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Economics 2005 Chapters 11, 14, 15

by: Tim Reynolds

Economics 2005 Chapters 11, 14, 15 ECON 2005

Tim Reynolds
Virginia Tech

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About this Document

These chapters will be covered on Exam 3 coming up.
Principles of Economics
Steve Trost
Class Notes
Economics, firms, Game Theory, perfect, Imperfect, search, information, monopoly, perfect competition
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This 6 page Class Notes was uploaded by Tim Reynolds on Monday April 11, 2016. The Class Notes belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Spring 2016. Since its upload, it has received 16 views. For similar materials see Principles of Economics in Economcs at Virginia Polytechnic Institute and State University.


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Date Created: 04/11/16
Econ 2005 Chapter 11 Game Theory: - In all conflict situations, and thus all games, there are decision makers, rules of the game, and payoffs (or rewards/prizes). - This theory is used to analyze and compare oligopolies. - Dominant Strategy: In game theory, a strategy that is best no matter what the opposition does. In an advertising game, both layers have a dominant strategy of advertising. - Prisoners’ dilemma: A game in which the players are prevented form cooperating o Example:  2 players: Rocky and Ginger  2 strategies: confess or don’t confess  Payoffs: if both stay mum, they each get 1 year, if they both speak they get 5 years, if rocky confesses he goes free and ginger gets 7 years, if ginger confesses she goes free and rocky gets 7 years.  Dominant strategy for both parties is to confess. Games without a dominant strategy - If both players have a dominant strategy, then it is easy to find the outcome. What if there is no dominant strategy for a player? o IF a player does not have a dominant strategy, they assume the other player will play in a way that is dominant to them. Therefore, the player without a dominant strategy should choose the option that could potentially yield the highest benefits for them (given that they guess correctly regarding the other player’s decision). Maximin strategy: “Playing it safe.” A strategy in game theory chosen to maximize the minimum gained that can be earned (i.e.- avoiding a really bad payoff). Nash Equilibrium: In game theory, the result of all layers’ playing their best strategy given what their competitors are doing. In other words, neither player would want to change their strategy given what the other player has chosen. *These are involving “one-shot” games, what if these games are repeated? This is when firms need to take into account, their short-run vs. long run profit in order to make the best decision for them. Tit-for-tat strategy: A company’s strategy that lets a competitor know the company will follow the competitors lead. A player in one round simply mimics the other layer’s behavior in the previous round- it’s the optimal strategy for getting the other player to cooperate. Coordination Game - The coordination game is a game in which each party is better off doing the same thing as the other player. - In these games, there are 2 possible Nash equilibria. Econ 2005 Chapter 14 Competitive Trends: - Pure Monopoly - Dominant Firm - Tight Oligopoly - Effective Competition Transaction Costs, Imperfect Information and Market Behavior Why do firms exist? - Firms minimize transaction costs by making things on a large scale - Firms minimize production costs – not easy though - Basically having a firm make stuff for you is more efficient than you trying to do it yourself Firm’s scope of Operation - Insourcing vs. Outsourcing o Vertical integration – “insourcing”  A vertically integrated firm controls several stages of the production process  However, they may not achieve minimum efficient scale (cheaper for someone else to make the input) o For these reasons, it might make sense for a firm to “outsource” (pay someone else to make a certain input). o Outsourcing is more attractive if there is a “well-functioning” market for the needed input.  i.e.- The quality of the product is easily verifiable *Advantage of Outsourcing is solely the cost-analysis. A firm outsources because it is cheaper than making an input themselves. *Disadvantages include lack of control over input production. This could influence customer confidence in the product if they are unsure of where the inputs come from. The firm cannot verify the quality of the inputs being made. Economies of scope: It is cheaper to produce different items in one firm. Average cost per unit falls as the firm supplies more types of products (scope increases) Switching Gears: The sources of Market Failure - Market Failure: Occurs when resources are misallocated or allocated inefficiently resulting in lost value or waste. - Imperfect Information: The absence of full knowledge concerning product characteristics, available prices, etc. o IF you don’t know everything about the product, you cannot know with certainty how much you would be willing to pay for it or how