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ECON 2005, Exam 3 Review

by: Shannon Cummins

ECON 2005, Exam 3 Review ECON 2005

Shannon Cummins
Virginia Tech
GPA 3.34

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These notes cover PowerPoints 20 through 28: monopolistic competition, oligopolies, game theory, antitrust, imperfect information, public goods, externalities, income distribution, and taxes. Goes...
Principles of Economics
Steve Trost
Study Guide
monopolistic, competition, oligopolies, Game, Theory, antitrust, Imperfect, information, Public, goods, externalities, Income, distribution, Taxes, exam, 3, trost, Econ, 2005
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This 11 page Study Guide was uploaded by Shannon Cummins on Tuesday April 26, 2016. The Study Guide belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Spring 2016. Since its upload, it has received 68 views. For similar materials see Principles of Economics in Economcs at Virginia Polytechnic Institute and State University.

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Date Created: 04/26/16
What’s going to be on the exam? Monopolistic competition  Like perfect competition with “differentiated products”  Demand slopes down due to product differentiation. Firms act as monopolists of their particular version of the product.  Long run, average profits = 0 (free entry)  Know the picture!!!  Many firms, differentiated product, open entry, price and quality competition In the short run, profits or losses are represented here. However, in the long run, ATC = demand at the point where marginal revenue = marginal cost.  Because of unrestricted entry and exit, total profit in the long run will equal zero.  Types of product differentiation: o Physical difference – appearance, quality o Location (spatial differentiation) o Services o Product image – promotion, advertising, marketing, packaging  Demand is less elastic than a product in a perfectly competitive market and more elastic than a product in a monopolistic market. Oligopoly  Few big firms with market power/concentration (can control price)  Interaction, interdependence, between firms  Not efficient since P > MC plus strategies may be wasteful  Models: o Cartel/collusion model o Price leadership model o Contestable markets  Few dominant and interdependent firms, differentiated or homogeneous products, barriers to entry.  Models: o Collusion/cartel: the act of working with other producers in order to limit competition and increase joint profits; firms band together to work as one big monopolist.  Tacit collusion – when agreements are implicit. The Market $ MC Pcartelm Ppc D MR Q cartelm Qpc Q o Price-leadership model: one dominant firm sets prices and all of the smaller firms follow its pricing policy; uses residual demand curve to determine where to set quantity.  Residual demand – the demand the leader faces after all of the follower firms sell whatever they want to at the price chosen by the leader.  Perfectly contestable market – a market in which entry and exit are costless  Oligopolistic markets are conducive of a higher rate of technological advancement. Game theory  Players, strategies, payoffs  Payoff matrix contains all relevant information  Be able to find “equilibrium”  Dominant strategy  Nash equilibrium  Maximin strategy – avoid bad payoffs  Tit-for-tat strategy  Decision-makers (“players”) choose from different strategies (“rules of the game”) and receive payoffs (“prizes”) based on their decisions. The solution is called “Nash equilibrium.” Payoff matrix  Dominant strategy – a strategy that is best no matter the outcome of the opposing player  Prisoner’s dilemma – each player’s dominant strategy leaves them both worse off than if they could collude.  Maximin strategy – a strategy chosen to maximize the minimum gain that can be earned (“minimize your losses”)  Tit-for-tat strategy—a firm will follow its competitor’s lead Antitrust  Regulation of natural monopoles o if set p = MC, firm loses money o if p = AC, firm earns zero economic profit but not quite socially efficient  FTC and DOJ monitor competitiveness in US industries  Use HHI to determine whether a merger should be challenged Random firm stuff  Transaction costs o When production is complex, firms reduce transaction costs.  Vertical integration o Control stages of production o “bounded rationality”  Outsourcing vs. insourcing  Economies of scale – sometimes supplier firms can achieve economies of scale when vertically integrated firms cannot  Economies of scope – cheaper to produce lots of different stuff  If they are not regulated, natural monopolies will attempt to produce where marginal revenue equals marginal cost. o The government could require that they instead produce where price = marginal cost, but then the firm would lose money. Thus, they’d have to be given subsidies. o Another option is to require that they produce where price = total cost; still not socially efficient, but much closer.  Federal Trade Commission – investigates the structure and behavior of firms engaging in interstate commerce to determine what constitutes “unfair” behavior  Antitrust Division – part of the Department of Justice and decides against whom to bring criminal charges  Herfindahl-Hirschman Index (HHI) A mathematical calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government. 1. If index < 1500 (“unconcentrated”), merger is not challenged. 2. If 1500 <= index < 2500 (“moderately concentrated”), merger warrants scrutiny. 3. If index > 2500 (“highly concentrated”), merger warrants scrutiny.  Vertical integration—“insourcing”; expanding to earlier/later stages in production; lowers transaction costs but may not be efficient and may be difficult to manage.  Outsourcing is more attractive if: 1. The quality of the input product is easily verifiable. 2. There are many producers of the input product.  Outsourcing is cheaper but produces a loss of control, and could cause an erosion of consumer confidence.  “Economies of scope” occur when it makes sense for a firm to produce lots of different products (Bic: stationary, razors, lighters) Imperfect information  Whenever one party in a transaction has more information than another party in a transaction  Adverse selection: if you don’t know if a product is good or bad, you are not willing to pay a high price—pushes good products out of the market  Moral hazard: when one party in a contract passes the risk or cost involved with their behavior on to the other party  Principal-agent problem: occurs when the agent’s goals differ from the principal’s and the agent’s behavior cannot be observed  Labor markets  The internet has helped with information problems  The government often collects and distributes info to lessen problems with information  Winner’s curse  Search model  Four major causes of market failure: 1. Imperfect market structure or noncompetitive behavior, 2. Imperfect information, 3. The presence of external costs and benefits, and 4. The existence of public goods.  