Microeconomics Exam Notes PDF

**Microeconomics Exam Notes \| Thursday 19^th^ December** **A** Description / terminology ------- --------------------------- **B** Critical point **Week 1** **Imperfect and incomplete information** A **Asymmetric information --** this describes a situation in which not all parties to...

**Microeconomics Exam Notes \| Thursday 19^th^ December** **A** Description / terminology ------- --------------------------- **B** Critical point **Week 1** **Imperfect and incomplete information** A **Asymmetric information --** this describes a situation in which not all parties to a potential exchange are informed equally - Typically, the seller of a product will know more about its quality than the potential buyers - Such asymmetries can stand in the way of mutually beneficial exchange in the markets for high-quality goods. This makes them unwilling to pay a corresponding price - Buyers and sellers respond to asymmetric information by attempting to judge the qualities of products and people based on the groups they belong to B A young male may know he is a good driver, but auto insurance companies must charge him high rates because they only know that he is a member of a group that is more frequently involved in accidents **The optimal amount of information** A - **Additional information** creates value but is costly to acquire - **Rational consumers** will continue to acquire information until its **marginal benefit equals its marginal cost.** Beyond this point, its rational to remain uninformed - Inevitably, **search incurs risk** because costs must be incurred without any assurance that search will prove fruitful *Minimising the risk* - This can be done by searching for goods where the variation in price / quality is relatively high and those for which the cost of search is relatively low **Expected value** A The expected value of the payoff from taking a particular decision: - the average of the payoffs associated with all possible outcomes of that decision - the average is computed by weighting each payoff by the probability that it will occur **Expected utility** A The expected utility of the payoff from taking a particular decision: - the average of the utility of the payoffs associated with all possible outcomes of that decision - the average is computed by weighting each utility by the probability that the corresponding payoff will occur **Attitudes toward risk** A **Risk Neutral:** U(x) = x - Constant marginal utility, MU = 1 implies that UEV = EU - Choose whichever option has the highest expected value **Risk averse:** U(x) = X^1/2\ =^ [\$\\sqrt{x}\$]{.math.inline} - Diminishing marginal utility, MU = ½ x^-1/2^ implies that **UEV \> EU** - Choose safe options (e.g. buy insurance) - Risk averse people are willing to buy insurance **Risk loving:** U(x) = x^2^ - Increasing marginal utility, MU = 2x implies that **UEV \< EU** - Choose risky options (like gambling) A graph of a graph of risk Description automatically generated with medium confidence **Week 2** **Risk** A **Definition:** uncertainty about which outcome will occur **Economists concern:** risks which can be described in terms of probability distribution **Risk pooling:** the risk of a pool of risks is lower than the sum of individual risks. If all individuals pool their assets and share the income equally **Insurance** A Insurance is a promise to make some payment in case of a particular event, in exchange for a payment, called a premium **Insurance premiums:** Money that is paid to an insurer so that an individual will be insured against adverse events **Consumption smoothing:** The translation of consumption from periods when consumption is high (low marginal utility) to periods when consumption is low (high marginal utility). Insurance is valuable because it helps individuals' smooth consumption across states of the world - Individuals will demand full insurance in order to fully smooth their consumption across states of the world **Insurance only exists because people are risk-averse** *Demand for insurance* - Reduces uncertainty - Provides security against bad outcomes B - Health insurance - Auto insurance - Life insurance - Casualty insurance - Property insurance **Diminishing marginal utility** A Always having a moderate amount of consumption for sure is better than a 50-50 chance of having a lot of nothing - The fourth slide of pizza is less important than the first i.e., always having two slices is better than sometimes having zero **Risk aversion and adverse selection** A Risk-averse people may still want to buy some insurance even if it is not actuarially fair - People differ in their risk aversion, and if insurance premiums are extremely unfair, then only the most risk averse will want it **Information asymmetry:** the difference in information that is available to sellers and to purchasers in a market **Adverse selection:** this is a consequence of information asymmetry. The fact that the insured individuals knows more about their risk level than the insurer - May cause those most likely to have the adverse outcome to select insurance - When the insurance company doesn't know what type of person they are, it could try charging a price that is fair on average or try charging separate prices - If insurance companies could charge actuarially fair prices then the insurance company would break even and the society would achieve the optimal outcome **Week 3 & 4** **Bayesian Nash equilibrium** A The Bayesian Nash equilibrium incorporates a broader concept of rationality and also takes into account hypothetical situations that do not occur in practice - Uninformed players assume rational behaviour for all the possible events even though they will not occur in practice, as the other players know **Adverse selection** A Adverse selection occurs when, in the presence of hidden (asymmetric) information, buyers or sellers with unfavourable traits are more likely to participate in the exchange - The party with more information has incentive to misreport to obtain better terms in contract Adverse selection means there is a positive correlation between riskiness and insurance coverage **Why?