguet and Aylin]

Part1: Market Equilibrium and the characteristics of competitive market

In a competitive market supply and demand depend on the price. The demand curve has anegative relation to the price, whilst supply has a positive relation to the price. At theintersection of supply and demand we find a stable Nash-equilibrium, because supply equalsdemand, the forces of the market move us in the direction of this point - no one can do anybetter than at the equilibrium point. Here the microeconomic allocation questions areanswered (cf. page 4 and graph on page 8).

Pareto efficiency

Economic efficiency is present, if resources are used in the best possible way to achieve therequired ends. Pareto efficiency (after Vilfredo Pareto): a situation is efficient if you cannotimprove anybody’s utility without reducing the utility of someone else. If you can still makesomeone better off without making someone’s utility decline then this situation is not Paretoefficient. That tells us two things: You cannot really compare peoples utility. Basically, Paretoseparated distribution from efficiency. It does not tell us anything about justice in a givensituation, but it may be economically efficient. An inefficient outcome is always bad, but anefficient outcome is not always good. We are hence dealing with a trade-off between justiceand efficiency.

So is a competitive market outcome efficient? Yes, but showing that is quite complicated. Arrow and Debreu were the first economists to develop the proof of this point. For an

economy that exists of multiple markets the outcome will be efficient. Why is this outcomeefficient? It answers all basic questions of allocation in an efficient way.

How should we produce that good? In a market a good is being produced in a costminimising way for the producers.

How much is produced? The demand curve shows the willingness to pay, the supply curverepresents the marginal cost (MC). As long as the willingness of the demanders to payexceeds the marginal cost, we should produce. Hence equilibrium is perfect where supplyand demand intersect.

Who should get the goods? The goods are sold to the demanders who value it most. Andthose how don’t pay enough will not get it. This is exactly what the market achieves.

What is the benefit that people get from participating in a market? The benefit that aconsumer gets out of operating in the market, is the difference between the willingness topay and the actual price - the so called consumer surplus (CS).





The suppliers’ profit is the producer surplus (PS), being the difference between revenue andcost (R-C, or between the price and the willingness to sell).

The welfare in a market is the sum of consumer and producer surplus (CS+PS), theequilibrium point is where the two meet.

Enrico Barone, the first great theoretician of socialism during the mid-World-Wars period,found that if a market can lead to an efficient outcome, the state should tell the producers todo so as well - pledge for the state as a social(ist) planner. A socialist planner can do what themarket can do an also more. This should be an advantage. Barone’s ideas reflect a strongpolitical economist thoughts. However, he was wrong practically. Socialist economies neverwork efficiently out of two reasons: in order to derive a market or planned economy,assumptions need to be made. Different assumption are made between the two systems,however, the market economy makes more realistic assumptions (cf. Adam Smith: “The

Wealth of Nations”). Why is that the case? Why does a planned economy not work eventhough the models are the same?

1. Incentive Assumption

Market economy: Consumers maximise their utility, firms maximise their profits.Socialist economy: The planners of the economy want to maximise welfare. This assumption

of benevolence is not clear.

The incentive assumption of the market model is hence more realistic than a socialist marketeconomy, being the first big advantage of market economies - realistic assumptions aboutpeoples incentives.

P

( p r i c e )

Q (quantity)

P

( p r i c e )

Q (quantity)



D

S

PCS

PS

D

P

benefit

consumer surplus (CS)



2. Information Assumption

Mises and Hayek claimed that the differences in incentives are not as important asinformation / knowledge assumptions.

Market economy: We have assumed that each household (being the basic unit) knows the

price, its preferences and its income. For firms we have assumed thatthey know their input prices and the technology of the good they make(production function), this is, however, not always the case.

Socialist economy: The planner knows all the preferences, technological possibilities, allgoods wanted, etc. - this is clearly impossible.

