University of Iowa Microeconomics Final Review (Fall 2018)

i. A type of market structure in between monopoly and monopolistic competition
ii. Consists of very few large firms, but at least two firms producing exact or differentiated products. Entry is possible, but not freely
iii. More firms than a monopoly but fewer firms than monopolistic competition
iv. Actions taken by 1 firm affect the other firms in the market

Four-firm concentration ratio
1. Percent of market (market share) accounted by the four largest
firms
2. What is the ratio for perfect competition and monopoly?
3. What are the shortcomings of concentration ratios

Herfindahl-Hirschman Index
1. Another way to measure market concentration

i. The nature of oligopolies implies decisions of one firm affect profits of the other firms, which in turn, affects the decisions the other firms make
ii. Need a model of strategic interaction: Game Theory

1. Set of players
2. Set of actions
3. Payoffs

A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off

A situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen

Battle of the Sexes: Suppose a couple are deciding on which event to attend for a date: a baseball game or a dance. The row player prefers to go to the game while the column player prefers to go to the dance. If they go to different events, they do not receive any benefit from going.

1. Punishment strategies in repeated interactions
a. Can we do better than the one-shot Nash equilibrium if we play the prisoner's dilemma more than once?
2. Implicit Collusion

1. Some types of games happen in turns
2. Example, Entry Games
3. Subgame Perfect Equilibrium is found via Backwards Induction

1. Determined by equating the marginal utility per dollar of consumption and leisure (Price of leisure=wage rate)

2. If wage increases=
a. Income Effect: Since consumers have more money for any number of hours they work, they can buy more leisure and more consumption
b. Substitution Effect: Leisure is now more expensive, buy less leisure and more consumption

3. Supply curve is the combinations of price (wage) and labor (L) as the wage changes

1. Determined by hiring workers as long as wage is less than marginal revenue product of labor

2. Assumptions=
a. Constant output price (Output market is perfectly competitive)
b. Firm has no effect on the wage rate (Labor market is perfectly competitive)

1. Price Floor: can't charge less than a certain amount for labor
2. In competitive markets, it causes deadweight loss, unemployment

i. Market power in the labor market is usually on the part of buyers
(employers) not sellers

ii. Firm's with market power in the labor market can set wages instead of a
market-determined wage, it faces an upward supply curve for labor
1. A price taking firm can hire any amount of labor at the market
wage, it faces a horizontal supply curve
2. A price-setting firm faces an upward-sloping supply curve

iii. Consider the situation in which only one firm is the only buyer of labor, this is called a monopsony
1. Monopsony: A market with a single buyer
2. Examples: Firms that account for a large share of employment in a
small community

iv. Since the firm has market power and faces an upward-sloping labor
supply curve it can set wages to increase/decrease the number of workers it hires.

v. This means the marginal cost of hiring an additional worker is not the wage paid to the last worker because the monopolist will have to increase the wage it pays to all workers in order to hire an additional worker

i. Marginal Revenue Product of Labor (MRPL)=MCL

ii. MRPL=MCL

iii. Analysis
1. The firm hires less labor and generates a lower wage than a
competitive market for labor
2. One policy solution for this inefficiency could be a minimum wage

i. Employment increases
ii. Wage increases

i. A good has an externality if production or consumption of that good affects the utility or costs of consumers or firms not engaged in the transaction

ii. Cause there to be a difference in how participants in the market and society values a transaction

iii. If externalities are negative, then society values the transaction less than the participants
1. Ex: Air pollution
2. Ex: Traffic congestion
3. Ex: Noise pollution
4. More about negative externalities
a. Cost of society is larger than the cost to producers
b. Social costs = private costs + external cost
c. Negative externalities lead markets to produce a larger quantity than is socially desirable.
d. What would social planner do?
e. Internalizing the externality (altering incentives so that people take account of the external effects of their actions and Government taxes output)

iv. If externalities are positive, the society values the transaction more than the participants
1. Ex: Flu Shot
2. Ex: New battery technology
3. Ex: Beekeepers
4. More about positive externalities
a. Benefit to society is larger than private benefit
b. Positive externalities lead markets to produce a smaller
quantity than is socially desirable.
c. Internalize the externality by through subsidy

v. Creates market inefficiency

i. Corrective Taxes
1. Def: a tax designed to induce private decision makers to take account of the social costs that arise from a negative externality
2. Pigouvian Tax

ii. Subsidies

i. Coase Theorem
1. Def: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own
2. Bargaining Rights

ii. Why Private Solutions Don't Always Work
1. Transactions costs
a. The costs that parties incur in the process of agreeing to and following through on a bargain
2. Bargaining breaks down (strikes or wars)
3. Large number of individuals involved, so coordination costly

Public goods are goods and services that are consumed by people regardless of whether or not they paid for them. national defense is a public good

i. Two Questions=
1. Is the good excludable?
a. Can people be prevented from using the good?
2. Is the good rival in consumption?
a. Does one person's use of the good reduce another person's ability to use it?

ii. Kinds of Goods=
1. Private Goods
a. Excludable and rival in consumption b. Ex: Hamburger
2. Public Goods
a. Neither excludable nor rival in consumption b. Ex: National Defense
3. Common Resources
a. Rival in consumption but not excludable b. Ex: Fish in the Ocean
4. Club Goods
a. Excludable but not rival in consumption
b. Fire Protection

1. Excludable and rival in consumption

2. Free Rider Problem (Def: a person who receives the benefit of a good but avoids paying for it)

3. Important public goods (Ex. National Defense, Sunlight, Clean Air)

4. Efficient Provision of Public Goods
a. Vertical Summation (add households; willingness to pay)

1. Rival in consumption but not excludable

2. Tragedy of the Commons (Def: a parable that illustrates why common resources are used more than is desirable from the standpoint of society as a whole)

3. Important Common Resources (Ex. Clean Air and Water, Congested Roads, and Fish, Whales, and other Wildlife)

Standard way to describe benefits of an economic decision (utility) doesn't work here

The expected value of a lottery over money is the sum of the value of each outcome weighted by the probability of that outcome occurring

i. We can represent the expected utility of a lottery between two outcomes
as a point on the secant line between the two outcomes
ii. Concave Utility Functions: Utility function is above the secant line, we say
consumers are risk-averse if they have a concave utility function
iii. Convex Utility Functions: Utility function is below the secant line, we say
consumers are risk-seeking if they have a convex utility function

i. How much is a lottery worth to a risk-averse consumer?
ii. For any gamble between two outcomes, we can find a certain outcome
that gives the same expected utility
iii. If the consumer is risk averse, the certain outcome will be less than the
expected value of the risky outcomes
iv. The certainty equivalent of a lottery is the x coordinate of the point on
the utility function with the same height as the expected utility of the
lottery

i. We need to know the probability of each outcome occurring
ii. As long as we can come up with an estimate of probability, expected
utility works
iii. But some things are harder to estimate a probability, for example, the stock price of a foreign company in 15 years (These types of questions are ambiguous rather than uncertain)

i. Reduces the difference in income for consumers between good and bad
outcomes so consumers face less risk
ii. Since firms don't care about the risk they face, they're willing to provide
insurance for a fee
iii. So long as the fee is small enough, consumers should be willing to pay it

i. One party has information that the other doesn't
ii. Can cause problems for markets that otherwise would function well iii. Adverse Selection: example, Market for Lemons, Insurance
iv. How to address adverse selection in markets?
v. Asymmetric information in advertising