MicroEconomics Review

Paul Romer – 2 secrets of economic success for countries

1. ideas
2. economic incentives

Positive economic analysis involves attempts to describe how the economy functions
Normative economic analysis relies on value judgments to evaluate or recommend alternative policies.

Value Maximization – if the total value created in State A > State B then the total economic value of the involved parties is maximized.

Equilibrium (reference the gas station model) – Ask the question, can any player improve his position by moving and will nobody else move? Note that replacing inelastic demand (price insensitive) with elastic demand (price sensitive) causes us to lose the clustering result.

Adam Smith’s Invisible Hand – price signals of the market lead people to maximize value

Pareto Efficiency – State A is better (more pareto efficient) than State B if at least one person is better off in State A and no one is worse off than they were in State B.
Value maximization is not pareto efficient {pareto efficiency is very narrow}
Pareto efficiency is a weak normative tool and says nothing about equity
Value maximization can only be pareto efficient by compensating the losers

Market failure – when an equilibrium is established that fails to maximize value
Transaction costs – costs of reaching, implementing and enforcing agreements

If everyone trades in the marketplace and all mutually advantageous trades are completed, the price system results in a pareto efficient resource allocation.

80% of factors affecting a firm are external to it {Boston Consulting Group}

Competitive market – no individual buyer or seller has market power

Supply and Demand diagrams are snapshots at a point in time

Inferior good – if income goes up and product demand goes down

Ceteris Paribus – all else constant

A change in price (ceteris paribus) equates to a move along the Demand curve (“change in quantity demanded”)
A change in a variable not represented on the axes equates to a shift in the Demand curve (“change in demand”)

The closer the substitutes for a product the flatter its Demand curve
Scarcity of a product results in sharper upward Supply curve

An outcome is a competitive equilibrium when each agent is optimizing subject to the quoted price (competitive) and there is balance (equilibrium, S-D)

In absence of wealth effects, the value maximizing outcome is the only efficient one, where value = sum of benefits – sum of costs

Reservation Price – price above (or below) which an agent will not make a trade
1^st Fundamental Theorem of Welfare Economics – in a free market, market forces bring about the value maximizing (efficient) outcome
Deadweight Loss – lost social value resulting from reduced trade (e.g. due to an excise tax); also called welfare cost {social benefit > social cost but not sold}
Economic incidence of tax – who actually pays; in general it doesn’t matter who pays

Increased opportunity for trade ⇒ increase size of social value pie. Only distribution of gains depend on comparative advantage (of the countries involved)

Rationing schemes show up most often in connection with necessity goods

• Limited resources require some sort of rationing, whether through the market or not

Any scheme which doesn’t contend with market forces – and the market mentality whereby agents continually seek gains from trade – will be undone by them

Rent Seeking

Coase Theorem – free-market economies tend to produce efficient resource allocation (even if inequitable income distribution) whenever:

• Property rights are clearly assigned
• Transaction costs of exchanging property rights are sufficiently low {exchange must be allowed}

Transaction costs are central to the study of organizations (and rise as the # of bargainers rise)

Externalities – exist when actions of one party affect utility or production possibilities of another party outside an exchange relationship. They can prevent a market from being efficient.

When private benefit (willingness to pay) ¹ social benefit free markets don’t necessarily provide the “right” outcome. This is the case when there are externalities

Externalities cause market failures
MSC = MPC + MEC Marginal Social Cost = Marginal Private Cost + Marginal External Cost
If MEC = constant then Total External Cost (TEC) = (Ps – Pp) * X
MSC is the relevant measure for normative analysis

It doesn’t matter whether external cost is added to Supply or Demand

Two reasons free-markets are more successful than central planning:

1. price system motivates better use of knowledge and information in economic decisions
2. free-markets provide stronger incentives for individuals to make productive decisions

General Knowledge – essentially free to transfer (e.g. prices and qualities)
Specific Knowledge – relatively expensive to transfer

3 factors influence costs of transferring information:

1. characteristics of sender and receiver (language, training, culture)
2. technology available for communication
3. nature of the knowledge itself

Prices economize on costs of transferring information to coordinate decisions
Wealth effects of economic decisions are borne directly by resource owners

Free exchange tends to move resources to their highest valued use, in which case the allocation of resources is said to be pareto efficient
Inelastic goods η<1
Elastic goods η>1
Unitary elasticity η=1

If you want to raise prices, you prefer an inelastic demand
If you want to lower prices, you prefer an elastic demand

Farmers have infinite elasticity of demand
Inferior goods have η_i<0
Normal goods have η_i>1

To get η empirically, run a regression Q = a + bP_product + cP_other + … {b = η}

Relationship between firm and industry: η_f = η_i/(fractional share of the market)

Determinants of demand elasticity for industry

• Availability of substitutes
• Importance (as a % of budget) of good to lifestyle
• Length of time over which demand is measured

Total Revenue = TR = (equation of demand curve) * Q
Marginal Revenue = MR = equation of demand curve with twice the slope

Winner’s curse – tendency of winning bidders to pay too much. With small # of bidders, average bid is approximately correct. The more bidders, the greater the excess amount of the winning bid over the correct amount. In large bidding, winners actually lose money!

• Implication ⇒ sell in an auction, don’t buy in one
• A solution ⇒ accept the 2^nd lowest bid

Dissipation of rent – because of a lack of exclusive use rights, scramble leads to tragedy of the commons which causes the value of property to go to zero.

