1. Introduction to the Class and States & Markets International Political Economy Prof. Tyson Roberts 1

2. Lecture 1 Goals The value of models Intro to decision theory & game theory Time horizons, Pareto efficiency, externalities Institutions & transaction costs Syllabus & expectations for class Questions, suggestions 2

3. The Value of Models 3 Source: Tetlock 2008: Expert Political Judgment

4. Commercial break If you want to learn more about models than we’ll be doing in this class, I recommend this online (free) course (starts Oct. 5, 2015): https://www.coursera.org/course/modelthinking Khan Academy also has some online tutorials that may be useful https://www.khanacademy.org/economics-finance- domain/microeconomics 4

5. Decision Theory Single actor (decider) Choices Value (utility) of outcomes Probability of each outcome, given each decision Expected utility of each choice Choose the action with the highest (expected) utility: rationality 5

6. Decision Theory Example Actor: You Choices: – Don’t have diploma – Take classes at UCI to get diploma 6

7. Decision Tree No diploma UCI What are the pros and cons of each decision?

8. Decision Theory Example Don’t have diploma – Costs: 0 – Benefits: Work full time right away 8

9. Decision Theory Example Take classes at UCI to get diploma – Costs: Lose 40 hours per week x 36 weeks per year x 4 years $$$$ Tuition Have to read some boring books, listen to boring lectures – Benefits: Earn more income with diploma Network of friends Smarter, healthier, happier 9

10. Decision Theory Example Assume utility of each choice= – Don’t have diploma: +100 now – Classes at UCI for diploma: -50 now, +250 later Which has the greatest utility? 10

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12. Decision Tree with Numerical Utilities No diploma UCI - 50 + 250 = 200 100

13. Time Horizons Taking classes has a higher expected utility, but… The costs are upfront, the benefits are delayed If you value the present more than you value the future, you might prefer not to wait 13

14. The Marshmallow Test http://www.youtube.com/watch?v=QX_oy9614HQ 14

15. Discount Factor Assume that – the costs and earnings during first four years are valued at full value – the benefits after four years (includes bump in pay & “happier, healthier, smarter”) are valued at half value Recalculate utility for “No Classes” and “UCI” 15

16. Decision Tree with Calculated Utilities No diploma UCI 100 – 50 + (1/2) 250 = 75

17. Decision Tree with Calculated Utilities & Discount Factor = ½ No diploma UCI 75 100

18. Game Theory Multiple actors Choices Value (utility) of outcomes Value of each choice, given other actors’ choices 18

19. Game Theory: Trade Choices: – Don’t trade – Trade Utility of outcomes – Utility if don’t trade vs. Utility if trade 19

20. Some Game Theory Terminology Pareto Improvement: At least one player is better off and no players are worse off Pareto Efficient/Optimal: No Pareto Improvements available Pareto Inefficient/Sub-Optimal: Pareto Improvements are available Trade enables Pareto Improvements for Pareto Sub- Optimal Situations 20 Vilfredo Pareto

21. Market as freedom: Trade enables Pareto improvements Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread Barista: 4 Baker: 4 Barista: 2 Baker: 2 Drink only coffeeBarista: 2 Baker: 2 Barista: 2 Baker: 2 “The possibility of coordination through voluntary co-operation rests on the elementary -- yet frequently denied -- proposition that both parties to an economic transaction benefit from it, provided the transaction is bi-laterally voluntary and informed.” (M. Friedman 1962) 21

22. Market as freedom: Trade enables Pareto improvements Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread Barista: 4 Baker: 4 Barista: 2 Baker: 2 Drink only coffeeBarista: 2 Baker: 2 Barista: 2 Baker: 2 Which outcome is Pareto Efficient? 22

23. Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread Barista: 4 Baker: 4 Barista: 2 Baker: 2 Drink only coffeeBarista: 2 Baker: 2 Barista: 2 Baker: 2 Market as freedom: Trade enables Pareto improvements 23 Which outcome is Pareto Efficient? Answer: Offer, Offer (at least one is better off, none are worse off)

24. So, should all assets be tradable? 24

25. So, should all assets be tradable? What about college diplomas? Why? Why not? 25

26. Externalities/Spillovers Externality: a cost (negative externality) or benefit (positive externality) that is not transmitted through prices and is incurred by a party who was not involved as either a buyer, seller, or producer of the goods or services causing the cost or benefit. 26

27. What are some possible positive externalities (for society) of college education? 27 Economic productivity Public health Democratic quality Other quality of life enhancements such as art, environmental quality, etc.