The beauty of the market mechanism is that it concentrates all relevant information in onepoint: the price. When buying a shoe or a bottle of wine, I just need to know the price,whether all other people want it is not relevant. These two systems are no longer a debate,since a pure socialist economy proved to be obsolete. However, a the third point is stillunder debate: the role of the state in a market economy.






Session 5 | 19.10.2010

Part 2: Government intervention in a competitive market .

If a competitive outcome is efficient (in a simple, perfectly competitive market withoutexternalities), than any fooling around with this outcome (standard government intervention)will lead to inefficiency and therefore it shouldn’t be done. We will show this by usingconsumer and producer surplus. There are two most important types of governmentintervention: price regulation & taxes and subsidies (being negative taxes).

1. price regulation

Let’s assume the government introduces a price ceiling (classic example in Austria: priceregulated rents on houses, e.g. “peace rent” introduced in 1916, when the prices had toreturn to 1914 levels, which is pretty low). The price regulation only becomes relevant whenthe price regulation (Pmax) is below the equilibrium price. Of course, at this low price, lots ofpeople would like to buy the good, but very few people are willing to sell. What happens, ifsupply and demand are not equal? Always the smaller side, in this case the suppliers,determines how much is actually transacted.

What’s the efficiency effect of this? Producers (people who want to offer flats) lose of courseB+D, because the prices are pressed. Consumers get less at a lower price.

producers -B -D (lost producer surplus)consumers +B -C (lost consumer surplus)welfare / efficiency loss -D -C

The achieved idea of price regulation is redistribution. However, nobody gains D and C,which is the efficiency loss. Because of the price ceiling too few goods are produced.Consumers would be willing to pay more than producers ask. So price regulation also leads

P

( p r i c e )

Q (quantity)



S

D

Pmax

! price regulatedequilibrium

A

B

C

D



to inefficiency. This, by the way is the minimum loss - in reality the loss would be higher,because - given this rent regulation - only those who particularly want the flats will get them.In reality, however, anyone of all the demanders can get the flat, even those who do not needit at all. On the other hand, those who would need it most, might not get it. At this low price,the availability matters. Two things follow: government intervention leads to inefficiency &distribution.

2. taxes (and subsidies)

The easiest way to capture a tax, is to say that it will raise the costs of the suppliers (thesupply curve shifts upwards (marginal costs + tax). The result is a higher price at a lower

quantity. The difference between the two curves is the tax rate (!).

What about consumer and producer surplus? Consumers now pay a higher price, so theyhave a loss in consumer surplus (A+B). Producers now charge a higher price, but they get alower price due to the tax they have to pay to the government (they are selling less at a lowerprice). Both producers and consumers lose. Who gains? The government. How much? Thequantity that is sold times the tax (A+C).

consumers -A -B (lost consumer surplus)producers -C -D (lost producer surplus)government gain +A +C

The point is, that the government gains less than the producers and consumers lose. B+D isan efficiency loss (dead weight loss). Taxes, thus, create an inefficiency by reducing output (itis no longer attractive to produce that much). A tax on wine leads to inefficient amounts ofwine drunk, etc. - but most importantly: a tax on wages leads to too little work (leisure is nottaxed, therefore people will work less). Almost every tax leads to distortion, except so-called lump-sum taxes, which do not connect to any economic activity (head tax, everybody pays it,

not avoidable by changing ones behaviour - however, they do not make much sense). Thedead weight loss (B+D) varies in size, depending on the elasticity: If the curves are very steep(the actions do not depend much on price), then the dead weight loss is relatively small.Whereas, when people react very much to price changes (if elasticities are high), then the

P

( p r i c e )

Q (quantity)



D

S=MC

C+tax

A

C

B

D

Q*

P*

!

( t a x

r a t e )



dead weight loss is much larger. So ! efficient taxes should be taxes on goods, which areeither inelastically demanded or inelastically supplied. You should never tax elasticallysupplied or demanded goods. Of course, it also depends on the size / level of the tax. Goodtaxes should hence also not be to high (cf. Laffer-Curve).

