1. Introduction to Economics 2 Games and Markets
Global Development
27. Augsut 2015
Introduction to Economics 2 Games and Markets
Henrik Hansen
Department of Economics
University of Copenhagen
Fun?
Google: ”supply demand”
Select pictures
Count the number of pictures like this

2. Agenda Trust and Games: The Nash Equilibrium (Dasgupta, Ch. 2)
Global Development
Global Development
27. Augsut 2015
Agenda
Trust and Games: The Nash Equilibrium (Dasgupta, Ch. 2)
Demand, Supply and Partial Equilibrium (Dasgupta, Ch. 4)
General Equilibrium and the Beauty of Mathematical Philosophy (Dasgupta, Ch. 4)
An important classification of goods and services (Dasgupta, Ch. 2)
Market Failures and Market Imperfections
September 13, 2016

3. Global Development
Global Development
27. Augsut 2015
Trust and Games
Economics is about joint actions (production) and exchange (consumption, investment) based on agreements
Economic actors are selfish, so why should we trust them to honor agreements? [The selfishness is “Axiom 1” in economics]
What if, at every stage of the agreed course of actions
it would be in the interest of each party to plan to keep his or her word if all others were to plan to keep their word
each party would believe that all others would keep their word.
This leads to “self-confirming” beliefs (Nash Equilibria)
September 13, 2016

4. An Agreement: A Coordination Game
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Global Development
27. Augsut 2015
An Agreement: A Coordination Game
Two people are hunting for meat; If they hunt together they can catch a stag (6 meals each); If they hunt alone they can catch a hare (2 meals each) If a hunter goes for a stag on his own, he gets nothing (0 meals) Number of meals for each hunter Discuss with your neighbor for 90 seconds: When will Hunter 1 do as planned, if he expects Hunter 2 to do as planned?
Hunter 2
Hunter 1
Stag
Hare
6,6
0,2
2,0
2,2
September 13, 2016

5. Enhancing Coordination: Laws and Norms
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Global Development
27. Augsut 2015
Enhancing Coordination: Laws and Norms
Many societies have tried to establish institutions where
people have incentives to “do business” with one another.
The incentives differ in their details, but they have one thing in
common: those who break agreements without cause are punished.
There are two ways.
To rely on an external enforcer (Law)
To rely on mutual enforcement (Social Norm)
Each gives rise to a particular type of institution.
September 13, 2016

6. A Work Agreement (a contract)
Global Development
Global Development
27. Augsut 2015
A Work Agreement (a contract)
The setting:
Ambra has wool, which is worth $4,000 to her (Opportunity cost/Alternative use)
Ambra knows Brigitta, who can use the wool to knit sweaters
The sweaters are worth $8,000 in the market but Brigitta has no access to the market
Brigitta can make $2,000 if he does not work for Ambra (Opportunity cost/Alternative use)
The agreement (contract):
Brigitta works for Ambra, knitting sweaters
Ambra goes to the market an sells the sweaters
Ambra subtracts $4,000 and Brigitta gets $2,000
The remaining $2,000 is shared equally between the two
The benefits:
Ambra makes $5,000, that is $1,000 above the opportunity cost
Brigitta makes $3,000, also $1,000 above the opportunity cost
The problem:
What keeps Ambra from taking the $8,000?
September 13, 2016

7. Global Development
Global Development
27. Augsut 2015
Enforcement
The agreement can be enforced by an established structure of power and authority (e.g., contract laws or labor laws)
As economists, we assume the punishment for breaking the agreement is severe relative to the gain. Basically, Angela must not be able to gain from breaking the contract
The agreement is enforced by a threat by members of the community that stiff sanctions will be imposed on anyone breaking the agreement.
Problem: Is the threat credible?
September 13, 2016

8. Global Development
Global Development
27. Augsut 2015
Social Norms
Threats are credible if the sanctions are aspects of social norms of behavior – in the sense that they are rule based. For a rule of behavior to be a social norm, it must be in the interest of each person to act in accordance with the rule if all others act in accordance with it! (BUT: That is a Nash equilibrium)
September 13, 2016

