Intermediate Microeconomics Week 1 Introduction Varian, 1 Budget Constraints Varian, 2 Preferences Varian, 3 Utility Varian, 4 Week 2 Optimal Choice Varian, 5 Consumer Demand Varian, 6 S. & I. Effects Varian, 8 Problem Set 1 Week 3 Exam 1 Buying & Selling Varian, 9 Intertemporal Choice Varian, 10 Game Theory Varian, 28 Week 4 Intertemporal Choice Varian, 10 Present Value Varian, 10 Choice Anomalies Thaler, 2 & 3 Problem Set 2 Week 5 Exam 2 Asset Markets Varian, 11 Uncertainty (Risk) Varian, 12 Risky Assets Varian, 13 Week 6 Risky Assets Varian, 13 Diversification Varian, 13 Choice Anomalies II Thaler, 6 -- 9 Problem Set 3 Week 7 Exam 3 Financial markets Thaler, 10 – 13 Consumer Surplus Varian, 14 Surplus, Demand Varian, 14 & 15 Week 8 Demand, Equilibrium Equilibrium Auctions Problem Set 4 Varian, 15 & 16 Varian, 16 Varian, 17; Thaler, 5 Week 9 Exam 4 Exchange Varian, 31 Exchange Varian, 31 Welfare Varian, 33 Week 10 Externalities Varian, 34 Asymmetric Information Varian, 37 Problem Set 5 Exam 5 General Equilibrium Economics and Welfare “Classical liberalism” and the free market argument: • The central focus of economics is allocation of scarce resources. • There are many ways to allocate resources, one of which is free (or unmanaged) markets. • In free markets, prices act as signals to participants in the marketplace. • The forces of demand and supply, which summarize the actions of market participants, determine prices. • The allocation of scarce resources determined by markets is superior to other allocations achieved under alternative methods. Pure Exchange x1 B B 4 UA 3 UA Good 2 1 UB W x 2 A U 1 A · U 2 A 2 xB 3 2 4 UB UB U B A Good 1 x1 A Pure Exchange x1 B B 4 UA 3 UA Good 2 1 UB W x 2 A U 1 A · U 2 A 2 xB 3 2 4 UB UB U B A Good 1 x1 A Pure Exchange x1 B B 4 UA 3 UA Good 2 1 UB W x 2 A U 1 A · U 2 A 2 xB 3 2 4 UB UB U B P1 P2 A Good 1 x1 A Pure Exchange x1 B B 4 UA 3 UA Good 2 1 UB W x 2 A U 1 A · U 2 A 2 xB P1 4 3 UB 2 UB P2 U B A Good 1 x1 A Pure Exchange x1 B B 4 UA X · 3 UA Good 2 1 UB W x 2 A U 1 A · U 2 A 2 xB 3 2 4 UB UB U B P1 P2 A Good 1 x1 A A Pure Exchange Economy x1 1 B B x2 A 2 · B 2 x · U1 A 0 UA U1 B 0 UB x2 A 1 A x1 The Algebra of Equilibrium Assumptions: Pure exchange economy Two goods: x1 and x 2 Two agents, A and B, with … Identical preferences: U A x1 , x2 x1 x1 2 1 0 1 U B x1 , x2 x1 x2 Arbitrarily determined, but different, endowments: A , B A 1 , A B 1 , B A 2 B 2 B Equilibrium is defined as a consumption bundle x x1 , x A ; x1 , x B A 2 2 Where aggregate excess demands are zero in both markets: z1 p1 , p2 0 Hence, we are seeking a set of prices, p1 , p2 , that z 2 p1 , p2 0 satisfies these equilibrium conditions. Pure Exchange x1 1 6 B B x2 21 A 2 · B 6 2 0 UA 0 UB x2 A 1 3 A x1 Pure Exchange and Equilibrium x1 1 6 B x1 4 B B x2 21 A 2 · B 6 2 15 x A x 2 · xB 12 2 U1 A 0 UA 1 0 UB UB P1 P2 x2 A 1 3 A x1 5 A x1 Pure Exchange and Redistribution 1 7 B x1 4.5 B x1 1 6 B x1 4 B B x2 ’ 21 A 2 · · B 6 2 15 x A x 2 2 x’ · xB 12 2 2 13.5 x A · xB 13.5 U1 A 0 UA 1 UB 0 UB x2 A 1 3 A x1 5 A x1 1 A 2 x1 4.5 A General Equilibrium and Welfare Economics “In the general case … the demand function are functions of m - 1 variables which are too numerous to be represented in space. It seems, therefore, that the problem when generalized can only be formulated and solved algebraically …” Leon Walras, Elements of Pure Economics (1874) “Political Economy does not have to take morality into account. But one who extols some practical measure ought to take into account not only the economic consequences, but also the moral, religious, political, etc., consequences” Vilfredo Pareto, Manual of Political Economy (1906) Leon Walras Vilfredo Pareto Francis Edgeworth 1834 – 1910 1843 -- 1923 1845 -- 1926 General Equilibrium and Welfare Economics “How do we evaluate alternative social organizations? There are many possible arrangements for meeting the needs of society and they satisfy many different needs … we use the notion of efficiency or optimality that is associated with the name of Vilfredo Pareto … Now, within this context, and under certain very special assumptions … efficiency can be achieved through a particular kind of social system, the price system.” Kenneth Arrow, The Limits of Organization (1974) Arthur Pigou Paul Samuelson Kenneth Arrow Gerard Debreu 1877 -- 1959 1915 – 1921 – 1921 – First and Second Theorems of Welfare Economics 1. All market equilibria are Pareto efficient. “With such a definition it is almost self-evident that this so-called maximum [Pareto-optimality] obtains under free competition … But this is not to say that the result of production and exchange will be satisfactory form a social point of view or will, even approximately, produce the greatest possible social advantage.” Knut Wicksell, “On the Problem of Distribution” (1902) 2. Every Pareto efficient allocation can be achieved as a competitive equilibrium (given an appropriate initial endowment and convexity of preferences). “[Pareto optimality] does not define, uniquely, a best situation in any sense of the word … Other criteria – roughly speaking, those we associate with the term „distributive justice‟ – have to be