Laffer was an advisor to president Reagan, he supposedly drew this curve on the back of anapkin. The idea was the following: if the tax rate is zero, then you have zero tax revenue. Asyou increase tax rate, your tax returns will go up. On the other hand, once you tax activitieswith 100%, nobody is going to do it. So if we start from zero and go back to zero, there mustbe a turning point - according to Laffer an optimum tax rate.

Theory of tax incidents - who has to carry the burden of a tax? Not who pays the tax, that

doesn’t matter (in most cases the suppliers pay the tax). Usually, if you tax a good, both thesuppliers and the demanders are hit - but who is hit more? That depends on elasticity. As arule the inelastic side is hit more by a tax. Example: inelastic demand curve (steep) and arelatively elastic supply curve.

The price of the consumers goes up a lot, whereas the price of the producers goes down onlya little bit. Therefore, the main burden lies with the consumers.

0% 100%

t a x

r e v e n u e

tax rate

P

( p r i c e

)

Q (quantity)



optimum tax rate

D

S



Subsidies

Everybody hates taxes, but most people love subsidies. However, from an economic point ofview, it’s just as bad - a subsidy is just as inefficient as a tax. A subsidy shifts the supply curveto the right (people only have to pay the MC minus the subsidy), the output is increased. The

effect now is, that from an efficiency point of view, too much is produced (goods havingmore costs than benefits).

Consumers, of course, love it, because they gain a consumer surplus (A+B). Producers cansell their stuff now at a higher price (including the subsidy - they gain C+D). Both producersand consumers win. However the government loses the quantity that is being produced timesthe subsidy (A+B+C+D+E), which is the efficiency loss (too much production).

consumers +A +B (consumer surplus)producers +C +D (producer surplus)

government loss -A -B -C -D -E ! more than consumers and producers gain!

Taxes are a redistribution from the people to the government (hated), subsidies are aredistribution from the government to the people (loved), still they are both inefficient. Whowill get the subsidy? Usually both, but again, it depends on the elasticities - the inelastic sidewill gain more.

In a perfect competitive market without externalities any government intervention (priceregulation, taxes and subsidies) in the market mechanism will lead to inefficiency andwelfare loss.

P

( p r i c e )

Q (quantity)



S=MC

C-subsidy

D

A B

C D

E




Session 6 | 21.10.2010

A competitive market leads to a beneficial, efficient outcome in the sense of Pareto, thevarious governmental interventions discussed so far lead to inefficiencies. Still, the

government is a rather big actor in all market economies using up to 50% of the resources,much more than in the 80s or 90s. What are the justifications for this? Even if there is a rolefor the government, it has to fight with the problems outlined (incentives, information).Potentially it could improve the outcome, but that does not mean that it automatically will doso. We will start with rather philosophical (non-economic) arguments, which often justifygovernment intervention, even if the market outcome is efficient.

1. distribution & justice

A market economy implies a certain distribution of income, because remunerations areprices that determine your income. This income distribution implicit to the market leads tothe incentive mechanism that one os being rewarded by what they contribute to consumersatisfaction (contribution to the solution of scarcity). Many people find this distribution just,yet many find this pure market distribution philosophically unjust (chancellor vs.entrepreneur, professor vs. footballer, etc.). In this case the government has to intervene.What becomes even more obvious, is the case of people born handicapped which wouldstart to die in a free market. Rawls said we should look at the link between philosophy andeconomy “under a veil of ignorance” - one cannot predict as what kind of person one will be

born (disadvantaged or not), which distribution system will be required (! one that providessome kind of safety net but does not completely change the distribution mechanism, since

this would drastically decrease a society’s development). Work incentives are being reducedby specific taxation systems. Social welfare payments are the bulk of state investments, noteconomically justified but philosophically.