28. States with more college graduates tend to be more productive 28

29. A farmer considers whether to drill a deeper well into the aquifer in order to grow more pistachios during the drought Should he? What is the “rational” thing to do? 29

30. Economic decision from market forces: supply and demand Demand: High – nuts increasingly popular Supply: Low – drought reduces ability to growth pistachios 30

31. High demand + Low Supply => High Prices Rational decision is to drill more during drought! Price 5 3 1 1 3 2 S D Quantity

32. Are there any externalities from increased drilling during a drought? 32

33. Thousands of farmers tap into the same aquifer If everyone drills “rationally” the aquifer may eventually dry up: Tragedy of the Commons 33

34. How does the “time horizon” concept play a role in this tragedy of the commons? Short term best choice (drill) leads to disaster in long term 34

35. “Fundamentally, there are only two ways of coordinating the economic activities of millions. One is central direction involving the use of coercion--the technique of the army and of the modern totalitarian state. The other is voluntary co-operation of individuals-- the technique of the market place.” (M. Friedman 1962) 35

36. “(a government official) is directed and controlled through a system of commands while (a business entrepreneur) is directed and controlled by a system of inducements.” (Lindblom 1982) 36

37. “Economic arrangements play a dual role in the promotion of a free society. On the one hand, freedom in economic arrangements is itself a component of freedom broadly understood, so economic freedom is an end in itself. In the second place, economic freedom is also an indispensable means toward the achievement of political freedom.” (M. Friedman 1962) 37

38. “Policy is imprisoned in market oriented systems… No democratic nation state has ever arisen anywhere in the world except in conjunction with a market system… But… no market society can achieve a fully developed democracy because the market imprisons the policy-making process.” (Lindblom 1982) 38

39. Market as prison: Trade ONLY allows Pareto improvements Diploma salesman (assume diploma sales are legal) Offer to take payment to stop selling Sell diplomas College graduatesOffer to pay diploma salesman to stop selling Grads: -4 Salesman: 4 Grads: -5 Salesman: 2 Leave diploma salesman to sell Grads: -5 Salesman: 2 Grads: -5 Salesman: 2 Which outcome is Pareto Efficient? 39

40. Market as prison: Trade ONLY allows Pareto improvements Diploma salesman (assume diploma sales are legal) Offer to take payment to stop selling Sell diplomas College graduatesOffer to pay diploma salesman to stop selling Grads: -4 Salesman: 4 Grads: -5 Salesman: 2 Leave diploma salesman to sell Grads: -5 Salesman: 2 Grads: -5 Salesman: 2 Which outcome is Pareto Efficient? Answer: Offer, Offer (at least one player is better off, none are worse off) 40

41. Market as prison: Trade ONLY allows Pareto improvements Diploma salesman (assume diploma sales are legal) Offer to take payment to stop selling Sell diplomas College graduatesOffer to pay diploma salesman to stop selling Grads: -4 Salesman: 4 Grads: -5 Salesman: 2 Leave diploma salesman to sell Grads: -5 Salesman: 2 Grads: -5 Salesman: 2 “policy is imprisoned not in the sense that it cannot break out of its confinement but in the sense that to release it we must pay ransom” (Lindblom) 41

42. What are three possible outcomes from drought and farmers digging wells? (According to podcast) 1.Mad Max (no restraint) 2.Government Regulation (imposed restraint) 3.Cooperation (negotiated restraint) 42

43. Which is the most promising way to avoid the Tragedy of the Commons for the aquifer? Why? Government regulation Because there are thousands of farmers. Negotiated agreements, when the “rational” choice is to “cheat,” are very difficult when there are many actors – More on that in coming weeks! 43

44. “Bottom of the Well” Thousands of other farmers Stop drilling wellsDrill Farmer 1 Stop drilling wells Farmer 1: 0 Other Farmers: 0 Farmer 1: -40 Other Farmers: -40 Drill Farmer 1: 10 Other Farmers: 0 Farmer 1: -40 Other Farmers: -40 NOTE: Payoffs assume short term individual benefit = 10 if drill, long term social cost = -100 x discount factor ½ = -50 if (almost) everyone drills. Which outcome is Pareto Efficient? 44

45. “Bottom of the Well” Thousands of other farmers Stop drilling wellsDrill Farmer 1 Stop drilling wells Farmer 1: 0 Other Farmers:: 0 Farmer 1: -40 Other Farmers: -40 Drill Farmer 1: 10 Other Farmers: 0 Farmer 1: -40 Other Farmers: -40 NOTE: Payoffs assume short term individual benefit = 10 if drill, long term social cost = -100 x discount factor ½ = -50 if (almost) everyone drills. Which outcome is Pareto Efficient? One farmer only drills 45

