Econ 201 Review Notes - Part 3 This is intended as a supplement to the lectures and section. It is what I would talk about in section if we had more time. After the first three chapters where we talked about rational decision makers; what they do and how they should make decisions, what happens when one individual interacts with another, and finally when many individuals interact together in a market. Next, we looked more closely at markets and how economists describe them and what they tells us. We looked at the demand side of the market (consumers), the supply side of them market (producers/sellers) and then talked about how the market induces outcomes that are efficient. Now we want to talk mostly about what happens when things aren't as perfect as in the simple model of perfect competition. But before that we want to talk about what competition does and the concept of the invisible hand. Then we will talk about markets where there does not exist perfect competition but rather imperfect competition. Finally we will talk about externalities, labor markets, information and governments. 7. The Invisible Hand The central concept that that when, in a perfect world, people act in a purely selfinterested way, an efficient outcome arises. But first what is self-interested? Well for firms it is profit maximization. To study this, it is necessary to understand what economists call profit and how that differs to the way you are probably used to thinking about it. A. Accounting Profit: This is what you are probably used to, this is simply the revenue taken in by the firm minus all of its explicit costs. This is what an accountant would report, or what is recorded in the firm's books. B. Economic Profit: This is different: This is the revenue minus all explicit costs and all implicit costs (opportunity costs). C. Normal Profit: Is simply the amount of accounting profit which exactly covers opportunity costs, it is the same amount as the opportunity cost. Why this difference in definition? Because economists are concerned with the decision to begin or remain in business and we figure that in order to do so, a businessperson must be doing at least as well in their business as they would doing the next best job available to them. If not, they should go out of business and take that job. When there is perfect information in an economy, prices play a vital role, and more than you might think on first glance.
D. Rationing Function of Price: Prices serve as a method of screening out potential buyers who do not value an item as much as others. E. Allocative Function of Price: Prices lead businesspeople to search for underserved markets (high prices) and avoid overserved markets (low prices). For these wonderful things to happen, information must be free and available to all and competition must be perfect. When is competition not perfect? When there are barriers to entry. F. Barriers to Entry: Something (like a patent or copyright) that prevents new firms from entering a market. 8. Imperfect Competition So what if there are barriers to entry, what then? We call this imperfect competition and talk generally about three broad categories monopoly, oligopoly, and monopolistic competition. These are all types of price setters. A. Price Setter: a firm who faces a downward sloping individual demand curve. B. Pure Monopoly: A firm that is the only supplier of a unique product. C. Oligopolist: A firm that produces in a market with only a few competing firms. D. Monopolistically Competitive Firm: A firm that produces in a market with many competitors, but who is able to differentiate its product from the others. All of these types have market power: or the ability to raise prices without loosing all of their sales (because of the downward sloping demand curve). In all cases the firms try to maximize profits and in order to do so, follow a simple rule, set output such that marginal revenue = marginal cost. Note that this is the same rule as perfectly competitive firms follow except that for competitive firms MR=Price. Because of the downward sloping demand curve, when imperfect competitors follow this rule the outcome will no longer be socially efficient. In fact, they will produce too little than is socially optimal. Imperfectly competitive firms can do better if they price discriminate. E. Price Discrimination: Different prices are charges to different consumers based on the consumers reservation prices. If a firm can perfectly price discriminate, or charge each individual consumer their reservation price, then the efficient outcome is restored, but with all of the surplus accruing to the firm.
