# Exam #2 (100 Points Total) Answer Key

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2 we reach the Pareto efficient allocation of resources. Do you agree that initial allocations are important for the reason given, or do you think that they re important for a different reason, or do you think that they re not important? Support your answer and otherwise comment on this quote. Initial allocations are a matter of equity; economists tend to focus on efficiency. As long as there are opportunities to trade, a Pareto efficient outcome will result regardless of the initial allocation. 5. (Overinvestment as a barrier to entry) Consider the following sequential move games of complete information. The games are between an incumbent monopolist () and a potential entrant (PE). You can answer these questions without looking at the stories, but the stories do provide some context and motivation. Story #1 (See figure 1): Firm is an incumbent monopolist. Firm PE is considering spending \$30 to build a factory and enter the market. If firm PE stays out, firm gets the whole market. If firm PE enters the market, firm can either build another factory and engage in a price war or peacefully share the market with firm PE. (a) (5 points) Identify (e.g., by circling) the likely outcome of this game. Backward induction predicts an outcome of (: 35, PE: 5). (b) (5 points) Is this outcome Pareto efficient? Yes No (Circle one. If it is not Pareto efficient, identify, e.g., with a star, a Pareto improvement.) Yes. PE Enter War Peace (: 10; PE: 10) (: 35; PE: 5) Stay Out (: 100; PE: 0) Figure 1: Story #1

3 Overinvest PE Enter War Peace (: 10; PE: 10) (: 5; PE: 5) Stay Out (: 70; PE: 0) Don t Invest PE Enter War Peace (: 10; PE: 10) (: 35; PE: 5) Stay Out (: 100; PE: 0) Figure 2: Story #2 Story #2 (See figure 2): The monopolist (firm ) chooses whether or not to overinvest by building a second factory for \$30 even though one factory is more than enough. Firm PE (the potential entrant) sees what firm has done and decides whether to enter or stay out, and if PE enters then decides whether or not to engage in a price war. (a) (5 points) Identify (e.g., by circling) the likely outcome of this game. Backward induction predicts an outcome of (: 70, PE: 0). (b) (5 points) Is this outcome Pareto efficient? Yes No (Circle one. If it is not Pareto efficient, identify, e.g., with a star, a Pareto improvement.) No; a Pareto improvement is (: 100, PE: 0). 6. Catalytic converters are devices that reduce the amount of pollution produced by motor vehicles. Imagine that each of the 500,000 residents of Seattle (including you) owned a car without a catalytic converter, and that each of you had to decide whether or not to purchase one. Imagine further that (1) it would cost you \$100 to purchase and install a catalytic converter; (2) the extra pollution caused by not having a catalytic converter on any given car would impose health costs of one-tenth of one penny (\$0.001) on you and every other resident of the city; and (3) like your fellow Seattle residents, you just want to do whatever has the lowest cost for you personally. (a) (5 points) If you and other Seattle residents were each allowed to choose whether or not to purchase a catalytic converter, what would you expect the outcome to be? A good prediction is that everybody would choose to not purchase a catalytic converter. For any given driver, purchasing the device would cost \$100; doing without it would impose health costs on that driver of only \$.001.

6 solely by money, he will therefore offer Player 2 the minimum amount (\$1) required in order to get her to accept, thereby maximizing his financial payoff. (c) (5 points) Daniel Kahneman and Vernon Smith won the 2002 Nobel prize in economics for exploring how real people actually make decisions in games like these. (Amos Tversky would have won the prize, too, but he died in 1996.) In classroom experiments, Player 1 sometimes offered Player 2 more than \$1, and in situations where Player 1 did offer Player 2 only \$1 Player 2 sometimes rejected the offer. Which of the following statements is true? (Provide a sentence of explanation for each.) This experiment showed that the basic assumption of economics (that decisions are made by optimizing individuals) is wrong. The basic assumption may or may not be wrong, but this experiment didn t show that it is wrong because optimizing individuals may not be solely motivated by money. This experiment showed that some of the Player 2 s were not motivated solely by getting as much money as possible. This is true; otherwise, Player 2 would always have accepted Player 1 s offer. This experiment showed that some of the Player 1 s were not motivated solely by getting as much money as possible. This is false. Player 1 s generosity (offering more than \$1) might be motivated by altruism, but it might also be motivated by a desire for money: if Player 1 thinks that Player 2 will turn down a lower offer, it s in Player 1 s financial interest to offer more. 9. (5 points) For the sake of simplicity, let us assume the following about the Great Classroom Auction Experiment of 2003: (1) each student made the minimum bid of \$.01, and the \$99 prize was divided equally among the students; and (2) given that all the other students had bid \$.01, no student wanted to change his or her bid. 1 Which of the following statements is true? (Provide a sentence of explanation for each.) From the perspective of the students (i.e., ignoring the instructor), the outcome was Pareto efficient. This is true. There s no way to make one student better off without making another student worse off. From the perspective of the class as a whole (i.e., including the instructor), the outcome was Pareto efficient. This is also true! Redistributing wealth (which is basically what happened) has no impact on Pareto efficient. Again, the key question is whether it s possible to make someone better off without making anyone else worse off. 1 Incidentally, this is a good example of a Nash equilibrium, the idea that won John Nash a share of the 1994 Nobel prize in economics

7 The information above shows that bidding \$.01 was a dominant strategy for each student. This is false because there s not enough information. A dominant strategy is one that you follow no matter what the other players do, and all we know here is what each player would do if the other players all bid \$.01. In fact, at least one student (Simon) said that he would have changed his bid if another student had bid \$50; this indicates that bidding \$.01 was not a dominant strategy for Simon. This experiment showed that some of the students were not motivated solely by getting as much money as possible. This is true. Students motivated solely by money would have changed their bid to \$.02 when given the opportunity.

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