** - Customers can misperceive their own risk - Some buyers might not be aware of the value of information they have - Less risky individuals might actually purchase more insurance because they are more risk-averse or wealthier **Preventing adverse selection** - Find ways for insurance companies to more accurately predict the risk of policy buyers - Allows them to adjust premiums accordingly B - **Health insurance:** the policyholder has relevant private information about his / her risk of bad health status - **Car insurance:** where high-risk drivers purchase higher amounts of supplemental insurance coverage - **Used cars:** where the owner has relevant private information about the quality of that car - **Labour market:** in which employee has relevant private information about his own ability - **IPOs:** the issuer has relevant private information about the value of the shares **Misperception of risk:** Older age is associated with greater misperception of the relative health risk of e-cigarettes and cigarettes among US adults who smoke **Preventing adverse selection** - Many life insurance sellers require a physical examination by a doctor before finalising the contracts **Moral hazard** A The opportunistic behaviour of agents whose actions taken after a contract has been signed - Individuals with insurance coverage have diminished incentives to devote effort to preventative care - Insurance companies are affected because less care results in more accidents, and more accidents in more claims **Social loss** The behavioural change of insured people creates a social loss, because insurance companies pay for extra procedures and treatments that would not have been necessary without moral hazard **Ex ante moral hazard:** behavioural change that occurs before insured events happen that makes these events more likely **Ex post moral hazard:** behavioural change that occurs after an insured event happens that makes recovering from that event more expensive **Limiting moral hazard** - **Cost sharing:** you can encore coinsurance where enrolees pay a percentage of each bill and the insurer covers the remaining portion or you can have co-payments where enrolees pay a fixed amount (co-pay) for each treatment and the insurer covers the remaining portion - **Deductibles:** Insurers set a minimum level of expenses below which the insurer does not help reimburse expenses - **Monitoring / Gatekeeping:** better observe people's behaviour for example letting doctors assess patients and decide how much care they require **Principal-agent problem** This arises when there is a conflict of interest between a principal (someone who delegates work) and an agent (someone who performs the work on behalf of the principal). Initially, the principal and the agent have asymmetric information and agree on a contract. After the contract has been signed, the agents act or obtain new information that is not observable to the principal - Agents may behave opportunistically In the standard principal-agent model, the principal is a manager and the agent is a worker. The aim of the principal is to give the right incentive to the worker. Unavoidably, there is a trade-off between concerns for risk and incentives - When effort can't be monitored (asymmetric information), efficiency cam still be achieved by linking wages to results - It is important to note that the bonus must increase with the risk aversion of the agent - The model can be used to explain the rationale of different contracts in different industries B **Ex ante moral hazard** - Skipping flu vaccinations, eat unhealthy and stop exercising after getting health insurance - Drive carelessly after getting car insurance **Ex post moral hazard** - Deciding to opt for knee replacement instead of painkillers after getting health insurance - Fully insured individuals not more likely to have certain conditions, but more likely to get treatment **Week 5** **Externalities** A Externalities arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing do **Positive externalities (external benefit):** a benefit of an activity received by other people other than those who pursue the activity **Negative externality (external cost):** a cost of an activity that falls on people other than those who pursue the activity **Private vs social welfare** Analysing externalities allows us to distinguish between private and social welfare **Private welfare:** the utility of one individual within a society; actions that would increase or decrease private welfare are said to have private benefits or costs **Social welfare:** the utility of all individuals in society; actions that would increase or decrease social welfare are said to have social benefits or costs **Externalities are an example of market failures:** a problem that causes the market economy to deliver an outcome that does not maximise efficiency Production or consumption externalities lead to inefficiency **Negative externalities** A **Negative production externality:** when a firm's production reduces the well-being of others who are not compensated by the firm - Can drive a wedge between private and social marginal cost - **Private marginal cost:** the direct cost to producers of producing an additional unit of a good - **Social marginal cost:** the private marginal cost to producers plus any costs associated with the production of the good that are imposed on others - i.e., the loss from pollution is a cost of production imposed on others - **Private marginal benefit:** the direct benefit to consumers of consuming an additional unit of good by the consumer - **Social marginal benefit:** the private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others - i.e., the loss of health or dining pleasure is a cost of smoking imposed on others **Negative consumption externality:** when an individual's consumption reduces the well-being of others who are not compensated by the individual B **Negative production externality:** - pollution from steel production - dumped in a river - hurts fishermen **Negative consumption externality:** - smoking at a restaurant **Positive externalities** A Externalities can be positive as well as negative **Positive production externality:** when a firm's production increases the well-being of others, but the firm is not compensated by them **Positive consumption externality:** when an individual's consumption increases the well-being of others, but the individual is not compensated by them **Solutions from policymakers** 1. corrective taxation to discourage use 2. Subsidies to encourage use 3. Regulation to directly change use B **Positive production externality:** - a pharmaceutical company invests in research and development to create a new drug **Positive consumption externality:** - an individual pursues higher education and gains new skills and knowledge **Pigouvian taxation** A Taxes and subsidies change the private marginal cost or marginal benefit without affecting the social marginal cost or marginal benefit without affecting the social marginal cost or benefit. This means they can be used to internalise the externality Taxes which correct externalities are called "Pigouvian taxation" after A.C. Pigou **Ideal world** - Pigouvian taxation and regulation would be identical - Regulation has been the traditional choice for addressing environmental externalities in many countries of the world. In practice, there