Market Failure and Behavioural Economics Flashcards
Draw a graph to demonstrate the business cycle
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State Say’s law
Supply and demand are equal
Did Mill and Ricardo agree or disagree with Say’s law?
Agree
What does Keynes’ model of liquidity preference say?
People want a certain level of savings - maybe 3 months’ salary. In a recession, liquidity preference rises
What does credit introduce?
Instability. In a boom, people and firms borrow assets that appreciate faster than the interest they pay
Give 4 things that happen in a recession. What do these mean?
- Some loans go bad, eating into capital
- The bank’s share price falls, further eating capital
- The regulator raises capital requirements from 6% to 8%
- The government competes for the available loans
So the money supply could contract sharply
What did Schumpeter mean by ‘creative destruction’?
Recessions are often tied up with technology change. A boom creates capacity, bust slashes prices. We’ve killed whole industries (telephone switchgear), taken over others (bookselling), marginalised others (local newspapers) and are disrupting most of the rest
What did Adam Smith mean by “Wealth of Nations”?
If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it off them with some part of the produce of our own industry, employed in a way in which we have some advantage
What was Ricardo’s view on trade?
It is comparative advantage that matters.
Give an example of comparative advantage in trade
England production costs: 15 for wheat, 30 for wine
Portugal production costs: 10 for wheat and 15 for wine
Portugal has an absolute advantage at producing both, but England has a comparative advantage in wheat since a unit of wheat only costs 1/2 a unit of wine
In the example you gave for comparative advantage, what would be the optimal trade solution assuming free trade? What is a downside?
For England to produce only wheat and Portugal only wine. But there are losers eg. English vintners
What are externalities?
Goods/bads people care about, not traded, typically side effects
Give an example of a consumption externality
Domestic heating emitting CO2
Give an example of a production externality
Steelworks emitting CO2
Give an example of a positive externality
Education (more years in education reduces crime)
Why might competitive equilibria be unlikely to be Pareto efficient?
Due to externalities
Explain tragedy of the commons
100 peasants each graze a sheep on the common. If one peasant adds one more, he gets 100% more while the others get 1% less
Explain public goods
Goods that are non-rivalrous and non-excludable. A good that someone produces that benefits everyone. They cause strong temptation for people to free-ride and not contribute
Explain club goods
Similar to public goods but on a limited scale in traditional comunities
Give 2 examples of tragedy of the commons
- Overgrazing
- Overfishing
Give an example of a public good
Scientific knowledge. The producer can appropriate a small part of the benefit (eg. PhD thesis) - the rest benefits all
Give an example of a public bad
CO2 emissions. Everyone gets to ‘consume’ the same amount
What is a public bad?
A good that is produced to everyone’s detriment
How can public goods be incentivised?
Prizes
How can public bads be decentivised?
Taxes
Give an example of a club good?
Fishermen in Turkey. 40 fishermen gather, arrange rota, signed by mayor
How are club goods enforced?
Self-enforced. If you find another boat in a good spot when it’s your turn, chase them
What is a rent?
An excess, undeserved income resulting from barriers to competition
Give an example of regulating prices not preventing rents
New York taxi licenses were very expensive but drivers made low income. License owners were making a lot of money. Politicians put up taxi fares to help drivers, but the value of a license increased by a lot so this helped the owners instead
What is lobbying?
Communicating with lawmakers to sway their decisions to pass legislation for the industries they serve. Influencing the decisions of government
What is collusion?
Conspiring to fix prices, allocate markets or engage in other anti-competitive activities
What effect does price fixing have on rents?
Price fixing extracts rents (enables companies to set arbitrary prices) by manipulating market conditions
Explain the ‘market for lemons’, an example of asymmetric information
100 used cars for sale. 50 good cars worth £2000, 50 lemons worth £1000. Buyers can’t tell the difference so price is £1000
How can Signalling Theory be applied to the ‘market for lemons’ example?
A warranty can be offered. This is cheaper for owners of good cars, so can act as a signal for the hidden information
What is Signalling Theory?
Suggests mechanisms for the transfer of information to another party to resolve information asymmetries
Give an example of Signalling Theory
It is hard for employers to tell smart diligent employees from an interview, so many use education as a signal
What sort of systems is Signalling Theory important for?
Recommender systems eg. Google, eBay
What is adverse selection and what is it an example of?
Adverse selection is when sellers have information buyers do not have, or vice versa. This is an example of hidden information.
What is moral hazard and what is it an example of?
Moral hazard is the tendency of individuals/institutions to take on more risk when they are insulated from the potential consequences of their actions. This is an example of hidden action
Give an example of adverse selection
Bad drivers buy a Volvo to survive accidents better
Give an example of moral hazard
Volvo drivers compensate for safety by driving faster
What are the 2 branches of asymmetric information?
- Hidden information
- Hidden action
What assumption does classical economics make?
That individuals are rational - they maximise self-interest utility with no cognitive limitations
What does behavioural economics recognise that classical economics does not?
Behaviours deviate form the rational choice model
What is Prospect Theory?
People prefer to gamble on their losses not wins. If offered £10 or a %50 chance of £20 usually prefer the former. If offered a loss of £10 or a 50% chance of losing £20 usually prefer the latter
What does the Asian disease problem tell us?
Framing actions as ‘saving’ can make them more attractive
Draw the graph of bounded rationality
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What is satisficing?
People try to make just-good-enough decisions
What is hyperbolic discounting?
People disregard far-future events
Give an example to demonstrate hyperbolic discounting
Most people have inadequate pensions
What is bounded rationality?
Humans make decisions that are not in line with the perfect economic rationality since we are limited by our mental capacity, the information available to us, and time
How can we approximate how people make decisions under cognitive constraints? Give an example
Using a greedy algorithm
Eg. selecting items in a shop in decreasing order of value to price ratio
What is cultural bias?
Some biases we acquired from evolution are modulated by culture
Give an example of cultural bias
Machine translation from gender neutral Turkish text gave male doctors and female nurses. Found that all MT systems were sexist, racist, homophobic etc. inhaling prejudice with their training data
What is Nudge Theory?
This is the application of behavioural economics to policy. The way choices are presented to people can have a powerful impact. Changes to context can induce individuals to make better choices
Give an example of Nudge Theory
Social media posts by the UK Home Office targeted towards potential immigrants showing images of big waves and warning people not to lose their lives over coming to Britain
What is a disadvantage of Nudge Theory?
Only works short term, does not address underlying structural problems
Which option do people normally choose?
The default
Give 2 example uses of the power of defaults
- Used in marketing - firms make people opt out of spam
- Used in governments - make people opt out of policy options such as pensions (UK), organ donation (Spain) etc.
What is a problem with classical economics? What possible better approach could be taken?
Classical economics sees institutions as rational, but decisions are made by individual managers who optimise their own utility too. New institutional economics instead study managers’ behaviour, and considers if we should give them stock options that align with their interest in shareholders.
What is public-choice economics?
Applying the incentive behind new institutional economics to civil servants and elected politicians
What subtopics does behavioural economics include?
- Bounded rationality
- Cultural biases
- Nudge theory
- Power of defaults
- Agency effects
