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Law & Economics Fall 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

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Competitive Firm MC quantity $ q1q1 P1P1 ATC MR 1 AVC ATC 1 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 = P C *C + P AOG *AOG Indifference Curves Shows all (C, AOG) pairs that provide same level of utility coffee AOG 1000 500 Ex: I = $1000 P C = $2 P AOG = $1 U 1 = 40 AOG* C* Consumer optimum

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Market Imperfections 1.Market power monopoly and monopsony imperfect competition 2.Externalities 3.Public goods 4.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 $ D1D1 S private Q1Q1 P1P1 P2P2 Q2Q2 External cost Free Market: P1, Q1 Optimal Outcome: P2, Q2 Free market overproduces goods that generate a negative externality S social

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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. 12345

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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’ Dilemma Prisoner A Confess Don’t Confess Confess Don’t Confess 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: Confess Prisoner B: Confess

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Prisoners’ Dilemma Prisoner A Confess Don’t Confess Confess Don’t Confess Prisoner B -5, -5-1, -10 -2, -2-10, -1 NE PO, but not NE Pareto 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? 1.(C, C) 2.(C, DC) 3.(DC, DC) 4.(DC, C) Player 1 Contribute Don’t Contribute Don’t Contribute Player 2 30, 305, 35 10, 1035, 5 12345

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Stage Hunt Hunter 1 StagHare Stag Hare Hunter 2 10, 100, 8 8, 8 8, 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 = $100 Tails = $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? a)$60 b)$80 c)$90 d)$105 12345

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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) = P H U($40,000) + P S U($20,000) = P H 90 + P S 70 Let P S =.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 healthy P H = probability of being healthy P S = probability of being sick P H + P S = 1

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Any risk-averse individual would always 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 12345

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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.

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