much you would benefit from it. Adverse Selection: Can occur when a buyer or seller enters into an exchange with another party who has more information. This can also be seen as a “hidden characteristic” problem. Efficiency Wage Theory: high wages attract better employees and encourage all to work hard. Moral Hazard: Another information problem that arises frequently in insurance markets is moral hazard. Often people enter into contracts that at least in part depend on the future behavior of one of the parties. In essence, it arises when one party to a contract alters their behavior in a costly manner because the cost of that behavior has been passed on to the other party to the contract. The “Principal-Agent” problem - Sometimes the goals of the agent are incompatible with those of the principal (person affected by agent’s decisions). - When the agent’s actions cannot be observed by the principal, then the agent is likely to pursues his own goals rather than do what is best for the principal. o i.e. - Managers and stock-holders, you and your mechanic, politicians and constituents Search - Finding more info out about a product - Marginal Cost f search o Time is the biggest cost in any search o The marginal cost of finding info- it is easy to find a little bit of info but gets much harder to find more detailed info (MC slopes up) - Marginal benefit of search o Better quality for a given price- find the best product o Lower price for a given quality- find the best deal o Marginal benefit of information slopes down as quantity of information increases - *These slopes cross, but never hit the y-axis (never account for 0 quantity of info) - Equilibrium is where MC = MB (called the optimal search) The Winner’s Curse - Auctions for a product of uncertain value create special “imperfect info” problem called the “winner’s curse” where many “winners” end up losers. o Value of product is uncertain o Winner posts the highest bid thinking product I worth a lot  Product may not always be worth as much as it appears due to imperfect information Econ 2005 Chapter 15-Regulation Regulating a Natural monopoly: - It might make sense to force the monopoly to produce at the point where P=MC. - However, for a natural monopoly, AC is always falling in the LR (economies of scale). So it must be the case that LRMC<LRAC. - In other words, at P=MC, this monopolist would be losing money. Federal Trade Commission and Antitrust Division are empowered to act against violator of antitrust laws. (Federal Regulation Groups) What do these groups do? - They keep an eye on the industries to regulate fair play - Price fixing: when competitors get together and decide to raise prices (Cartels) - Tying contracts: making customer buy something from someone else in order to be allowed to buy from you. - Exclusive dealing: not letting customers buy from a competitor. - Interlocking directorates: when someone serves on the board for 2 competing firms. The Enforcement of Antitrust Law - If a firm or industry is engaging in any of these actions, an “antitrust suit” is filed against them. - Sanctions and Remedies (from the court to a firm): o Forbid the continuation of illegal acts o Force the defendants to dispose of the fruits of their wrong (pay back money you stole) o Restore competitive conditions - Consent decrees: Formal agreements on remedies among all the parties to an antitrust case that must be approved by the courts. Consent decrees can be signed for, during or after the trial. o i.e.- paying a fine and dropping the case Regulation of Mergers - These groups also regulate mergers to keep firms from getting too much market power. - Herfindahl-Hirschman Index: A math calculation that uses market share figures to determine whether or not a proposed merger will be challenged by the government. (Sum of squared shares of each firm in the industry) o If above 2500, industry is highly concentrated (ALL mergers will be challenged) o If between 1500-2500, industry is moderately concentrated (some mergers) o If less than 1500, the industry is considered un-concentrated (any merger will go through virtually) “Capture Theory” of Regulating - Regulation ideally serves public interest by reallocating resources in a way that increases total surplus. - However, many believe that regulation often serves the interests of the firms rather than the interest of social efficiency. - This is known as “capture theory.” It is the result of the strong lobbying groups associated with some industries. Antitrust Policy - Trust: An arrangement in which shareholders of independent firms agree to give up their stock in exchange for trust certificates that entitle them to a share of the trust’s common profits. A group of trustees then operates the trust as a monopoly, controlling output and setting price. - Rule of reason: The criterion introduced by the Supreme Court in 1911 to determine whether a particular action was illegal or legal within the terms of the Sherman Act. Under this rule, behavior was the key. *You will not need to know all historical details for the exam.


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