called into play.” Kenneth Arrow, The Limits of Organization (1974) Externalities Positive vs. negative externalities Consumption vs. production externalities • Assignment of property rights • Command & control approaches • The Coase Theorem • Internalization of external costs • The “missing market” interpretation The “tragedy of the commons” Adverse selection as a result of externalities Pure Exchange and Consumption Externalities B · X’ · Good 2 X · A · Good 1 Pure Exchange and Consumption Externalities B · X X’ · · Good 2 A · Good 1 Traditional (“Pigovian”) Analysis of a Negative Externality P S = MC = MPC + MSC MPC (Marginal Private Cost) P** P* D = MPB (Marginal Private Benefit) MSC (Marginal Social Cost) Q Optimal Output Optimal Output -- Society’s View -- Supplier’s View Externalities – Internalizing the social costs… Effects of a tax on suppliers (The so-called “Pigovian” solution) P The Market P The Firm MC 1 S1 MC0 S0 ATC 1 ATC 0 P1 MR1 P0 MR0 D Q q Q1 Q0 q* Establishment of a Pollution Rights Market Suppose that two utilities each release 10 tons of sulfur dioxide into the atmosphere, and that the government wants to reduce the total amount of sulfur dioxide emissions to 16 tons. Further, assume that it costs utilities different amounts to reduce their emissions: Total Cost to reduce emissions to … Utility 9 Tons 8 Tons 7 Tons A $50,000 $125,000 $225,000 B $100,000 $250,000 $450,000 How much will the reduction to 16 tons cost if the government simply limits each utility to 8 tons of sulfur dioxide emissions? If the government issues each utility the “right” to release 8 tons of sulfur dioxide, and further allows the utilities to sell these rights, what will happen and how much will reduction to 16 tons cost? Markets with asymmetric information Varian’s “market for plums and lemons” P S plums : P 44Q p s 2200 Pplums ˆ 1925 Pplums D plums : P 4400 44Q p d Slemons : P 1100 44Qls ˆ 1375 Plemons Duncertain quality 1100 Plemons pr plums* D plums prlemons* Dlemons Dlemons : P 3300 44Qld ˆ Q plums Q plums ˆ Qlemons Q || || || 43.75 56.25 Qlemons || 50 Adapted from Varian, Intermediate Microeconomics, 7th ed., 695 – 696. His example is itself an adaptation from a famous paper by George Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 (1970): 485 – 500. Markets with asymmetric information General categories of problems of asymmetric information: Adverse Selection: A situation in which individuals possess hidden information, leading to a market selection process that results in a pool of individuals with economically undesirable characteristics. Moral Hazard: A situation in which one party to a contact takes a hidden action that creates benefits at the expense of another party to the contract. Social institutions that help solve these market inefficiencies: Private agent responses to problems of asymmetric information: Signaling – the party possessing private information takes action to generate a credible signal. Screening – the party with imperfect information takes action to induce a advantageous sorting of the market. Public / Private sector responses to problems of asymmetric information: Compulsory purchase plans (insurance markets) Licensing and certification (note that this may also be done by private agents). Market regulation, including “truth” laws and “insider trading” laws. Markets with asymmetric information: warranties as signals Two used car dealerships compete side by side on a main road. The first, Harry‟s Cars, sells high-quality cars that it carefully inspects and, if necessary, services before putting them up for sale. On average, it costs Harry‟s $8,000 to buy and service each car it sells. The second dealership, Lou‟s Motors, sells lower-quality cars. On average, it costs Lou‟s $5,000 to acquire and resell each car on its lot. Generally, as far as appearance is concerned, the vehicles at Harry‟s are indistinguishable from the cars at Lou‟s. If consumers knew the quality of the used cars they were buying, they would gladly pay $10,000 on average for high-quality cars, but be willing to pay only $7,000 for a low-quality car. The dealerships, however, are too new to have established reputations, so consumers do not know the quality of each dealership‟s cars. Consumers shopping at these dealerships figure that they have a 50-50 chance of ending up with a high-quality car, no matter which dealership they go to, and hence are willing to pay, on average, $8,500 for a car. Harry has an idea -- offer a warranty on all the cars he sells. He knows that a warranty lasting Y years will cost, on average, $500Y . He also knows that if Lou tries to offer the same warranty, it will cost Lou an average of $1000Y (why?). If Harry offers a one-year warranty, will this generate a credible signal of quality? Lou Offer Don‟t Offer Offer Harry Don‟t Offer Markets with asymmetric information: job market signals w, wage clow quality e chigh e quality wh be wl e, amount of education e* Adapted from Varian, Intermediate Microeconomics, 7th ed., 703 -- 705. His treatment is itself adapted from Michael Spense, “Job Market Signaling.” Quarterly Journal of Economics 87 (1973): 355 – 374, and Market Signaling (1974).