EC109 Term 2

Question 1

Descriptive models

Answer 1

Models of how people actually make decisions

Question 2

Normative models

Answer 2

Models of how people ought to make decisions if they wish to achieve a given objective

Question 3

Explanatory models

Answer 3

Examine the mechanisms underlying some phenomenon

Question 4

Predictive models

Answer 4

Make predictions about the economy

Question 5

Exogenous variables

Answer 5

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.

Question 6

Endogenous variables

Answer 6

These are the variables we want to understand/predict/explain.

Free to vary in response to changes in the environment (exogenous vars.).

Question 7

Partial equilibrium models distinguish between…

Answer 7

Exogenous and endogenous variables

Question 8

Models as maps

Answer 8

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

Question 9

What sort of information do prices convey?

Answer 9

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

Question 10

Prices can coordinte economic activity by aggregating information? What can go wrong? (3)

Answer 10

Externalities
Asymmetric information
Imperfect information

Question 11

Efficient market hypothesis (EMH)

Answer 11

Prices reflect all available information

Question 12

Ex-ante

Answer 12

Before the event

Question 13

A Social choice problem

Answer 13

The problem of ranking items which differ along several different dimensions

Question 14

A way to explain what a social welfare function is

Answer 14

Aggregating the welfare of individuals in to a society wide welfare measure (a numerical ‘score’ like a utility)

Question 15

Utilitarian social welfare function

Answer 15

Sum of all utilities

Question 16

Dictorial social welfare function

Answer 16

Compare only along one dimension

Question 17

Weighted utilitarian social welfare function

Answer 17

Weighted sum of all utilities

Question 18

Rawlsian social welfare function

Answer 18

Measure social welfare by the impact on the individual who is made worst-off

Question 19

Paerto optimality

Answer 19

A minimum necessary condition for an outcome to be efficient/optimal/desirable

An outcome in which we cannot make a Pareto improvement.

Question 20

Random serial disctatorship or random priority mechanism

Answer 20

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!)

Question 21

Payoff dominant outcome

Answer 21

An outcome which is Pareto superior to all the others

Is stable (NE) but requires coordination

Question 22

Coordination failure

Answer 22

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.

Question 23

Assumptions of the Cournot Model

Answer 23

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

Question 24

Joseph Bertrand’s critique of Cournot’s model in 1883

Answer 24

Quantity competition is not realistic - firms usually pick prices

Question 25

Milton Friedman ‘as if’ argument - what it means

Answer 25

It doesn’t show how people really play billiards, predicting exact angles, etc.

However, models would make good predictions on how they would play

Question 26

Market demand depends on…

Answer 26

Price of good of interest
Prices of other goods in the economy
Vector of all incomes

Question 27

Issues with Consumer (and Producer) Surplus

Answer 27

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

Question 28

Comparing the effects of tariffs and quotas

Answer 28

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)

Question 29

Deadweight loss

Answer 29

Any surplus which is lost following a change in prices/quantities

Question 30

Two flaws with backwards indusction

Answer 30

It cannot be applied to games of imperfect information

It cannot be applied to games without a finite end point

Question 31

What is a subgame?

Answer 31

Any part of the game which begins at a single decision node and contains all successor nodes.

Question 32

Contestable market definition

Answer 32

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.

Question 33

Characteristics of monopolistic competition

Answer 33

Firms can control prices
Perfect information
Large numbers of buyers and sellers
No technological barriers to entry

Question 34

Assumptions of the Cournot Model

Answer 34

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

Question 35

Assumptions of the Bertrand Model

Answer 35

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

Question 36

Bertrand paradox

Answer 36

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

Question 37

Oligopoly - conclusions with Bertrand and Cournot

Answer 37

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

Question 38

Arrow’s Impossibility Theorem

Answer 38

There is no perfect SWF which:

1. Allows individuals to be free to rank alternatives any way they like.
2. Ranks 𝐴 ≻ 𝐵 whenever 𝐴 ≻𝑖 𝐵 for all individuals 𝑖. (‘Unanimity’)
3. Accounts for the wishes of multiple individuals and does not always mimic the
   preferences of a single individual. (‘No dictatorship’)
4. Is complete and transitive.
5. 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}.