are many complications that may make taxes a more effective means of addressing externalities **Efficient solution:** - SMB = SMC - SMC = PMC Pigouvian taxes set equal to the harm caused by pollution are more efficient **Main benefits of taxation over regulation** - Taxes are better when different plants have different costs for reducing pollution - The challenge is figuring out how much each plant should produce **Efficiency of regulation** - Regulation usually makes each plant reduce the same amount of pollution - It's more efficient if plants with lower costs reduce more pollution Using taxes leads to lower costs but less control over the amount of pollution production - The instrument choice depends on whether the government wants to get the amount of pollution right or whether it wants to minimise costs **Coase theorem** The Coase theorem states that when property rights are well defined, and transaction costs are low, parties can negotiate privately to correct externalities and reach an efficient outcome regardless of the initial allocation of property rights - Can be a resolution of externalities Ronald Coase showed that under certain conditions, markets can achieve the socially optimal outcomes, even with externalities and without Pigouvian interventions **Week 7** **Public goods** A Goods that are perfectly non-rival in consumption and are non-excludable **Non-rival --** one individual's consumption of a good does not affect another's opportunity to consume the good **Non-excludable --** individuals cannot deny each other the opportunity to consume a good **Impure public goods --** goods that satisfy the two public conditions (non-rival in consumption and non-excludable) to some extent, but not fully  **Optimal provision of public goods** - The markets will not provide the correct amount - The optimality condition for the consumption of private goods is written as  A mathematical equation with black text Description automatically generated - Social efficiency is maximised when the marginal cost is set equal to the sum of the MRSs, rather than being set equal to each individuals' MRS **Private provision of public goods & the free rider problem** The market does not produce the efficient amount of public goods because of the free rider problem **Free-rider problem --** when an investment has a personal cost but a common benefit, individuals will underinvest - This results in the private market producing an inefficiently low quantity of the good so there is a need for government intervention The free rider problem does not lead to a complete absence of private provision of public goods and in some cases, the private sector can combat free rider problem to provide public goods by charging user fees that are proportional to their valuation of the public good **Altruism and warm glow** Private markets provide public goods when people are altruistic **Altruistic:** when individuals value the benefits and costs to others in making their consumption choices **Social capital:** the value of altruistic and communal behaviour in society **Warm glow model:** a model of the public goods provision in which individuals care about both the total amount of the public good and their particular contributions as well **Public provision of public goods** Despite private provision, there is a role for government in the provision of public goods Under private provision, not everyone contributes to the good, even though everyone benefits Government provision potentially solves the problem of non-contributors, but there are some challenges - **Crowd-out:** as the government provides more of a public good, the private sector will provide less - decrease in private provision will offset the net gain in public provision from government intervention - extent of crown-out depends on preferences of private individuals providing the public good - **Warm-glow:** if people care about contributions per se, they may continue to contribute even when the government contributes - Extreme case of no crowd-out when all people care about is how much they give **The right mix of public and private** One extreme is provision entirely by the public sector. The other extreme is subsidised or mandated private provisions, with the government providing incentives **Contracting out:** an approach through which the government retains responsibility for providing a good or service but hires private-sector firms to actually provide the good or service - **Issue:** the private sector's incentives may not align with public goals - This could lead to lower public costs but worse outcomes along other dimensions that policymakers may care more about **Success of intervention depends on the:** 1. Ability of government to measure costs and benefits. 2. Ability to implement optimal plan. Optimal good provision requires knowing the MRS for each person. There are three challenges in measuring preferences for public goods: 1. **Preference revelation**: People may not want to reveal their true valuation because the government might charge them more for the good if they say that they value it highly. 2. **Preference knowledge**: People may not know what their valuation is. 3. **Preference aggregation**: How can the government combine the preferences of millions of citizens? B **Free rider problem** Online information: - Over 500 million unique visitors consult Wikipedia - The content is exclusively written by volunteers - About 6% of readers have ever made an edit - About 3% of non-editing readers donate to the non-profit so others can make edits **Week 8** A **The lemons problem** The lemons problem was introduced by George Akerlof and describes a situation where the quality of products in a market is uncertain, leading to adverse selection **Perfect Bayesian Equilibrium** The game theoretic models of adverse selection are usually sequential games with asymmetric information For sequential games with asymmetric information, we can find the Perfect Bayesian Equilibrium (PBE) in addition to finding the Bayesian Nash Equilibrium (BNE) - Best-response strategies at each node - Updated beliefs about the "type" of the players at each information set **There are two elements:** 1. Sequential rationality or credibility a. This implies that the choices made by the buyer have to be consistent with the beliefs held at any information set of the game b. Essentially, the buyer's actions should make sense given what they know at each point in the game so if the buyer sees the seller has made a certain move, the buyer should choose the best response based on that information 2. Consistency of beliefs c. The belief held by the buyer has to be consistent with the initial belief and choice of the seller d. Essentially, the buyer's beliefs about the game should