9. Ambra and Brigitta in a short term arrangement
Global Development
Global Development
27. Augsut 2015
Ambra and Brigitta in a short term arrangement
If Ambra and Brigitta only meet once they will not work together:
If Brigitta works for Ambra and she honors the agreement they make ($1000; $1000) extra
If Brigitta works for Ambra and she cheats they make ($4000;-$2000) extra
If Brigitta does not work for Ambra they make ($0; $0) extra
This is a version of a famous game known as prisoners dilemma
September 13, 2016

10. Ambra and Brigitta in a long term arrangement
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Global Development
27. Augsut 2015
Ambra and Brigitta in a long term arrangement
If Ambra and Brigitta expect to meet every day from today and into to the infinite future they may work together:
The future is discounted by the rate r (think of an interest rate)
A rule (Grim Strategy or Trigger Strategy)
Start by cooperating and honor the arrangement
Continue cooperating every day as long as the past has shown cooperation
End the arrangement permanently the day following the first defection.
September 13, 2016

11. Brigitta’s options Assume Ambra has adopted grim Honor the agreement:
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Global Development
27. Augsut 2015
Brigitta’s options
Assume Ambra has adopted grim
Honor the agreement:
Break the agreement:
September 13, 2016

12. Global Development
Global Development
27. Augsut 2015
The present value of the Extra Income for Brigitta if she works and Ambra does not cheat
September 13, 2016

13. Ambra’s options Assume Brigitta has adopted grim Honor the agreement:
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Global Development
27. Augsut 2015
Ambra’s options
Assume Brigitta has adopted grim
Honor the agreement:
Break the agreement:
Breaking the agreement results in a loss if r < 0.25
Non-cooperative punishment can act as a social norm
September 13, 2016

14. Global Development
Global Development
27. Augsut 2015
The General Finding
Social norms of behavior can sustain cooperation if people care sufficiently about the future benefits of cooperation.
The precise conditions will vary across time and place
What is common to them all is that cooperation is mutually enforced, it isn’t based on external enforcement.
The Downside:
Non-cooperation can also be sustained even when cooperation is beneficial and sustainable
Initial conditions are important for the outcome
And we should be looking for “tipping points” (r)
September 13, 2016

15. Global Development
Global Development
27. Augsut 2015
A variable tipping point: Ambra’s minimum share of the gain as a function of the discount factor
September 13, 2016

16. Markets: Supply, Demand and Equilibrium
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27. Augsut 2015
Markets: Supply, Demand and Equilibrium

17. Global Development
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A Single Market
We analyze the market for a single non-durable consumption good. The good is denoted X
Assumptions [The Economists’ Perfect Market Axioms: There are many variations]
There are many firms who could potentially supply the good
There are many households who could potentially buy the good
None of the firms or households can indvidually affect the supply or demand of the good in large measures. (All actors are ”small” relative to the total supply and demand of the good)
An enforcer (regulator) ensures nobody steals/cheats or colludes
Both firms and households are ”price-takers”
September 13, 2016

18. Household Demand and Market Demand
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Global Development
27. Augsut 2015
Household Demand and Market Demand
A household’s demand for the good X, is the quantity it would wish to purchase at the price P.
If the household’s willingness to pay (wtp) for each unit of the good is decreasing in the number of units it purchases, the wtp for last unit equals the price of the good
The market demand for the good is the sum of households’ demands at every possible price
September 13, 2016

19. Firms’ Production and Supply and Market Supply
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Global Development
27. Augsut 2015
Firms’ Production and Supply and Market Supply
Firms produce the good. The production technology is such that increasing production has diminishing returns (producing unit no. 200 requires more input than producing unit no. 199, which requires more than producing unit no. 198) [this assumption is considered to be non-inferential or self-contained, in the words of Gudeman]
If input prices are constant (no quantum discounts) the diminishing returns implies increasing costs of production
A firm’s supply of the good X, is the quantity it is willing to sell at the given price P.
The firm is making the best it can (largest profit) when the cost of the last unit produced equals the price. Hence, the firm’s supply is increasing in the price.
The market supply is the total quantity of the good that all firms are willing to sell at the given price P.
September 13, 2016

