Transcript Law & Economics Fall 2008 Dr. Delemeester What is Law & Economics? Three Strikes Laws? No-Fault Divorce Laws? Kelo v.

Law & Economics
Fall 2008
Dr. Delemeester
What is Law & Economics?
Three Strikes Laws?
No-Fault Divorce Laws?
Kelo v. City of New London (2005)?
Good Samaritan Laws?
Review of Microeconomic
Theory
Rational man model
 An individual seeks to maximize his or her utility.
This involves taking actions till the marginal
private cost of further action equals the
marginal private benefit of that action.
 For social optimality the rule is:
Taking action till the marginal social cost of
further action equals the marginal social
benefit of that action
Market Model
Price
Deadweight Loss
Supply
CS
P*
PS
Demand
Q
Q*
quantity
 Free Market Outcome: P*, Q*
 Maximizes social welfare: SW = CS + PS
Competitive Firm
Profit Maximization rule:
P = MR = MC
$
MC
ATC
AVC
P1
ATC1
MR1
q1
What happens to the market price in the long run?
quantity
Consumer Choice
 Budget Line
 I = PC*C + PAOG*AOG
Ex:
I
= $1000
PC = $2
PAOG = $1
AOG
1000
Consumer optimum
AOG*
U1 = 40
 Indifference Curves
 Shows all (C, AOG)
pairs that provide
same level of utility
C*
500
coffee
Market Imperfections
1. Market power
• monopoly and monopsony
• imperfect competition
2.
3.
4.
5.
Externalities
Public goods
Severe informational asymmetries
Coordination and collective action
problems
Market Power
 Monopoly
 The condition of one seller and significant barriers to
entry.
 A monopolist charges too high a price and sells too little
of the monopolized good or service.
 Corrective: antitrust and regulation.
 Monopsony
 The condition of one buyer and significant barriers to
entry.
 The monopsonist charges pays too little for the
resources that he uses and hires too few of them.
Externalities
 Unintentional Costs imposed on third parties by
the profit-maximizing actions of one person.
 Examples: air and water pollution, secondhand tobacco
smoke.
 Unintentional Benefits that are conferred onto
third parties by the profit-maximizing actions of
one person.
 Examples: elementary education, pollination services
provided to beekeepers by a neighboring apple orchard.
Externalities in a Graph
Ssocial
Sprivate
$
P2
P1
External cost
D1
Q2 Q1
steel
 Free Market: P1, Q1
 Optimal Outcome: P2, Q2
Free market overproduces goods
that generate a negative externality
A consequence of a positive consumption externality is that
social benefits are ______ than private benefits, and the socially
optimal level of output is ______ than the private level of output.
a)
b)
c)
d)
greater; greater.
greater; less.
less; less.
less; greater.
1
2
3
4
5
;l
le
ss
te
r.
;g
ss
le
re
a
es
s.
ss
.
le
te
r;
gr
ea
gr
ea
te
r;
gr
ea
te
r
.
0% 0% 0% 0%
Public goods
Two characteristics:
 Non-excludability
 Non-rivalry
Free rider problem
Corrective:
 Public provision
 Public subsidization
Examples:
• Fireworks display
• Radio broadcast
• National defense
• Information
Severe informational asymmetries
 Two parties to a potential transaction have
very different information about some
important aspect of the potential transaction.
 Example: consider the very different knowledge of
the true quality of a used car as between the buyer
and the seller.
 Why is this a problem?
 Because fear of uncertainty about the unknown
attributes may prevent otherwise value-maximizing
transactions from taking place.
 Corrective
 Compelling information disclosure by punishing
failures to disclose
Coordination and collective action
problems
 Traffic congestion
 Drivers make decisions about using the roads independently
with the sometime result that the roads are terribly congested.
 How can drivers coordinate their decisions so that the roads
are not too crowded?
 Congestion pricing
 London now charges £8 for cars to come within the central
business district on weekdays.
 Traffic is down 20 percent since early 2003.