2. Merit good argument (paternalism)

Has also nothing to do with economy and efficiency. Economics is about maximising yourwishes under scarcity - this is the outcome the market achieves. We don’t ask what thesewishes are. Yet very often people think that consumers are not aware of what is good to themor their wishes are wrong for moral or other reasons. In such cases the market economy will

not lead to the desired outcome, because it would rely on a wrong assumption. Merit goodsare things that people should want but (often) do not want (e.g. schooling, health andpension insurance, etc.) If you think that people are too stupid to understand the risks andimagine some contingencies, then the government has to force them to do it (obligatorypayments, welfare state). Opposite: de-merit goods (e.g. watching child pornography) - things

people would like to do but are not “good” ! prohibition.

Both arguments are easy to make, yet both very dangerous (how to distribute, what toprohibit, etc.) - may lead to self-interested corruption of politicians. Social insurance is both a

distribution and merit good argument. Let us take a look at the truly economic arguments:





3. public goods

A public good is not something done or provided by the state, it is something definedtechnically, having two characteristics: a) non-excludability, b) non-rival consumption. Aclassic case is the army. A private good would be a glass of wine (private: if I have the glass ofwine, I can exclude everybody else). The Austrian army gives us benefits (security) that does

not exclude anybody living in this country, whether I like it or not. When I’m drinking myglass of wine, nobody else can drink it at the same time (b). My benefits of being protectedby the Austrian army on the other hand does not diminish anybody else’s protection (i.e.consumption of a public good). Clearly public goods are useful, however, a market wouldnot provide them, mainly because of (a). Why should I pay for it, if others do (free-rider problem)? Because public goods are very important, we need the state to provide it(fundamental argument for the need of a state). Indeed, the existence of a market presupposed some public goods (the market would not work without defence, protection). Alegal system is also a public good. What we need for a market economy are property rights,which have to exist and be protected by a strong state (fulfilment of contracts - inter-temporaldecisions) - public goods / state intervention are not an alternative to the market economy!

The very existence of the state is a precondition of a market economy .

How is the size of a public good (e.g. army) decided? The government has to makecompromises due to different public interests. There is an enormous number of difficulties inproviding an optimal quantity of such a public good efficiently, even with benevolentgovernments. The argument for government intervention is undisputed, however, it is still alimited number of public goods. Many are partly or impure public goods (should they beprovided by the private markets or the government) - they fulfil only condition (a) or (b).

Cases:

1. fishing in the high seas - rivalry & non-excludability - common resource problem, leads toinefficiency. That problem arises with many goods offered by the government (commonfields, etc.),

2. a bridge on a river that not many people use - non-rival consumption & excludability (e.g.tolls). Theoretically, there could be private bridges, roads, undergrounds, etc. - inefficientexclusion. Should these goods be provided by the state or the market? Usually bothoutcomes would be inefficient, economic theory has no answer since it depends (on the

efficiency of the government).

4. externalities (positive or negative)

Externality results from an economic action of production or consumption. These actionshave a (positive or negative) effect on a third party which is not directly involved, they do notshow up in the books of the actors causing the externality (not noticed).

Consumption. You smoke because it gives you benefits, and you have costs (money, health).

But there are also costs that effect other people (smoke). Let’s assume that I’m wearing myties only to please myself (in front of the mirror) - that’s my benefit, the cost is, of course, that





I have to buy the stuff. We all get the benefit to see Prof. Neudeck’s tie - this is an externalbenefit of his consumption, for he creates happiness for us.

Production. Here things are quantitatively much more important (! pollution is the classiccase of negative externality). In producing steel, you have costs (ore, fuel, workers, etc.) butyou also create (air, water, noise) pollution effecting other people. If you are an apple farmer,

the bees come to your tree and are happy, which brings a benefit to the bee-keeper. But moreimportantly is innovation. You create new ideas that can by applied by other people too(positive externality). These externalities abound. We have costs and benefits that are notcovered by the market (the demand and supply function only look at the private benefits andcosts) - from the economic point of view the prices not capturing the relevant scarcity valuesare thus not true. The market will provide too little of the respective goods if they do notcapture the external benefits. On the other hand, if there are external costs, too much of thegoods will be provided - the market outcome will be inefficient.