align with what they thought at the beginning and with the seller's choices, so if the buyer initially believes the seller is honest and sees actions consistent with honesty, then the buyer should continue to believe the seller is honest **Summary of PBE** Consider a strategy profile and beliefs over nodes at all information sets. These are called a perfect Bayesian equilibrium if: 1. each player's strategy is a best response given his beliefs to the other players' strategies 2. the beliefs are consistent with the Bayes' rule **There are two types of equilibria:** 1. **separating equilibria;** in which different types behave differently 2. **pooling equilibria;** in which different types make the same choice **Job market signalling** - Player 1 is a job applicant of either high or low productivity - Player 2 is an employer who seeks to offer the applicant a competitive wage equal to player 1's expected productivity - High productivity types may have an incentive to undertake a costly activity (get an MBA) that does not directly enhance productivity - As MBAs are more costly for low types than the high types, we have a separating equilibrium The agent may use strategies to signal their type - In the market for lemons the good quality car sellers may offer a free repair guarantee - In the labour market the high skilled workers may use educational qualifications The principal may use strategies to screen the agents according to their type - Insurance firms may offer contract with different combinations of coverage leve (deductibles) and premiums - Lenders may ask for different levels of collateral and interest rates However, only credible (costly) signals may work - Inefficiency still arises - Insurance contract with limited (not full) coverage B **The lemons problem** **Scenario**: Imagine a market for used cars. **High-Quality Cars**: Often called \"peaches\". **Low-Quality Cars**: Often called \"lemons\". **Information Asymmetry**: Sellers know more about the car's quality than buyers. **Outcome**: Because buyers can\'t distinguish between peaches and lemons, they are only willing to pay an average price, which may be lower than the value of high-quality cars. **Consequence**: Sellers of high-quality cars may leave the market, leaving only low-quality cars (lemons) available, which further drives down the market value. This problem highlights how a lack of information can lead to market inefficiencies and the decline in overall product quality. **Week 10** **Principal-agent game** Players -- the principal and the agent (+Nature) Strategies -- the principal defines a contract specifying a wage w and a bonus b for the agent. The latter is pain only if the project is successful The agent accepts or rejects the contract and decides the level of effort to exert in the production **Finding equilibrium** For any wage offer (w, b) the game can be solved by backward induction Various sub-games supply a set of constraints: - **The effort subgame**: agent's incentive compatibility constraint - **The accept-reject agent's subgame:** agent's participation constraint - **The principal's subgame:** principal's participation constraint The principal will always pay the lowest wage accepted by the agent. If the principal wants high effort, he needs to make sure the expected payoff for the agent is barely higher than the payoff for the agent for rejecting the offer and for the low-effort scenario **Summary** - Efficiency requires that higher effort should be exerted whenever the expected surplus is larger than the cost of effort - With perfect information about the effort, the bonus can be conditioned on the effort - When effort can't be monitored (asymmetric information) efficiency can still be achieved by linking wage to results - However, the incentive effect of a bonus is related to the level of risk aversion of the agent **PP1: The effect of alcohol consumption on mortality (Carpenter & Dobkin, 2009)** **What is the research?** This paper investigates the effect of alcohol consumption on mortality using a regression discontinuity design based on the minimum drinking age **RDD:** a quasi-experimental method used in statistics and econometrics to estimate a casual effect **What are the findings?** The study finds that turning 21 leads to a significant increase in alcohol consumption and a corresponding increase in mortality rates, particularly due to motor vehicle accidents, alcohol-related deaths, and suicides **Specifically:** - There is a 21% increase in the number of drinking days when individuals turn 21 - The probability of consuming 12 or more drinks in one year increases by c11% - The probability of engaging in heavy drinking (five or more drinks in one sitting) increases by approximately 18% - There is a 9% increase in the overall mortality rate at age 21, primarily due toa 10% increase in deaths related to external causes such as vehicle accidents, suicides and alcohol-related deaths - The increase in mortality is largely driven by white males who are high school graduates or attending college **What are the policy recommendations?** The research suggests that policies aimed at reducing alcohol consumption among young adults can have substantial public health benefits Reducing drinking age nationality to 20 could result in approximately 408 additional deaths among 20 year olds, with an estimated cost of about \$3.4 billion per year in 2007 **How does it relate to class?** **Externalities:** the increase in mortality due to alcohol consumption at age 21 represents a negative externality This is because the social costs (e.g., loss of productivity, increased mortality, healthcare costs), are not fully borne by the individuals consuming alcohol but are instead imposed on society **Public goods and government intervention:** the study supports the role of government intervention in regulating alcohol consumption to improve public health outcomes. By setting a minimum legal drinking age, the government can reduce negative externalities and improve social welfare **PP2: The effect of ACA state Medicaid expensions on medial out-of-pocket expenditures (Abramowitz, 2020)** **What is the research?** This paper examines the impact of the Affordable Care Act (ACA) state Medicaid expansions on medical out-of-pocket expenditures It uses data from the 2011 to 2016 Current Population Survey Annual Social and Economic Supplement (CPS ASEC) The analysis employs a difference-in-difference framework to compare out-of-pocket expenditures for health insurance premiums and medical care between expansion and non-expansion states before and after the Medicaid expansions **What are the findings?