 Public goods present a collective action problem
 Free riders
 Corrective: compulsory contribution.
Game theory
 A formal means of modeling strategic interaction involving:
 2 or more players
 Strategies
 Payoffs
 Types of games
 Cooperative vs Non-cooperative
 Sequential vs simultaneous move
 Single play vs repeated play
 Solution strategies and Nash Equilibrium
Prisoners’ Dilemma
Prisoner B
Confess
Don’t Confess
Confess
-5, -5
-1, -10
Don’t
Confess
-10, -1
-2, -2
What strategy would you choose in a single shot game?
Solution Strategies
 Dominant Strategy
 One that is optimal no matter what opponent does
Prisoner A: Confess
Prisoner B: Confess
(Confess, Confess) is a Nash Equilibrium
 Nash Equilibrium
 No player has a unilateral incentive to change their
strategies
Prisoners’ Dilemma
Prisoner B
Confess
Don’t Confess
NE
Confess
-5, -5
-1, -10
Don’t
Confess
-10, -1
-2, -2
Pareto optimal outcome maximizes joint payoff
What if you play a repeated prisoner’s dilemma?
PO, but not NE
Consider the voluntary contribution game below.
What is the Nash Equilibrium for this game?
(C, C)
(C, DC)
(DC, DC)
(DC, C)
Player 2
1
2
3
4
5
,C
)
10, 10
0%
(D
C
35, 5
0%
)
Don’t
Contribute
C
)
5, 35
0%
(C
,D
30, 30
(C
,C
Contribute
)
0%
,D
C
Contribute
Don’t
Contribute
(D
C
1.
2.
3.
4.
Stage Hunt
Hunter 2
Stag
Hare
Stag
10, 10
0, 8
Hare
8, 0
8, 8
Decision-making under uncertainty
 How to evaluate future outcomes when there are
multiple possibilities?
Flip a coin gamble:
Heads = $100
Tails = $500
How much
would you pay
to play this
game?
 Calculate the expected value
 Weight each possible outcome by its probability and then
add them
EV = 0.5 ($100) + 0.5 ($500) = $300
Consider a lottery with three possible outcomes: $125 will be
received with probability .2, $100 with probability .3, and $50
with probability .5. What is the expected value of the lottery?
a)
b)
c)
d)
1
$60
$80
$90
$105
2
3
4
5
0%
0%
0%
60
80
90
0%
105
Decision-making under uncertainty
 Now suppose that there are two uncertain courses of action
 Should one always choose the course of action with the higher
expected value?
A1: EV = $300 = 0.5 (100) + 0.5 (500)
A2: EV = $400 = 0.99 (0) + 0.01 (40,000)
 People have different attitudes toward risk or uncertainty and
these attitudes may influence how they behave when facing
uncertain outcomes
 Risk neutrality
 Risk aversion
 Risk seeking
Expected Utility Theory: Risk Aversion
Assumes diminishing marginal
utility of income
Utility when
healthy
Utility
U
90
86
PH = probability of being healthy
PS = probability of being sick
PH + PS = 1
E(U) = PHU($40,000) + PSU($20,000)
= PH•90 + PS•70
Let PS = .20
70
Utility when
sick
$20
$36 $40
E(U) = (.80)90 + (.20)70 = 86
E(Y) = (.80)(40,000) + (.20)(20,000)
= $36,000
Income (thousands)
Any risk-averse individual would always
a)
take a 10% chance at $100 rather
than a sure $10
take a 50% chance at $4 and a 50%
chance at $1 rather than a sure $1
take a sure $10 rather than a 10%
chance at $100
take a sure $1 rather than a 50%
chance at $4 and a 50% chance at
losing $1
b)
c)
d)
1
2
3
4
5
0%
0%
0%
a)
b)
c)
0%
d)
Decision-making under uncertainty
 Insurance
 Allows risk-averse individuals to convert uncertain
outcomes into certain outcomes
 Two problems:
 Moral hazard
 Adverse selection
 Corrective:
 Co-insurance and deductibles.