EC109 Term 2 Flashcards
Descriptive models
Models of how people actually make decisions
Normative models
Models of how people ought to make decisions if they wish to achieve a given objective
Explanatory models
Examine the mechanisms underlying some phenomenon
Predictive models
Make predictions about the economy
Exogenous variables
Background variables which are not the main focus on the model.
These are ‘fixed’, i.e. assumed to take a certain value with no need for any explanation by the modeller.
Endogenous variables
These are the variables we want to understand/predict/explain.
Free to vary in response to changes in the environment (exogenous vars.).
Partial equilibrium models distinguish between…
Exogenous and endogenous variables
Models as maps
They are abstractions
They do not perfectly describe the terrain
They deliberately sacrifice realism for clarity
Map are adapted for different applications
Certain styles of map become dominant due to ease of use
What sort of information do prices convey?
Prices provide information about the relative scarcity of goods
Price changes can reveal changes in buyers’ willingness to pay
Producers use price changes to guide their decision making
Prices can coordinte economic activity by aggregating information? What can go wrong? (3)
Externalities
Asymmetric information
Imperfect information
Efficient market hypothesis (EMH)
Prices reflect all available information
Ex-ante
Before the event
A Social choice problem
The problem of ranking items which differ along several different dimensions
A way to explain what a social welfare function is
Aggregating the welfare of individuals in to a society wide welfare measure (a numerical ‘score’ like a utility)
Utilitarian social welfare function
Sum of all utilities
Dictorial social welfare function
Compare only along one dimension
Weighted utilitarian social welfare function
Weighted sum of all utilities
Rawlsian social welfare function
Measure social welfare by the impact on the individual who is made worst-off
Paerto optimality
A minimum necessary condition for an outcome to be efficient/optimal/desirable
An outcome in which we cannot make a Pareto improvement.
Random serial disctatorship or random priority mechanism
Step 1: Have agents submit their ranked list of preferences
Step 2: Randomly assign each agent a place in a ‘virtual queue’
Step 3: 1st place agent in the queue gets their first choice
Step 4: 2nd place agent in the queue gets their top choice of the remaining houses.
Step N: Last place agent in the queue gets their top choice of remaining houses.
Result: This simple mechanism is Pareto efficient and Strategy-proof (but potentially very unfair for the person who is last!)
Payoff dominant outcome
An outcome which is Pareto superior to all the others
Is stable (NE) but requires coordination
Coordination failure
A situation where multiple parties fail to coordinate their actions on a mutually beneficial outcome
NEs may exist but are undesireable for all parties. They lack coordination, not incentive.
Assumptions of the Cournot Model
Products are homogenous
Firms are homogenous
Firms pick their output
Price determined by joint output produced
Firms compete just once and pick outputs without observing the other’s decision
There is no entry by other producers
No fixed cost and constant marginal cost
Joseph Bertrand’s critique of Cournot’s model in 1883
Quantity competition is not realistic - firms usually pick prices
Milton Friedman ‘as if’ argument - what it means
It doesn’t show how people really play billiards, predicting exact angles, etc.
However, models would make good predictions on how they would play
Market demand depends on…
Price of good of interest
Prices of other goods in the economy
Vector of all incomes
Issues with Consumer (and Producer) Surplus
Does not account for distributional concerns
Each consumer/producer has the same weight in this function
Does not distinguish between changes along intensive and extensive margin
Comparing the effects of tariffs and quotas
Tariffs and quotas both:
-Raise domestic prices
-Support domestic producers
Comparing effect of tariff vs quotas:
-Consumer and domestic producer surplus identical
-Quotas no better than tariffs, can be worse (unless import prices are restricted)
Deadweight loss
Any surplus which is lost following a change in prices/quantities
Two flaws with backwards indusction
It cannot be applied to games of imperfect information
It cannot be applied to games without a finite end point
What is a subgame?
Any part of the game which begins at a single decision node and contains all successor nodes.
Contestable market definition
Entry and exit is costless
Entrants can undercut the monopolist and exit at no cost
The monopolist can only prevent this by pricing at average cost, limiting deadweight loss.
Characteristics of monopolistic competition
Firms can control prices
Perfect information
Large numbers of buyers and sellers
No technological barriers to entry
Assumptions of the Cournot Model
Products are homogeneous
Firms pick their output
Price determined by joint output produced
Firms compete just once and pick outputs without observing the other’s decision
No fixed cost and constant marginal cost
Assumptions of the Bertrand Model
Products are homogeneous
Firms pick prices
Buyers know all prices and buy from the chepaest firm
Firms compete just once and pick prices without observing the other’s decision
No fixed cost and constant marginal cost
Bertrand paradox
Two firms competing on prices make zero profit
But in the Cournot model, two firms competing on quantities made positive profit
This is actually a surplus maximising outcome - we get social efficiency without needing free entry or large N
Oligopoly - conclusions with Bertrand and Cournot
Corunot - profitability is higher in markets with more concentration of market power (fewer firms).
In Bertrand, profitability is low even with only two firms.
Differences in the predictions of the baseline models will narrow if we allow for product differentiation
Arrow’s Impossibility Theorem
There is no perfect SWF which:
- Allows individuals to be free to rank alternatives any way they like.
- Ranks 𝐴 ≻ 𝐵 whenever 𝐴 ≻𝑖 𝐵 for all individuals 𝑖. (‘Unanimity’)
- Accounts for the wishes of multiple individuals and does not always mimic the
preferences of a single individual. (‘No dictatorship’) - Is complete and transitive.
- Satisfies ‘Independence of Irrelevant Alternatives’: If we rank 𝐴 ≻ 𝐵 when the
options are 𝐴,𝐵, 𝐶 , we also rank 𝐴 ≻ 𝐵 when the options are {𝐴,𝐵, 𝐶,𝐷}.