** **Reduction in out-of-pocket expenditures:** the Medicaid expansions were associated with higher likelihood of having zero premium expenditures for individuals with family income below 138% of the federal poverty level **Crowding out of private insurance:** the expansions led to a decrease in policyholder employee-sponsored coverage. It led to an increase in policyholder direct-purchase coverage with no associated premium expenditures and a decrease in policyholder direct-purchase coverage with positive out-of-pocket premium expenditures **Increased use of preventative care:** the expansion facilitated increased use of care by making it more affordable, aligning with other studies that found an increase in preventative care associated with the expansions **Differential effects by income level:** the effects of the expansions on nonpremium medical out-of-pocket expenditures were significant for individuals with family income between 100% and 138% of FPL but not for those with income below 100% of the FPL **Overall:** APA state Medicaid expansions effectively reduced the burden of out-of-pocket medical spending for low income individuals, allowing them to better allocate resources for other uses. **What are the policy recommendations?** **Support and maintain Medicaid expansions:** given the positive impact, states should consider adopting or maintaining Medicaid expansions to improve the financial well-being of low-income individuals **Address crowding out of private insurance:** policymakers should be aware of potential crowding out and consider strategies to balance public and private insurance coverage to ensure comprehensive coverage options for all income levels **How does it relate to class?** **Insurance and risk pooling:** this expansion is a form of social insurance, which pools risk across a large population to provide financial protection against high medical costs. This reduces the financial burden on low-income individuals and spreads the risk of healthcare expenses **Moral hazard:** the potential for increased utilisation of medical care to lower out-of-pocket costs is an example of moral hazard. When individuals are insulated from the full cost of care, they may consume more healthcare services than they would if they were paying the full cost **Adverse selection:** Medicaid expansions aim to decrease adverse selection by providing coverage to a broader population, including those who might otherwise be uninsured or underinsured. This helps to balance the insurance pool and reduce the risk of only high-cost individuals seeking coverage **PP3: Forward-looking moral hazard in social insurance (Eliason et al, 2019)** **What is the research?** This focus for this paper is to test for the presence of forward-looking moral hazard in the sickness insurance system The study investigates how long-term sickness absentees respond to economic incentives, specifically examining whether they prolong their absence from work due to the potential future cost of returning to work This is analysed by exploiting a 1991 reform in Sweden that reduced the replacement rate for short- and medium-term absences but not for long-term absences, thereby introducing a potential further cost for returning to work The study aims to provide casual evidence on the impact of these dynamic incentives on absence behaviour **What are the findings?** **Forward-looking behaviour:** long-term sickness absentees respond to economic incentives in a forward-looking manner. The potential future cost of returning to work, introduces by the 1991 reform through reduced replacement rates for short- and medium-term absences, casually decreased the transition rate back to work among long-term sickness absentees **Gender difference:** Women responded more strongly to the potential future cost of returning to work than men **Impact of sickness absence history:** individuals with more frequent or longer sickness absences in the past responded more strongly to the reform. This suggests that those with a higher perceived risk of relapse were more likely to prolong their current absence **Robustness of results:** the findings were supported by placebo ad sensitivity analyses, which confirmed the casual interpretation of the results **Overall:** the study suggests that dynamic incentives such as the cost of re-entering the program can create "locking-in" effect where individuals remain in the program longer than necessary **What are the policy recommendations?** **Consider forward-looking behaviour:** when designing and evaluating social insurance programs, policymakers should account for the forward-looking behaviour of individuals. This means recognising that individuals may respond to potential future costs and dynamic incentives, not just immediate costs **Comprehensive policy analysis:** a more complete policy analysis should integrate dynamic incentives and forward-looking behaviour. Simple reduced-form analyses may be biased if they do not account for these factors. Models which incorporate dynamic programming or option value approaches may provide more accurate estimates of the impact of policy changes **How does it relate to class?** **Moral hazard:** this is explored in the sense that individuals may alter their behaviour in anticipation of future costs or benefits. In this context, long-term sickness absentees may prolong their absence to avoid the potential future cost of returning to work under a less favourable replacement rate **Risk and uncertainty:** the study addresses how individuals assess and respond to the risk of relapse and the uncertainty of future sickness absences. This assessment influences their behaviour in the context of sickness insurance **Additional notes** **DWL Tax -** Deadweight Loss (DWL) in the context of a tax refers to the loss of economic efficiency that occurs when the equilibrium outcome is not achieved due to the tax. It tends to be smaller when demand is less elastic because when consumers are less responsive to price changes, this leads to a smaller reduction in quantity demanded and hence a smaller deadweight loss from the tax **Intuition for analysis questions** **When Firm 1 has private information:** For sequential games with asymmetric information, we can find the PBE in addition to the BNE. We assume each player's strategy is the best response given his beliefs to the other players' strategies and the beliefs are consistent with the Bayes' rule. First, we need to write down the profit functions that each of the players are maximising. Given that firm 1 has private information, we need to write down separate profit functions for each type of player 1 (high demand and low demand). Afterwards, we take the first order conditions of the profit functions, which allows us to establish the best response functions for each player. *mathematics* In order to find the Bayesian Nash Equilibrium, we now need to plug