law & economics fall 2008 dr. delemeester. what is law & economics? three strikes laws? ...
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Law & EconomicsFall 2008
Dr. Delemeester
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What is Law & Economics? Three Strikes Laws? No-Fault Divorce Laws? Kelo v. City of New London (2005)? Good Samaritan Laws?
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Review of Microeconomic Theory Rational man model
An individual seeks to maximize his or her utility.
For social optimality the rule is:
This involves taking actions till the marginal private cost of further action equals the marginal private benefit of that action.
Taking action till the marginal social cost of further action equals the marginal social benefit of that action
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CS
Market Model
Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS
Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS
Supply
Demand
quantity
Price
Q*
P*
PS
Deadweight Loss
Q
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Competitive Firm
MC
quantity
$
q1
P1
ATC
MR1
AVC
ATC1
Profit Maximization rule: P = MR = MC
What happens to the market price in the long run?
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Consumer Choice Budget Line
I = PC*C + PAOG*AOG
Indifference Curves Shows all (C, AOG)
pairs that provide same level of utility coffee
AOG
1000
500
Ex: I = $1000 PC = $2 PAOG = $1
U1 = 40
AOG*
C*
Consumer optimum
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Market Imperfections1. Market power
• monopoly and monopsony• imperfect competition
2. Externalities3. Public goods4. Severe informational asymmetries 5. Coordination and collective action
problems
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Market Power Monopoly
The condition of one seller and significant barriers to entry.
A monopolist charges too high a price and sells too little of the monopolized good or service.
Corrective: antitrust and regulation. Monopsony
The condition of one buyer and significant barriers to entry.
The monopsonist charges pays too little for the resources that he uses and hires too few of them.
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Externalities Unintentional Costs imposed on third parties by
the profit-maximizing actions of one person.
Examples: air and water pollution, secondhand tobacco smoke.
Unintentional Benefits that are conferred onto third parties by the profit-maximizing actions of one person.
Examples: elementary education, pollination services provided to beekeepers by a neighboring apple orchard.
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Externalities in a Graph
steel
$
D1
Sprivate
Q1
P1
P2
Q2
External cost
Free Market: P1, Q1
Optimal Outcome: P2, Q2
Free market overproduces goodsthat generate a negative externality
Ssocial
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a) greater; greater. b) greater; less. c) less; less. d) less; greater.
a) greater; greater. b) greater; less. c) less; less. d) less; greater.
A consequence of a positive consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output.
0% 0%0%0%
1 2 3 4 5
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Public goods Two characteristics:
Non-excludability Non-rivalry
Free rider problem Corrective:
Public provision Public subsidization
Examples:• Fireworks display• Radio broadcast • National defense • Information
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Severe informational asymmetries Two parties to a potential transaction have
very different information about some important aspect of the potential transaction. Example: consider the very different knowledge of
the true quality of a used car as between the buyer and the seller.
Why is this a problem? Because fear of uncertainty about the unknown
attributes may prevent otherwise value-maximizing transactions from taking place.
Corrective Compelling information disclosure by punishing
failures to disclose
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Coordination and collective action problems Traffic congestion
Drivers make decisions about using the roads independently with the sometime result that the roads are terribly congested.
How can drivers coordinate their decisions so that the roads are not too crowded?
Congestion pricing London now charges £8 for cars to come within the central
business district on weekdays. Traffic is down 20 percent since early 2003.
Public goods present a collective action problem Free riders Corrective: compulsory contribution.
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Game theory A formal means of modeling strategic interaction involving:
2 or more players Strategies Payoffs
Types of games Cooperative vs Non-cooperative Sequential vs simultaneous move Single play vs repeated play
Solution strategies and Nash Equilibrium
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Prisoners’ DilemmaP
riso
ner
A
Confess Don’t Confess
Confess
Don’tConfess
Prisoner B
-5, -5 -1, -10
-2, -2-10, -1
What strategy would you choose in a single shot game?
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Solution Strategies Dominant Strategy
One that is optimal no matter what opponent does
Nash Equilibrium No player has a unilateral incentive to change their
strategies
(Confess, Confess) is a Nash Equilibrium
Prisoner A: ConfessPrisoner B: Confess
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Prisoners’ DilemmaP
riso
ner
A
Confess Don’t Confess
Confess
Don’tConfess
Prisoner B
-5, -5 -1, -10
-2, -2-10, -1
NE
PO, but not NEPareto optimal outcome maximizes joint payoff
What if you play a repeated prisoner’s dilemma?
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Consider the voluntary contribution game below. What is the Nash Equilibrium for this game?
0% 0%0%0%
1. (C, C)2. (C, DC)3. (DC, DC)4. (DC, C)
Pla
yer
1
ContributeDon’t
Contribute
Contribute
Don’t Contribute
Player 2
30, 30 5, 35
10, 1035, 5
1 2 3 4 5
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Stage Hunt
Hu
nte
r 1
Stag Hare
Stag
Hare
Hunter 2
10, 10 0, 8
8, 88, 0
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Decision-making under uncertainty How to evaluate future outcomes when there are
multiple possibilities?
Calculate the expected value Weight each possible outcome by its probability and then
add them
Flip a coin gamble:Heads = $100Tails = $500
EV = 0.5 ($100) + 0.5 ($500) = $300
How much would you pay
to play this game?
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Consider a lottery with three possible outcomes: $125 will be received with probability .2, $100 with probability .3, and $50 with probability .5. What is the expected value of the lottery?
60 80 90 105
0% 0%0%0%
a) $60b) $80c) $90d) $105
1 2 3 4 5
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Decision-making under uncertainty Now suppose that there are two uncertain courses of action
Should one always choose the course of action with the higher expected value?
People have different attitudes toward risk or uncertainty and these attitudes may influence how they behave when facing uncertain outcomes Risk neutrality Risk aversion Risk seeking
A1: EV = $300 = 0.5 (100) + 0.5 (500)A2: EV = $400 = 0.99 (0) + 0.01 (40,000)
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Expected Utility Theory: Risk Aversion
Utility
Income (thousands)$40$20
90
70
Utility when sick
E(U) = PHU($40,000) + PSU($20,000)
= PH•90 + PS•70 Let PS = .20
E(U) = (.80)90 + (.20)70 = 86
E(Y) = (.80)(40,000) + (.20)(20,000) = $36,000
$36
86
U
Assumes diminishing marginal utility of income Utility when
healthyPH = probability of being healthy
PS = probability of being sick
PH + PS = 1
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Any risk-averse individual would always
a) b) c) d)
0% 0%0%0%
a) take a 10% chance at $100 rather than a sure $10
b) take a 50% chance at $4 and a 50% chance at $1 rather than a sure $1
c) take a sure $10 rather than a 10% chance at $100
d) take a sure $1 rather than a 50% chance at $4 and a 50% chance at losing $1
1 2 3 4 5
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Decision-making under uncertainty Insurance
Allows risk-averse individuals to convert uncertain outcomes into certain outcomes
Two problems: Moral hazard Adverse selection
Corrective: Co-insurance and deductibles.