46. “Bottom of the Well” Thousands of other farmers Stop drilling wellsDrill Farmer 1 Stop drilling wells Farmer 1: 0 Other Farmers: 0 Farmer 1: -40 Other Farmers: -40 Drill Farmer 1: 10 Other Farmers: 0 Farmer 1: -40 Other Farmers: -40 But if EVERY farmer chooses to drill => Tragedy of the Commons 46

47. Now assume transaction costs: Going to market costs 2 units Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread 4 – 2, 4 – 2 = 2, 2 2 – 2, 2 = 0, 2 Drink only coffee2, 2 – 2 = 2, 02, 2 Which outcome is Pareto Efficient? 47

48. Now assume transaction costs: Going to market costs 2 unit Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread 2, 20, 2 Drink only coffee 2, 02, 2 48 Which outcome is Pareto Efficient? Answers: Offer, Offer AND Drink only coffee, Eat only bread

49. What if cost of going to market = 3 49 Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread 4 – 3, 4 – 3 = 1, 1 2 – 3, 2 = -1, 2 Drink only coffee2, 2 – 3 = 2, -12, 2 Which outcome is Pareto Efficient?

50. What if cost of going to market = 3 50 Baker Offer some bread for some coffee Eat only bread BaristaOffer some coffee for some bread 4 – 3, 4 – 3 = 1, 1 2 – 3, 2 = -1, 2 Drink only coffee2, 2 – 3 = 2, -12, 2 Which outcome is Pareto Efficient? ANSWER: Drink only coffee, Eat only bread

51. Institutions “Institutions are the rules of the game in society or, more formally, are the humanly devised constraints that shape human interaction.” (North, 1990) “Institutions – at least those that support markets – are social arrangements designed to reduce such transaction costs.” (Rodrik) 51

52. Some institutions that reduce transaction costs Law & order (police, courts, etc.) Regulation (food safety, water usage, car emissions, etc.) Monetary system (stable currency, etc.) Tax collection & administration (road construction, etc.) 52

53. Market exchange is an institution to change the distribution of assets What institution might be used to enable honest students to prevent salesmen from selling diplomas without resorting to payment? 53

54. Markets & states as complements (Rodrik) States rely on markets for lending, taxes, etc. Markets rely on states to create and enforce rules, and to preserve the legitimacy of markets by protecting people from risks and insecurities of markets 54

55. Review of concepts Utility Time discounting/present value Pareto efficiency/optimality Externalities Transaction costs Institutions Market as freedom vs. market as prison 55

56. Takeaways from College Diploma Example People with short time horizons often make choices that are not optimal in the long run Because of externalities, society is sometimes better off if it puts restrictions on free trade by encouraging or discouraging certain types of transactions For individuals with weak impulse control, societal restrictions (institutions) may motivate choices that are better for that individual (as well as society) in the long run 56

57. Takeaways from Rodrik Chapter 1 Markets & states are substitutes: alternative institutions for allocation & re-allocation of resources Markets & states are complements: – States (and interstate arrangements) enable markets to function, and – Markets efficiently facilitate economic exchange for states 57

58. “If men were angels, no government would be necessary.” – James Madison “If students were angels, no graded work or deadlines would be necessary.” – Tyson Roberts 58

59. Syllabus The syllabus is designed to encourage you to make choices that will be good for you in the long run! – Read, work, attend lecture every week – Actively engage with material 59

60. Topics Lectures 1-2: Introduction to basic concepts Lectures 3-10: Economics & politics of trade, development, & the global economy In-class midterm Lectures 11-17: Multinational corporations, financial globalization, and crises Lecture 18: Globalization, Inequality, and the Environment 60

61. Lecture activities (4 hours/week) Lectures Videos Discussions, small group and plenary Practice exercises Midterm and final exam 61

62. At home learning (~12 hours/week) Readings (1 required textbooks, the rest online) Podcasts Videos Problem sets (3) Research exercises (3) Studying for exams Extra credit: Reading responses 62

63. Evaluation Reading quizzes (10%) (3 dropped) Problem Sets (10%) Research exercises (10%) (1 PS or RE dropped) Midterm exam (30%) Final exam (40%) Extra credit: – Reading responses (+ 1-2%) No late work accepted 63

64. Questions? Suggestions? 64

65. Thank you 65