Exam #3 Study Guide  

What is Human capital theory?

Signaling Theory of Education 

College Wage Premium: When you get a college degree, you will earn more money  over your lifetime than if you only had a high school degree= wage premium  

1) Human capital theory: college transforms unskilled ppl into skilled ppl, ppl  without a college degree not as valuable to employers (students as clay that  professors mold)

∙ Problems:

a) Most students study subjects unrelated to their future jobs (many required  courses unrelated to major)

b) Most professors don’t know what jobs you want (professors unable to tailor  courses to student interest)

c) Most professors only know how to be professors (most professors don’t have  much specialized knowledge beyond the scope of their own specialty, most  haven’t spent much time working in the “real world” so not many job skills to  teach you)

2) Signaling theory: college identifies skilled people and certifies them (college is a  costly way to separate high quality and low-quality job applicants for employers) ∙ Effective signal (college did not make you more productive, but a college  degree proves that you are a high-quality person bc you accomplished  something hard)

What is Signaling theory?

∙ Skills signaled by college:

a. Intelligence

b. motivation (intrinsic, self-starter)

c. obedience (according to human capital theory ppl should know information  for the rest of their lives, but signaling theory only requires you know the  information for a final exam on a certain date, you can pass your classes  which shows obedience to profs and eventually future employers)  d. conformity (can you fit in within a class and then eventually a workplace?)

1. Why do students cheat?

∙ In the human capital theory, cheating makes no sense because that  implies the only important thing about going to school is to get a degree  to signal your worth (signaling theory) instead of remembering the info  you learn.  

∙ Different schools have different degrees of quality attached to them,  sends a better signal bc you have been tested by quality educators

Why do students cheat?

We also discuss several other topics like csn ch

2. Why do students worry more about failing a class than forgetting the  information? If you want to learn more check out occules

∙ Students more worried about getting a degree to show their future  employers than enriching their minds by learning and gaining human  capital

3. Why do students pay tuition?

∙ Anyone can walk into a lecture and learn from it, no one will ask them for  a receipt to show they paid tuition, but you can only get a degree if you  pay tuition, which is what matters more than learning

4. Why do students worry if they can’t complete their last class before  graduating?

∙ Example of 120 minute workout vs. 120 credit hours in college: if you only do 119 minutes of your workout, that still has almost the same value, but  if you do 119 credits, it is of much less value than 120 because 120 is the  amount that allows you to get the degree that signals to employers

∙ Sheepskin effect: average premium from completing your fourth year of  college is 31% higher than completing years 1-3 not because the only  valuable information you learn is in your fourth year, but because finishing your fourth year is what allows you to obtain a diploma If you want to learn more check out philosophy midterm

5. Should we have more subsidies for college education?

∙ No because if everyone can go to college and get a degree, it devalues  that degree

∙ Credential inflation- as more people get diplomas, each diploma becomes  a weaker signal (ppl continue to try and find new ways to separate  themselves from competition increase in higher education)  

∙ People are often forced to compete for jobs that are beneath the level of  their credentials because of overeducating (37% of college grads have  jobs that only require a high school Don't forget about the age old question of chapter 4 civil liberties

 diploma)

6. Productivity in Society?  

∙ In Human Capital theory, society is overall more productive because  competition

∙ In signaling, society is overall less productive and poorer because  resources are devoted to unproductive activities (going to school where  you don’t learn anything, but spend valuable time& money and end up  with the same degree as everyone else)  We also discuss several other topics like cognitive science uc merced

∙ Everyone ends up making the same salary instead of the higher wage  they were seeking from going to college in the first place (ppl still go to  college because they don’t want to fall behind the norm) If you want to learn more check out ∙ What happens to the market for SUVs when the price of gas (a compliment) falls?

Chapter 11 

Competitive Markets:

∙ Free entry and exit

∙ Large numbers of buyers and sellers

∙ Identical output

∙ Each firm has no pricing power because market determines equilibrium  

1. Marginal revenue (MR)- revenue from selling one more unit  

1) Equal to P (price of good)

2. Marginal cost (MC)- cost of producing one more unit  

2) MC rises as output becomes more difficult to produce

3. MR>MCproduce more (capitalize on the low MC and create more product for  more revenue)

MR<MCproduce less (MC is becoming too expensive and cancelling out the  revenue)

MR=MC profits maximized  

Profit/Loss:

Average cost (AC)- total cost divided by output  

1. AC<MCaverage cost rises  

AC>MC average cost falls  

2. P=profit

P>AC: P (price greater than average generates profit) encourages firms to  enter market  