Let’s assume the production of the good creates pollution (negative externality)

The problem is not that a cost is being created, but that it does not show up in the balance. A. C. Pigou discovered that if a negative externality exists, then the government should taxthe production of the good (so high as to cover the social costs - “Pigou-tax”, e.g. carbon-

tax), if a positive externality exists, the government should subsidise. The trouble is tomeasure externalities. This is a so-called price- or market-based government intervention. Inthis case taxes would lead to more efficiency ( prima facie argument for governmentintervention). Are there other ways a government could intervene?

• regulative measures (command & control, usually market-based interventions are better)• create pollution rights and sell them (to market the externality)

P

( p r i c e )

Q (quantity)



S=MC

S=PMC[private MC]

positive externality(too little produced)

negative externality(too much produced)

D

welfare loss!

these goodsshould not beproduced!




Session 7 | 28.10.2010

5. market power

Deriving the Pareto-optimality we have assumed perfect competition. The efficiencyproblem / failure of monopolies is that they have an incentive to produce too little (marginalrevenue equals marginal cost [MR = MC], and not where the price is equal to the cost).

The government has the following possibilities of intervention:

1. break up the monopoly and create competition,2. nationalise the monopoly and order the new state monopoly to set up marginal costs,3. engage in price regulation, i.e. introduce a maximum price at the level where a

competitive market would produce it. In this case the monopolist will behave like aperfect competitor and take the prices as granted. In reality, however, this remainsimpossible, since the government cannot know the optimal prices.

In a competitive market price ceiling will always reduce output and reduce efficiency, in amonopolist market just the contrary would be the case. If the right price would be known, itwould justify price regulation by the government.

J. A. Schumpeter (the most quoted economist at the time of his death) defended monopolists.The discussed model is nice, but it doesn’t capture the essential idea of capitalism, because itis static (“like Hamlet without a prince of Denmark”). Capitalism is a dynamic process

“driven by the hero of the entrepreneur” - capitalist development goes in stages:

1. invention [Erfindung]: a new idea (about the product, marketing, etc. - e.g. the typewriter,invented by Mitterhofer - economic consequence: zero)

2. innovation (Erneuerung): when a given new idea is applied in the economic process (e.g.Remington supposedly introduced the first functioning typewriter into the market: greateconomic impact). According to Schumpeter the innovator is by definition always amonopolist. Being a monopolist, he or she of course restricts output to achieve a higherprice and earn monopoly profits. But these profits attract imitators.

3. imitation: the product is being broadly sold.

Schumpeter’s definition became a defence of monopolists (based on innovation), asinnovators are being seen as driving forces of the market (not like the “crazy” inventors).Economically, only innovation counts, not invention. The high profits are an importantincentive for (a) innovators and (b) imitators, who will destroy the former in the end anyway.Government intervention would destroy these incentives. The classical example is the marketof pharmaceuticals. A price cap on medications would completely destroy the incentives forfurther developing new / better medicines.

A second contribution by Schumpeter in this dynamic view of the market is the process ofcreative destruction, the discussed dynamic development is not only “nice”: once the

innovation is done, the people who haven’t innovated (the old producers) are going to bethrown out of the market - there are a lots of losers, not out of their fault. It’s also a brutal andnasty business - you can rise quickly, but also fall quickly.