• 2 forms: overexploitation and under-exploitation
• common property equilibrium is when net worth = 0 (the “tragedy”)
• 3 solutions: privatize, government stimulated market solution (e.g. fees), regulation
• communist collapse example of common property dissipation/tragedy {had avoided for a while by using ranks}
• common property is good when cost of privatizing > income possibilities of property (as private)

Morton-Miller Effect – within a firm, you must decide which resources to treat as common (e.g. paper, pencils) versus private (PCs, autos, desks…)

Asymmetric information – leads to partial market failure (a degenerate cyclical equilibrium where customer pays average price but lemons dominate causing downward pressure on average price)

• 2 solutions – large, brand-name firms or specialized firms selling information
• managerial implication – educate public about your product

Accounting costs – amounts actually paid or incurred
Opportunity costs – value of what you give up to get what you want (some definitions include accounting costs)

Equations

ATC = TC/Q = AVC + AFC
AVC = TVC/Q
AFC = TFC/Q
MC = dTC/dQ
TVC = Costs which vary with Q in TC equation (i.e. TC = 1400*60Q ⇒ TVC = 60)
TFC = constant in the TC equation (i.e. 1400)
Profits (P) = (P – ATC) * Q

Choose Q* where MR=MC

Economic law of unintended consequences – poorly crafted laws ⇒ unintended (negative) effects (e.g. seat belt laws decrease deaths but lead to more reckless driving)

• Freedom of contracts should be the rule if:
  • Markets are competitive
  • No externalities
  • No wealth effects

Incentive compatibility – laws and rules which give people incentives to behave in ways compatible with group goals (efficient laws are self-enforcing because expected benefits of obeying > benefits of disobeying)

• Efficient laws reduce transaction costs and increase economic value (caveat venditor)
• Managerial implications – firms’ rules are similar to legal system. Firm must have:
  • Fair and clear rules
  • Compensation and rewards/incentives must cause behavior to align with firm’s interests/goals

Price Discrimination – varying prices for reasons unrelated to differentials in production and distribution costs. Two necessary conditions:

1. Existence of sub-markets where price elasticities are different
2. Ability of firm to identify and target these sub-markets while preventing trade among them

⇒ Customer segmentation techniques: geography, age, peak periods, coupons

Yield Management – price discrimination + capacity management (i.e. American Airlines)

Perfect Price Discrimination – Auctions attempt to do this
2-Part Pricing – 1^st part is fixed fee set at almost all of the consumer surplus for the average consumer; 2^nd part is to sell product to people who paid a fee of price = MC (e.g. Sam’s club, cable, telephone service)

Limit Pricing – a monopolist can prevent entry if they have a cost advantage by setting price below ATC of potential entrants, but this shouldn’t be the goal – do cost benefit analysis of short-term profits with higher prices versus long-run future profits (present value)

Game Theory – the study of strategic interaction
Nash Equilibrium – collection of strategies (one played by each player) where no player can improve his payoff by changing his strategy, holding constant other players’ strategies

Dominant Strategy – when a given strategy is the best response in every case

Self-enforcing agreement – an agreement from which no party wants to defect (Nash Equilibrium)

Avoiding the prisoner’s dilemma – altruism or contracting technology

• When a game has 2 or more Nash equilibrium, coordination problems arise
• Battle of sexes – solve with conventions (e.g. alternative weekends, etc.) or commitment technology – anything that lets a player move fast (so only 1 can have commitment tech)
• Moving first doesn’t add value when you have a dominant strategy
• Contracting technology won’t solve coordination problems
• When playing a 2-stage or higher game, players are forward-looking
• With finite play, the future cannot be used to enforce cooperative outcomes

A “survival model” of biology has been proposed as a replacement for rational choice

• Property rights in nature and politics not well defined
• Species with territoriality and dominance hierarchies have an advantage
• Human behavior can be described by a Darwin-type dominance hierarchy, with success based on genes, hormones, the environment as well as rational choices
• 3 types of economic selection
  1. directional
  2. stabilizing
  3. group
• The greater the external threat to a group, the steeper the hierarchy. 4 implications
  1. r vs. k – r is a generalist, emphasizing adaptability (thrive in variable environs); k is a specialist, emphasizing quality (thrive in stable environs)
     r strategists have shorter time horizons while k strategists have long ones
     r = offensive; k = defensive
  2. Law of increasing competition – lobbying and political intervention are not distortions but different ways of competing
     ⇒ economic efficiency cannot be expected in a world of pure power b/c property rights are not defined
     ⇒ 2 consequences: dominance hierarchies get steeper through time hence expect lobbying, tax avoidance, lawsuits and other measures of re-distributive behavior to increase with density; hierarchies multiply
  3. It’s impossible to separate economics and politics
  4. Animal territoriality is equivalent of private property

Political rent seeking is just a transaction cost of interactive activity. 4 ways to behave in interactive relationships:

1. Cooperative
2. Selfish
3. Altruistic
4. Spiteful

⇒ economic relationships are horizontal (cooperative)
⇒ political relationships are vertical

Stabilizing selection ~ long-run economic competition

• groups with fewer selfish individuals grow faster (countries with more re-distributive behavior grow more slowly than countries with less)
• free riders don’t belong to any group and thus are vulnerable