in BR(1H) and BR(1L) into BR(2). *mathematics* The Bayesian Nash Equilibrium is for firm 1 to produce \[x\] when demand is high (P =x) and \[x\] when demand is low (P = x), and for firm 2 to produce \[x\]. **Finding BNE from extensive form** The Bayesian Nash equilibrium incorporates a broader concept of rationality and also takes into account hypothetical situations that do not occur in practice. Uninformed players assume rational behaviour for all the possible events even though they will not occur in practice, as the other players know We know that the game involves sequential decisions where one player makes a decision based on their information, and subsequent players make decisions based on observed actions. In Bayesian games, players have private information (types) and beliefs about other players' types. We want to establish how each player forms beliefs about the other players' types and then, for each player, determine the best response strategy to the other players' strategies given their beliefs. Finally, we will solve the system of best response equations to find the Bayesian Nash Equilibrium. **Short answer questions** **2023 past paper** **Explain the role of information asymmetry in the principal-agent problem, and how it affects the relationship between the principal and the agent? (10 marks)** The principal-agent problem describes a situation where a conflict of interest arises between a principal (someone who delegates work) and an agent (someone who performs the work on behalf of the principal). Initially, there is asymmetric information between both parties and therefore agree on a contract. Once the contract has been signed the agent may act opportunistically or gain new information that is not observable to the agent. Information asymmetry in the principal-agent problem leads to a misalignment of interests, trust issues, and increased costs for monitoring and incentives. Addressing these issues requires careful design of contracts, monitoring systems, and incentive structures to align the interests of the agent with those of the principal. To illustrate this, we can describe interactions between an employer (principal) and a worker (agent). The aim of the principal will be to give the right incentive to the worker and when efforts cant be monitored (asymmetric information), they can link wages to results to achieve efficiency. Furthermore, in the case of shareholders (principal) and managers (agent), managers know more about the performance and internal decisions within a company than the shareholders. Managers may engage in hubris (acting for personal gain such as status or salary increase) which does not align with shareholder interests. To solve this, managers compensation contracts could be linked to the long-term performance of the company or also debt-based contracts such as deferred payment to therefore align interests **2022 past paper** **Small companies typically find it more expensive, on a per-employee basis, to buy health insurance for their workers compared to larger companies. Similarly, it is usually less expensive to obtain health insurance through an employer-provided plan than purchasing it directly from an insurance company -- even if your employer requires you to pay the entire premium. Using concepts discussed in this course, explain these observations. (10 marks)** The cost disparity in health insurance between small and large companies, as well as the difference in cost between employer-provided plans and individually purchased plans, can be explained through several economic concepts. Firstly, large companies benefit from economies of scale and risk pooling because with a larger number of employees, the risk of high-cost health claims is spread across a broader base which reduces the average cost per employee. In contrast, small companies face higher per-employee costs because they cannot spread risk as effectively, which leads to increased premiums. Most notably, individual health insurance purchasers face adverse selection, where those seeking insurance are often higher-risk individuals, leading to higher premiums. Employer-provided plans, however, mitigate this by pooling a mix of healthy and less healthy employees, thereby lowering the average risk and cost. Additionally, individuals purchasing insurance directly face higher administrative burdens because they don't have access to economies of scale and negotiating leverage that large employers have. This explains why small companies and individual purchasers typically face higher health insurance costs compared to large companies and employer-provided plans. **Describe a situation in which the government would be better off imposing quantity restrictions through regulation than setting a tax and explain why quantity restrictions are better in that case. (7 marks)** We can discuss this by looking at the situation of regulating certain harmful pollutants, for example regulating the emissions of a particularly dangerous pollutant such as sulphur dioxide, which is known to cause severe environmental and health issues. In this scenario, setting a tax might not effectively limit the total amount of pollution because firms could choose to pay the tax while continuing to emit high levels of the pollutant. This could lead to uncertain an potentially unacceptable environmental outcomes. By introducing quantity restrictions, this provides a clear and enforceable limit on the amount of the pollutant that can be emitted. By capping total emissions and issuing permits or allowances for specific quantities, the government ensures that the overall pollution level does not exceed a safe threshold, regardless of the willingness of the firm to pay for pollution rights. This approach directly addresses the environmental and health risks by guaranteeing a reduction in harmful emissions to a safe level, which is more effective in protecting public health and the environment in this context. **2018 past paper** **When are quantity restrictions not the same as price restrictions (via taxes) to alleviate the problem of externalities?** While they both aim to address externalities, they can have different outcomes depending on various factors. Quantity restrictions are not the same when referring to uncertain abatement costs. In the context of reducing pollutants, when the costs of reducing emissions are uncertain and variable, quantity restrictions can result in uneven economic impacts and inefficiencies, while taxes allow firms to respond flexibly and minimise overall costs. However, if there is a critical environmental threshold that must not be exceeded, quantity restrictions may be preferred to ensure the total pollution does not surpass safe limits. **How could pollution permits lead to a socially efficient allocation of pollution and describe how this outcome would occur?