20. Global Development
Global Development
27. Augsut 2015
The Legacy of Alfred Marshall Supply and Demand Curves: And Market Equilibrium
At a Market Equilibrium total supply of a good equals total demand for the good.
AND
For each household and firm their buying and selling is as planned given the price:
No firm or household wishes to make changes at the given market price.
This is immense coordination
The production is efficient in the sense that the cost of producing the last unit (the marginal cost) is the same for each firm.
September 13, 2016

21. Global Development
Global Development
27. Augsut 2015
General Equilibria
With some effort we can move from one market to many markets
We assume
All goods are private
All goods are traded in competitive markets today, including
Factor markets (labor and machines, inputs)
Final goods markets
Future and contingent markets
Firms are owned by households and the profit is payed to the households [But we are not assuming equal shares]
Households own their labor and human capital and are remunerated at market prices for these goods
A general equilibrium is a set of prices – one for each and every commodity, such that total demand equals total supply for each of the commodities.
September 13, 2016

22. Economics as Mathematical Philosophy
Global Development
Global Development
27. Augsut 2015
Economics as Mathematical Philosophy
Given certain assumptions, General Equilibria exist. That is, there is a set of prices for which supply equals demand for each commodity
In general there is more than one equilibrium.
Every market equilibrium is an efficient allocation
There is no feasible allocation of goods that ALL households would prefer over the market equilibrium. (Or you cannot make any household better off without making at least one other household worse off)
Every efficient allocation can be obtained as a market equilibrium
If we can find an efficient allocation, there is a set of prices supporting this allocation as a market equilibrium.
[These are Welfare Theorems 1 and 2 showing the immense beauty of the economic model]
September 13, 2016

23. Economic Theory and Justice
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Global Development
27. Augsut 2015
Economic Theory and Justice
Market allocations in competitive equilibrium are efficient, but they aren’t necessarily equitable or just.
An allocation can be
Efficient and not egalitarian
Egalitarian and not efficient
Both egalitarian and efficient
Neither egalitarian nor efficient
Equity and efficiency are thus different ethical properties of allocations.
Notice that market allocations depend on initial endowments — which are inheritances from the past.
The universal theory takes initial endowments as given from the outside (exogenous)
September 13, 2016

24. Economic Theory and Consumerism
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27. Augsut 2015
Manfred Steger is Professor of Global Studies in RMIT's Centre for Global Research. He is also Professor of Political Science in the Department of Political Science at the University of Hawai’i-Manoa, USA.
Professor Steger's landmark study 'Globalism: The New Market Ideology' (Rowman & Littlefield) won the American Political Science Association's 2003 'Michael Harrington Award of the New Political Science Section'.
(Source:
Economic Theory and Consumerism
In the almost complete absence of other sustained macro-political and social narratives – concern about global climate change notwithstanding – the pursuit of the 'good life' through practices of what is known as 'consumerism' has become one of the dominant global social forces, cutting across differences of religion, class, gender, ethnicity and nationality. It is the other side of the dominant ideology of market globalism and is central to what Manfred Steger calls the 'global imaginary'.
[Paul James and Imre Szeman (2010). Globalization and Culture, Vol. 3: Global-Local Consumption. London: Sage Publications. p. x.]
Efficiency in Micro Economic Theory has nothing to do with promotion (or not) of consumerism
This does not imply that consumerism is not discussed – but it is not part of core economics as taught most places today
September 13, 2016

25. Snap Back To Reality, Oh, There Goes Gravity
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27. Augsut 2015
Snap Back To Reality, Oh, There Goes Gravity

26. Market Failures and Market Imperfections
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Market Failures and Market Imperfections
The General Equilibrium Theory is a Benchmark
In reality (whatever that means) we have many deviations from the perfect markets. In economics we call these ”Market Failures” and ”Market Imperfections”:
Public goods and externalities
Market power (Monopolies/Oligopolies)
Imperfections (private information, missing markets)
September 13, 2016