P<AC: loss encourages firms to exit market  

P=AC: long run equilibrium no incentive for firms to enter or exit market  Chapter 12 

Invisible Hand Properties:

1. Cost Minimization-Competition allocates resources within markets to  minimize costs

2. Value Maximization-Competition allocates resources across markets to  maximize value

∙ Profits move resources into value-creating markets (when firms are making a  profit, other people move into that market so that they can also profit) ∙ Losses move resources out of value destroying markets (when firms are not  making a profit, other firms will not move into that market bc they know they  will not make money)

3. Elimination principle-Competition tends to eliminate profits (loss of business  to competitors)

4. Creative destruction- Competition encourages firms to find new sources of  profit by innovating (example of Netflix taking all of blockbuster’s profits  because they innovated and came up with a better system)

5. Diffusion- Competition encourages widespread use of valuable ideas (other  companies adding a touchscreen to their cellphones because of Apple’s  success with the iPhone)

Chapter 13 

Q*- optimal amount of profit based on circumstances  

When you are the only legal seller of a product you have a monopoly  

1. Companies that have a monopoly on a product that is profitable bc a captive  audience do well bc Q* dictates a high production rate to match the high  demand

2. Some monopolies do not make a profit though bc Q* actually causes the  company to take a loss since there is less demand less production less sold (no captive audience)  

3. Monopolies have market power (price setting), but are constrained by the  demand curve  

∙ Pc price= avg cost of production, no profit left over in a competitive  market  

∙ Bounce Pc off demand curve= Qc or quantity that sells

4. Consumer surplus= difference between value you get from product and price  of product

∙ In a competitive market, much more consumer surplus that monopoly  ∙ In a monopoly, Qm is quantity sold

∙ Pm is price customers are willing to pay (higher than competitive  market bc lack of options)  creates more profit for that one monopoly

Problems with Monopolies  

1. Monopolies create deadweight loss bc ppl who own monopolies are self interested and don’t care that they destroy social surplus by restricting the  free market if they make a larger profit for their company

2. People can gain wealth by lobbying for gov protections (“rent seeking”) ∙ Diverts resources from productive to unproductive activities (creative  minds shift their energy from coming up with new ideas to lobbying  senators bc gov auctions off different industries)

(1) Monopolies are inefficient bc there are not unlimited resources to be  auctioned off  

(i) Countries rich in natural resources encourage ppl to get rich by  getting preferential access to resources instead of producing  

what ppl want/ creating growth by inventing better things (ppl  

competing for a bigger slice of the same pie instead of working  to make the pie bigger)

Benefits of Monopolies  

1. Innovation may require costly research and development  

2. Innovation is slow when inventers are not motivated by enough profit/  invested enough

3. Monopoly is efficient when it encourages innovation (pharmaceuticals) ∙ R&D costs for developing a new drug are the same whether the disease is  rare or common, but most medicines are developed to treat common  diseases bc there is more customers and therefore greater revenue ∙ Example of monopoly efficiency: Orphan Drug Act gave sponsors of drugs  for rare diseases seven years of market exclusivity (monopoly) even  against entirely different drugs that treat the same disease, was actually a good thing for ppl with rare diseases bc it made it worth it for  

pharmaceutical companies to develop drugs for ppl with rare diseases

(guaranteed profit bc monopoly created by gov) and led to lower mortality rate for rare diseases bc drugs were more available

Patents- temporary monopoly on ideas (gives ppl stronger incentive for R&D to  invent new things bc they’re more likely to make a profit on the other side since  others can’t copy them without consequences)

Problems:

1) Patents allow old innovators to block new innovators

∙ Example: smartphone patent lawsuits that are preventing new inventers from building on and improving older technology

2) Resources flow to patents for defensive purposes rather than for innovation ∙ Companies constantly suing each other for violating patents (no one makes  money off of this)

∙ Companies arming themselves with patent arsenals causes them to divert  funds instead of using that money to create a better product

Patent Puzzle= no dramatic acceleration in the rate of technological progress even  though that are a lot more, stronger patents for a larger variety of ideas in the U.S  than ever before  

Tabarrok Curve- weakening the amounts of patents given out would actually\  increase overall innovation

Chapter 15  

Cartels-When a market has few firms, the firms can cooperate to raise prices

Prisoner’s dilemma: mutually beneficial cooperation may not be in an individual’s  self-interest  