Imperfect information – the absence of full knowledge concerning product characteristics, prices, etc. o Adverse selection: occurs when, because of a lack of information, consumers aren’t willing to pay a high price—pushes good products out of the market (lemon market) o Moral hazard: when one party in a contract passes the risk or cost involved with their behavior on to the other party (people who have insurance often act in a riskier manner) o Principal-agent problem: occurs when the agent’s goals differ from the principal’s and the agent’s behavior cannot be observed (a mechanic and his customer)  A way to get around the imperfect information problem is by doing research  Winner’s curse – when the “winner” ends up paying more for a product than it is worth (auctions) Public goods  Non-rival and nonexclusive  Markets don’t provide these goods in an efficient manner a. Free-rider problem b. Drop-in-the-bucket problem  Public goods need to be provided by the government  Know other types of goods as well – (private, open-access, “natural monopoly”)  Public choice—median voter, rational ignorance, rent seeking, etc.  Types of legislation—public good, special interest, populist, competing interest  Four major causes of market failure: 1. Imperfect market structure or noncompetitive behavior, 2. Imperfect information, 3. The presence of external costs and benefits, and 4. The existence of public goods.  Public goods – goods that are non-rival and non-excludable. o Non-rival – one person’s enjoyment of the item does not affect another person’s. o Non-excludable – no one can be excluded from enjoying the good’s benefits.  Free-rider problem – a problem intrinsic to public goods; if people can enjoy regardless of whether they contribute, they will not contribute.  Drop-in-the-bucket problem—because the contribution from one person doesn’t really help in the grand scheme of things, no one will contribute.  BECAUSE OF THESE TWO PROBLEMS, PUBLIC GOODS WILL NOT BE PROVIDED WITHOUT GOVERNMENT HELP.  Legislation can be divided into four groups based on the distribution of costs and benefits.  Rent-seeking – lobbying by special interest groups to government officials to support issues that benefit the group. Externalities  Private cost vs. social cost  Negative externality means MSC > MPC. o Difference is “marginal damage cost” (MPC + MDC = MSC) o Too much is being produced  Ways to correct for externalities o Regulation o Taxes (=MDC) o Coase theorem (set property rights and negotiate) o Auction or allocate tradable pollution permits.  Fixed vs. variable technology  In any market, the fixed tech firms will be willing to pay more for pollution permits  Know externality pictures!!!  Four major causes of market failure: 1. Imperfect market structure or noncompetitive behavior, 2. Imperfect information, 3. The presence of external costs and benefits, and 4. The existence of public goods.  Externality – a cost or benefit resulting from some activity or transaction that is imposed or bestowed on parties outside the activity or transaction a. Can be positive or negative Negative Externalities Marginal Social Cost (MSC) $ $1.50 Marginal Private Cost Marginal damage cost $1.15 $1.00 D Q2 Q1 Q t b. Fixed-production technology – externalities cannot be changed without reducing production. c. Variable technology – externalities can be changed without reducing production.  The goal is to either internalize externalities or eliminate them altogether.  Five solutions to the externality problem are: 1. Direct government regulation  May put legal limits on what is sold  Taxes 2. Government-imposed taxes and subsidies  Would internalize the externality  Could tax the product or the pollution 3. Private bargaining and negotiation  Assign a party the property rights (“free market approach”) 4. Legal rules and procedures  Injunction  Liability rules 5. Sale or auctioning of rights to impose externalities  Allocate “pollution permits” that can be bought and sold Optimal Level of PollutionAbatement $ / unit MSC MSB % of pollution 0 50 100 Abatement Income distribution  Measuring income inequality  Sources of income: o Wages o Property o Transfers  Income vs. wealth  Trends in inequality—top getting a higher share, bottom getting a lower share  Poverty = 3 times USDA food budget.  Redistribution (arguments for and against)  Government programs o Social insurance (social security, medicare) o Income assistance (“means tested” –TANF, Medicaid, food stamps)  Lorenz curve: the more bowed the line, the more inequality  Gini coefficient: the closer to 0, the less inequality; the closer to 1, the more inequality.  Poverty line – three times the Department of Agriculture’s minimum food budget  Sources of income: o Wages  Human capital – stock of knowledge, skill, and talent that people possess.  Compensating differentials – differences in wages that result from differences in working environments o Property  Property income – income from ownership of real property and financial holdings o Transfers  Payment from the government to people who do not provide goods or services in exchange  Explaining inequality: o Life-cycle events o Living arrangements and work patterns o Idiosyncratic factors o Human capital investment  Redistribution policies: o Social insurance – payments out of the system are correlated to payments into the system (social security, Medicare, unemployment assistance) o Income assistance – payments are correlated to need (TANF, Medicaid) Taxes  Tax base, tax rate structure  Taxes on stocks vs. taxes on flows  Progressive, regressive, proportional taxes  Marginal vs. average tax rate  Tax incidence  Burden of a tax: taxes cause deadweight loss or burden because they distort people’s behavior o Taxes usually move us away from efficiency o Taxes move us toward efficiency if there is a negative externality.  Neutrality—more “neutral” taxes create less distortion and are better  Effects of price elasticity of supply demand on tax incidence  Measuring excess burdens


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