** These are also known as cap-and-trade systems, which can lead to a socially efficient allocation of pollution by creating a market for emission allowances. The government sets a cap on the total amount of pollution allowed, and this cap is based on environmental standards and the desired level of pollution reduction. Emission permits, which represent the right to emit a certain amount of pollution, are either allocated to firms for free or auctioned to the highest bidder. Firms can buy and sell permits in a market and if a firm can reduce its emissions at a lower cost, it can sell its excess permits to other firms that face higher reduction costs. Firms with lower abatement costs will reduce their emissions and sell excess permits to firms facing higher abatement costs, ensuring that the marginal cost of pollution reduction is equalised across all firms. This system encourages innovation and investment in cleaner technologies, reduces overall compliance costs and guarantees that total emissions remain within environmentally safe limits. This aligns economic activities with social welfare goals. **Tutorial 3** **Why can the "public good provision\" problem be thought of as an externality problem?** This is because it involves the challenge of providing goods that have non-excludable and non-rivalrous characteristics, leading to both positive and negative externalities. Individuals cannot effectively be excluded from using the good and one person's use does not reduce its availability to others. Externalities arise when the costs of benefits associated with the product or service extends beyond the individual using or producing it. In a free market, individuals may understate their true willingness to pay for public goods because they can benefit from them without directly paying (free-rider problem). This results in under provision, as private markets do not account for the full social benefits of public goods. To address this, governments often step in to provide public goods directly or subsidise their provision with the aim of achieving the social optimum by taking into account external benefits that the market fails to internalise. Essentially it involves the provision of goods that generate significant external benefits (and sometimes costs) that are not captured by private markets, leading to suboptimal provision levels without government intervention. **In two-car automobile accidents, passengers in the larger vehicle are significantly more likely to survive than are passengers in the smaller vehicle. In fact, death probabilities are decreasing in the size of the vehicle you are driving, and death probabilities are increasing in the size of the vehicle you collide with. Some politicians and lobbyists have argued that this provides a rationale for encouraging the sale of larger vehicles and discouraging legislation that would induce automobile manufacturers to make smaller cars. Discuss this argument in light of our course.** This could potentially lead to negative externalities. As larger vehicles are heavier and more powerful, they contribute to increased road wear, higher fuel consumption and greater emissions of pollutants which negatively impact the environment and public health. They are also a greater risk to others on the road, for example pedestrians or cyclists. This is due to a concept called risk compensation, where individuals adjust their behaviour in response to perceived levels of risk. If drivers in larger vehicles feel safer, they may engage in riskier driving behaviours. This can result in an inefficient allocation of resources and a reduction in overall social welfare. This could also lead to adverse selection because drivers of larger vehicles may be aware that they are more protected in the case of accidents and because the insurance company cannot perfectly monitor their driving behaviour, the company may adjust premiums based on vehicle size leading to a situation where safer, smaller vehicles face higher premiums or opt out of insurance altogether, leaving the pool with a higher proportion of riskier drivers in larger vehicles. The vehicle market may also shift in favour of large vehicles, exacerbating negative externalities for smaller vehicles. The argument for promoting larger vehicles has to be balanced and safety and efficiency standards should be implemented to provide adequate protection for smaller vehicles. Policymakers could also use taxes or subsidies to promote the adoption of safer, more fuel-efficient cars or invest in road infrastructure to enhance safety. **Tutorial 4** **It is generally acknowledged that people driving safer cars are more likely to have accidents. Using our class content, discuss why [moral hazard] may be the reason for this.** Research shows that people with safer cars have more confidence which can lead to them engaging in riskier driving behaviours such as speeding. One study actually found that when seatbelts were introduced, more drivers took part in speeding. Moral hazard occurs when people take on more risk because they don't bear the full consequence or cost of those actions. In this case, due to increased confidence, drivers with safer cars may not consider the full consequences of a potential accident as less harm may come to them than other parties involved in the accident. They may not consider that other drivers may not have the same safety features that they do. **As mentioned above, it is also generally acknowledged that people driving safer cars are more likely to have accidents. Using our class content, discuss why [adverse selection] may be the reason for this.** **Adverse selection occurs when there is information asymmetry between buyers and sellers and so, in the context if insurance and risk, people who are more likely to engage in riskier behavior are more likely to seek insurance or certain protections, leading to an imbalance in the risk pool.** **Car manufacturers and insurers may not fully know the driving habits and risk preferences of each driver. Drivers which are more aggressive may be more inclined to purchase cars with advanced safety and therefore insurance companies may find safer cars are more frequently involved in accidents and so they adjust premiums which could result in higher premiums for those drivers despite safety features.** **This leads to an imbalance where cars driven by individuals with higher inherent risk are safer.** **Performance-related pay packages have been widely used to try to align managerial incentives to the interests of shareholders. Explain how such contracts, including share options, may create incentives for short-term profit maximization at the expenses of the long-run profitability of the firm.