27. A Famous Classification of Goods (and services)
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Global Development
27. Augsut 2015
A Famous Classification of Goods (and services)
All goods or services have certain attributes. Two important attributes are
Rivalry: If I consume the good; can you consume it too?
Excludability: If I posses the good, can I keep you from accessing/consuming it?
We can look at both attributes to get a 2x2 classification of goods
Main problem: Undersupply
Rival
Non-rival
Excludable
Private goods
Food, clothing
Club goods
Theater, Cable TV,
Physical infrastructure
Non-excludable
Commons goods
CPRs
Forest products
Water systems
Public goods
The Law, Defense
Knowledge
Light from Lighthouses
Main problem: Overuse
September 13, 2016

28. Global Development
Global Development
27. Augsut 2015
Externalities
The Public goods, Club goods and Common Pool Resource problem are all special cases of a central issue in economics: Externalities
An externality is the effect that decisions have on people who have not been party to the decisions
Some well-known goods with externalities are
Immunization
Literacy, numeracy
Pollution
Solutions to externality problems
Public ownership of production units (Public provision)
Taxes and subsidies (known as Pigou taxes)
Regulation (quotas)
Contracts and laws
September 13, 2016

29. The Theory of the Second Best
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Global Development
27. Augsut 2015
The Theory of the Second Best
Economists have lots of fun proving interesting mathematical results
One result is Arrow’s impossibility theorem illustrated with voting in Dasgupta (Chapter 8)
Another strong result is the theory of the second best (from 1956), which illustrates that simple partial reasoning does not work in general.
Consider the situation when one or more optimality conditions cannot be satisfied: Specifically, if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the values that would otherwise be optimal!
The theory implies that if it is infeasible to remove a particular market distortion, introducing a second market distortion may partially counteract the first, and lead to a more efficient outcome.
September 13, 2016

30. Paul Krugman referred to the theory in June 2014
Global Development
Global Development
27. Augsut 2015
Paul Krugman referred to the theory in June 2014
“Readers well versed in economics will recognize that I’m talking about what is technically known as the “theory of the second best.” According to this theory, distortions in one market — in this case, the fact that there are large social costs to carbon emissions, but individuals and firms don’t pay a price for emitting carbon — can justify government intervention in other, related markets. Second-best arguments have a dubious reputation in economics, because the right policy is always to eliminate the primary distortion, if you can. But sometimes you can’t, and this is one of those times.” (see
September 13, 2016

31. Sometimes even the simple world is surprising
Global Development
Global Development
27. Augsut 2015
Sometimes even the simple world is surprising
Consider two people; Rahul, a small rice farmer with a small plot of land and Ayesha, a rice trader.
Rahul needs working capital to buy seed. For this he needs to borrow money.
Rahul borrows from Ayesha, who has access to loanable funds elsewhere
Rahul sells his crop to Ayesha, who markets it.
Ayesha subsequently sells the paddy on the market at a given price
We may think of a situation in which Ayesha offers Rahul a contract that specifies a price for his crop and an interest on the loan
Rahul can accept or reject the offer and determine how much he wishes to borrow at the offered interest rate.
Rahul’s rice production depends directly on the amount of seed. Thus, the contract and loan size also determines how much he earns
This example is from Debraj Ray (1998) Development Economics, Princeton University Press, Chapter 14.
September 13, 2016

32. The value of Rahul’s rice production
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Global Development
27. Augsut 2015
What would happen in this model if the government decided to introduce a minimum farm gate price on rice?
The value of Rahul’s rice production
It is optimal for Ayesha to offer Rahul a low interest rate and a low price on his rice! Why?
Drawn in Stata
September 13, 2016

33. Global Development
Global Development
27. Augsut 2015
Take away
Economics looks for patterns in economic life that are widely generalizable:
If, despite differences in culture, norms and values, a similar-enough set of behaviors can be observed in many places and over time, then a small set of simple assumptions should be sufficient to explain them
A critical element is the assumption of the self-regarding choice-making individual…she has always been under attack, but the modern economic attacks are not sacrificing formalization and generalizability
The difference between a [reductionist] parsimonious and a complicating approach has had enormous consequences for the role of the social scientists disciplines in development policy:
Many social scientists hate the economists’ linear mono-causal explanations—but simplicity rules in policy circles!
September 13, 2016