The three pillars of market economy:

Smith (incentives)Hayek & Mises (price information)

Schumpeter (innovation incentives, dynamics)

These where the traditional reasons for government intervention. In more recent times (80s,90s), however, other problems in the context of failing markets have been analysed. The buzzword here is:

Asymmetric information

So far, we have assumed perfect knowledge (about preferences and prices by consumers, andabout the production function and input function by the producers). If I buy a Schnitzel, I donot know exactly how I’m going to like it. Producers have an idea about the costs, but thereis an uncertainty. That means that people have to form expectations. That would seem like arather big criticism of the whole model. We have thus to adapt it by adding an“expected” (utility, budget constrain, prices, revenues) to it. This means I may bedisappointed by the taste of the Schnitzel, but the expected benefit was higher than theexpected cost. Two things would have to be added to the simple model:

1. risk preferences (additionally to preferences about goods) - these may be risk neutral, riskaverse (normal case), or risk loving,

2. this gives rise to new markets: insurance markets - trade between risk neutrals and risk

averse - (implicit) insurance contracts are extremely common. Practically every regularlyearned wage is an insurance contract (otherwise I should earn accordingly to the amountof my work). A salary consists of an incentive contract and an insurance contract. Theclassic insurance contract is employment insurance of civil servants.

If we introduce uncertainty, the market will still lead to the best possible outcome, a newinsurance market will emerge, the consumer and producer surplus will be maximised andthe outcome will be efficient - provided that there is no asymmetric information. Normallythis works - sometimes, however, it does not. Sometimes the wrong side of the market knowsmore than the right side. Classic case: You go to a doctor, he not only knows how to producehealth, (being an expert) he also knows better how much your happiness will increase by the

treatment than you do. In extreme cases the market might break down.

G. Akerlof was the first to analyse the breakdown of markets in a situation of asymmetricinformation. He pioneered the a idea of adverse selection.What is a lemon? A car, which doesn't work properly (the workers were still drunk whenputting it together, etc.) - this can be the case with any car. In a normal market it may be evenefficient to have some lemons (would be reflected in the price - control mechanism). Akerlofwas interested in the market for second hand cars. Here the prices were much lower than itwould have been justified by the use of the car. Why? Because there is an asymmetry ofinformation. With second hand cars, the one who sells it has already driven the car and

knows therefore if it is a lemon, the potential buyer knows that the seller knows and thebargaining process may break down. The price signal from the seller (lowering it) sends thewrong signal (there might be something wrong with the good) - I will not buy the car or I will





accept to buy a lemon at a very low price. Under these circumstances markets malfunction.Unfortunately this process happens not only in the car market, but also in other markets,such as the insurance market: the insurance company doesn’t know the risk of the insuredperson as well as the latter knows him or herself. If the insurance company increases theprice, then the good drivers will not take the insurance, while those knowing that they’reprone to accidents will still take the insurance - this is a classing rationing case in the

insurance market. An other examples would be the loan market: you borrow something andyou pay back later with interest. Risk for the bank: will you pay back? Being willing to pay ahigher interest rate is a signal to the bank that I’m a crook.

There is a second problem: moral hazard . Here the asymmetry does not concern the qualityof the good (loan, car, insured person), but the (unobserved) actions of one of the persons. ifyou insure someone, it will change the incentives and he or she may take different actions(more expensive treatments, etc.). This will reduce the possibility to insure someone. If iwould be health insured for 100%, I would profit on my pain.

Imperfect information is not a problem. Indeed, it is a feature of everyday life. However,there are many cases where information is not only imperfect, but also asymmetric, meaningthat the wrong side of the market knows too much, giving incentives to adverse selection(quality of the goods) or moral hazard (hidden actions) - then markets do not work perfectlyor not at all. The trouble is that in these cases the government cannot do much since it facesthe same moral hazards itself. Established markets normally find some way around this (e.g.build up a long-time relationship with my bank). The market is very efficient in giving theright incentives, concentrating information and driving an economy (which a plannedeconomy cannot achieve). But we need the state to interfere in certain areas to a certainextend. How much state we need is much more difficult to say. Often we just have to live insituations where waste occurs.


Documents

NOTES_Microeconomics (John Hildred's Conflicted Copy 2013-11-27)