9. Games Economists use the theory of games to best describe the interaction among a few firms. The idea is that a firm makes its decision both with its demand curve in mind and knowing that its competitor will like respond with some sort of re-action. There is really not a lot that I need to say about games except what we mean when we say the "solution" to the game is But first a little set up: When we describe simultaneous move games (were each player moves without knowing what the other players do) we use a payoff matrix, and when we describe sequential move games, when players move in order, one after the other we use a game tree. A. A Payoff Matrix: Describes all of the possible payoffs based on the combination of strategies chosen when players move at the same time. B. A Game Tree: Describes all of the possible payoffs based on the combination of strategies chosen when players move one after the other. Next, we talk about solutions. C. A Dominant Strategy: Is a strategy for one player that yields higher payoffs no matter what the opponent chooses. D. A Nash Equilibrium: Is a combination of strategies that is the best choice for each player based on the action of the opponent. Finally a special kind of game. E. A Prisoner's Dilemma: Is a game where each player has dominant strategies and when they play these strategies they both get payoffs that are smaller than if they had played dominated strategies. 10. Externalities Economists believe that markets are efficient. Implicit in this statement are the assumptions of perfect information, zero transactions costs, rational consumers, etc. In fact there are so many assumptions that there are often cases where these assumptions do not hold and the efficient outcome is not realized by the market. The classic example of this is externalities. An externality is a cost or a benefit that people have to pay or enjoy who are not undertaking the activity that produce these costs and benefits. Another way of expressing this is that these costs and benefits are not included in the prices of the activities and therefore there is no way for the market to act efficiently in the allocation of these resources. A. Negative Externality: Is a cost that must be born by people other than those undertaking the activity. B. Positive Externality: Is a benefit that is enjoyed by people other than those undertaking the activity.
But what if there were prices for the externalities, would the efficient market outcome be restored? The answer is yes, as long as there can be costless negotiation between all of the affected parties. We call this result the Coase theorem. C. The Coase Theorem: If people can costlessly negotiate the purchase and sale of the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by the externalities. One interesting outcome of this is that if negotiation is costless, it does not matter who has the right to do what, either way the efficient outcome will emerge. 11. Labor Markets Now we take a step back for a moment and consider how labor markets work. Not surprisingly, they work in the very same way that goods markets work. A laborer's worth is determined by what they produce and their salary reflects this. Firms measure the worth to them of a worker by assessing their marginal product. A. The Marginal Product of Labor (MP): Is the additional output a firm would gain by hiring that worker. B. The Value of Marginal Product of Labor (VMP): Is the MP times the price of the product the firm produces, or the dollar value of MP. So firms will hire workers until the VMP is equal to wages. This statement is equivalent to saying until the marginal benefit of doing so equals the marginal cost. How is MP determined? By two things, how many workers are already employed and by the worker's human capital. C. Human Capital: Is the total education, training, reliability, work ethic, health, intelligence, etc. that determine how productive a worker is. Finally, the concept of winner-take-all markets is one coined by Prof. Frank and describes the case where very small differences in human capital translate into huge differences in compensation. 12. The Economics of Information The efficient market idea rests on the assumption of perfect information, but this is obviously not true in general. In fact information is often scarce and as consumers we are constantly trying to find out more about products, option and prices. But there is a cost associated with doing so, so we again can think of the search for information along traditional cost-benefit lines. One question is why is information seemingly so scarce? Well it is usually costly to provide and there is the free rider problem.
A. The Free Rider Problem: When it is difficult to exclude non-payers from utilizing a certain good, it will be underprovided. This is one reason why it is hard to find knowledgeable salespeople when shopping, and with more and more internet-based shopping, it is sure to get worse. Another problem arises when one party in a transaction has more information than the other. This can lead to exploitation of the uninformed, but can also hurt the informed in some cases. We call this asymmetric information. B. Asymmetric Information: The situation when buyers and sellers are not equally well informed about the goods in the market. The result of this is often that the level of the quality of goods in the marketplace falls. This is known as the lemons model. In this case if the seller of the high quality item can credibly signal its quality then the problem is solved and there is no more asymmetric information, but often times this is very difficult. 13. Government Since there are all of these cases where the efficient market assumptions fail, what should be done? For example, if all of the residents of Ithaca value having the snow cleared from the streets, how do we overcome the externality problem? Usually it is through government intervention. Governments are charged with the provision of public goods. A. A Public Good: Is a good or service that is nondiminishable and nonexcludable, in general. B. Nondiminishable: If the consumption of the good or service by one person does not affect the quantity available to other consumers. C. Nonexcludable: If it is difficult or costly to prevent people who do not pay to consume the good or service. So clean roads in winter are public goods. How does government pay for the provision of these goods, well in a democracy this is a very difficult question and one that occupies a whole field of economics, but in general through taxes, donations, private contracting, etc.