1) Within these few firms, they can all agree on a set amount to produce ∙ When all firms produce the agreed upon amount, they all make an equal  profit

∙ If one firm cheats and produces more, that firm will earn more  ∙     If all firms cheat and produce more, all firms end up earning less (many still  do because rational self-interest)

Game theory- understanding behavior when outcome depends on choices of all  persons involved

∙ Example

 Bonnie and Clyde questioned separately:

Mutually beneficial outcome: Bonnie silent, Clyde silent

Bonnie’s self-interest leads her to confess

Clyde’s self-interest leads him to confess

Actual outcome is that they both confess

Solutions to prisoner’s dilemma:

1) Communication- individuals are most likely to reach best outcome by  coordinating behavior (Bonnie and Clyde conspire to be silent beforehand) 2) Repeated games- individuals cheat less when they could be punished in  subsequent games/ later on  

3) Government restraints- Individuals use the government to force the game to the  group’s best outcome  

∙ Example: government restricted cigarette companies from running ads, which was actually the best outcome for all cigarette companies

i) All firms made more money if none of them produced ads

ii) All firms would “cheat” by producing ads bc self-interest and all of them  made less money

iii) Restriction from gov eliminated the possibility to produce ads and all firms benefitted  

Self-restraints- individuals impose costs on themselves to force the game to the  best outcome

∙ Example: Getting married is a form of self-restraint that makes both parties  less likely to leave bc the cost becomes higher to do so

∙ You can play a game in which the other player is your future self (letting your  phone die so that you won’t have access to it when you need to study and  your future self gets a good grade)

Rational ignorance  

Theory

1) Marginal cost- time and effort to acquire information  

2) Marginal benefit-fewer costly errors from false beliefs  

3) Rational ignorance- it is rational to be imperfectly informed because MC>MB to  change your beliefs

Ignorance does not denote stupidity

Market for Political information

1) Marginal benefit- fewer costly errors from voting incorrectly  

1. One vote rarely determines election

2. Benefit of one informed voter is nearly zero

∙ Outcome: It is rational for individuals to be extremely ignorant about politics  Consequences

∙ Politicians favor interest bias groups at the expense of the public (politicians  support popularly held misconceptions to get votes, which hurts the general  public)

Ignorant voters does not cause ignorant election outcomes

Political campaigns/elections

∙ Political entrepreneurs can bear the cost of informing voters

∙ Information shortcuts-ignorant voters primarily rely on endorsements and  third-party ratings

∙ Miracle of Aggregation- Ignorant voters make random errors based on their  lack of information, so their errors cancel each other out and the votes that  count are the ones of the informed voters who make the right choice

Rational Irrationality  

With rational ignorance there is an assumption the person is not emotionally  invested, but in politics ppl are invested (they feel their belief is just and makes  them happy to be a good person)

Some beliefs are false though logic forces you to choose between truth and  happiness when you find out your beliefs are false

∙ Irrationality-suspending logic to believe comforting lies  

1. Marginal benefit- happiness from believing lies decreases overtime in the  market for irrationality  

2. Marginal cost- losses from taking actions based on lies increase over time in  the market for irrationality  

3. Rational irrationality- it is rational to believe some comforting lies, ppl weigh  the costs and benefits of acting/thinking irrationally (cost of “flying” on the  ground vs. “flying” off a roof)

∙ Irrational does not equal crazy, same rational brain will believe irrational  ideas if the cost is low enough  

∙ Market for political irrationality: MB decreases over time, MC Is almost flat  1. Marginal benefit- happiness from believing political lies

2. Marginal cost- losses from voting based on political lies

3. One vote rarely determines election cost of one irrational vote is nearly  zero

Outcome: It is rational to be extremely irrational about politics bc people are self interested and the cost/impact of one irrational vote is very low (cost vs. benefit  analysis)  

Rational ignorance:

1. More info alleviates the problem because they are easily swayed since they  just don’t know, no strong beliefs

2. Wasteful policies are caused by interest groups bc they take advantage of  ppl’s ignorance

3. Voters make random errors, miracle of aggregation happens (errors cancel  out)

Rational Irrationality:

1. More info worsens the problem because ppl have strongly held beliefs and  will cling to their misconception even more when confronted with evidence  (say that all the evidence is lies)

2. Wasteful policies are caused by voters bc they genuinely believe something  that is wrong

3. voters have systematic biases, and therefore most of them cluster on the  same wrong side of the issue and miracle of aggregation does not happen

Solution: to reduce irrationality, raise the price of being irrational