** These packages are designed to align with managerial incentives with the interest of shareholders by tying compensation to company performance. Managers may receive stock options that vest over a short period of time, giving them a direct financial incentive to boost the company's stock price in the short term. When contracts are designed to link with annual, monthly or even weekly wages, this can incentivise mangers to make decisions which boost short-term performance and deter long-term performance. Fo example, they may cut R&D and marketing expenditure. Public companies produce quarterly earnings reports which includes performance-related pay which can make managers act to improve short-term performance, even if it is not sustainable in the long term. This can damage brand and reputation while also affecting employee morale and inducing higher turnover rates. These actions can lead to underinvestment in long-term growth projects which leaves the company vulnerable to competitors and technological advancements. To mitigate these issues, companies could issue restricted stock units that vest over several years, aligning managers interests with the long-term health of the company. They could also introduce debt-based contracts such as pensions or deferred payments. Additionally, clawback provisions enables the company to reclaim bonuses if they find that short-term gains were a result of unsustainable or unethical practices. **Week 10 extra questions** **To determine the right amount of a certain public good to provide, the government of West Essex decides to survey its residents about how much they value the good. It will then finance the public good provision through taxes on residents. Describe a tax system that would lead residents to underreport their valuations. Describe an alternative system that could lead residents to over-report their valuations.** **A tax system which could lead to underreporting is a system which is based on reported valuations. Residents may believe that they will be taxed lower amounts if they reduce their stated vale and free ride on public goods.** **An alternative which could lead to overreporting is the Lindhal tax system which is designed so each person pays a tax which is proportional to the benefit they derive from the public good. Residents may overreport to ensure the government provides a higher amount of the public good.** **True / false questions** 1. **An uninsured patient who incessantly visits his doctor because he always thinks he is getting sick is an example of moral hazard.** False -- this patient is uninsured and therefore there is no insurance company to bear the risk of his actions. It is likely that, without insurance, the patient will have no choice but to cover the costs of these visits himself. As long as he is paying for medical services, he is not a moral hazard. Although, you could argue that in countries with free health care, this is an example of moral hazard because he may assume that tax payers or the system will cover the costs. 2. **A woman who uses her fireplace only after she buys homeowner's insurance is an example of moral hazard.** True -- technically this is true because the individual is engaging in riskier behaviour after she becomes insured (ex-ante moral hazard). However, you can argue that this is rational behaviour and that, since a fireplace is a legal and normal house appliance to use, the woman is actually making a safe decision by only using it when she is insured. 3. **Pauly (1974) shows that the socially optimal level of insurance in a market is either full or none, depending on whether moral hazard or risk aversion predominates.** False -- Pauly argued that the optimal level of insurance involves a trade-off between the benefits of risk reduction and the costs associated with moral hazard. He suggested that the level of insurance should be adjusted based on which factor (moral hazard or risk aversion) has a stronger influence. The actual optimal level in economics is where the marginal utility of risk reduction equals the marginal cost, including the cost of potential increased risk-taking behaviour. 4. **If a health insurance company could somehow monitor everything a customer does and plans to do, it could create a full-insurance contract with no moral hazard.** True -- by being able to effectively monitor and predict a customers actions, they can offer actuarially fair premiums which would enable the insurance company to break even and also tie prices to customer behaviours and risk preferences. This would also be a solution to adverse selection. 5. **Taxing private producers of education can help overcome the externality problem of education.** False -- this would only place more burden on the state as this cost would likely be passed onto the end user and create a situation where more individuals are being educated by public producers. Additionally, the externality of education is positive as it leads to a higher pool of high-skilled workers who can therefore be financially independent without relying on state support. 6. **Typically, if the government chooses to tax polluters, pollution levels fall to zero.** **False -- while a tax on pollution would most likely decrease pollution levels, it is close to impossible for levels to reach zero for the simple reason that the technology required for this does not exist. We don't have the capability to reach zero and therefore this is inaccurate. Additionally, this type of tax is called a Pigouvian Tax, which is designed to correct a market outcome that is not efficient.** 7. **The Akerlof (lemons) model indicates that government intervention is the only way to solve the adverse selection problem.** False -- this model essentially explains that the quality of goods in a market is uncertain and therefore this leads to adverse selection. This is due to asymmetric information. If we consider the car industry, buyers cannot efficiently distinguish between lemons (low quality) or peaches (high quality), and so this can lead to a higher number of lower quality cars being bought at unfair prices. 8. **If one person consumes a good, so that no other person can consume it at all, then the good is excludable.** False -- this explains a rivalrous good. An excludable good is one which you can easily exclude certain people from using it, for example by attaching a price tag or an age limit. It is not inherently linked to the good being diminished by consumption. 9. **The Coase Theorem implies that there are no externalities.** False -- the Coase Theorem says that when property rights are well defined, and transaction costs are low, externalities can be efficiently resolved through negotiation. Externalities will always exist as long as asymmetric information exists.