1. Intermediate Microeconomics Week 1 Week 2 Week 3 Week 4 Week 8 Week 5 Week 6 Week 7 Week 10 Week 9 Problem Set 1 Problem Set 2 Problem Set 3 Problem Set 4 Problem Set 5 Exam 1 Exam 2 Exam 3 Exam 4 Exam 5 Financial markets Thaler, 10 – 13 Consumer Surplus Varian, 14 Surplus, Demand Varian, 14 & 15 Demand, Equilibrium Varian, 15 & 16 Equilibrium Varian, 16 Auctions Varian, 17; Thaler, 5 Exchange Varian, 31 Exchange Varian, 31 Welfare Varian, 33 Externalities Varian, 34 Asymmetric Information Varian, 37 Introduction Varian, 1 Budget Constraints Varian, 2 Preferences Varian, 3 Optimal Choice Varian, 5 Consumer Demand Varian, 6 S. & I. Effects Varian, 8 Buying & Selling Varian, 9 Intertemporal Choice Varian, 10 Game Theory Varian, 28 Intertemporal Choice Varian, 10 Present Value Varian, 10 Choice Anomalies Thaler, 2 & 3 Asset Markets Varian, 11 Uncertainty (Risk) Varian, 12 Risky Assets Varian, 13 Risky Assets Varian, 13 Diversification Varian, 13 Choice Anomalies II Thaler, 6 -- 9 Utility Varian, 4

2. The central focus of economics is allocation of scarce resources. There are many ways to allocate resources, one of which is free (or unmanaged) markets. In free markets, prices act as signals to participants in the marketplace. The forces of demand and supply, which summarize the actions of market participants, determine prices. The allocation of scarce resources determined by markets is superior to other allocations achieved under alternative methods. “Classical liberalism” and the free market argument : General Equilibrium Economics and Welfare

3. A B Good 1 Good 2 W · Pure Exchange

4. A B Good 1 Good 2 W · Pure Exchange

5. A B Good 1 Good 2 W · Pure Exchange

6. A B Good 1 Good 2 W · Pure Exchange

7. A B Good 1 Good 2 W · X · Pure Exchange

8. A B  · x · A Pure Exchange Economy

9. Assumptions: Pure exchange economy Two goods: and Two agents, A and B, with … Identical preferences: Arbitrarily determined, but different, endowments: Equilibrium is defined as a consumption bundle Where aggregate excess demands are zero in both markets: Hence, we are seeking a set of prices,, that satisfies these equilibrium conditions. The Algebra of Equilibrium

10. A B  · Pure Exchange

11. A B  · x · Pure Exchange and Equilibrium

12. A B ’’ · x’x’ ·  · x · Pure Exchange and Redistribution

13. Vilfredo Pareto 1843 -- 1923 Leon Walras 1834 – 1910 Francis Edgeworth 1845 -- 1926 General Equilibrium and Welfare Economics P olitical Economy does not have to take morality into account. But one who extols some practical measure ought to take into account not only the economic consequences, but also the moral, religious, political, etc., consequences” Vilfredo Pareto, Manual of Political Economy (1906) “ I n the general case … the demand function are functions of m - 1 variables which are too numerous to be represented in space. It seems, therefore, that the problem when generalized can only be formulated and solved algebraically …” Leon Walras, Elements of Pure Economics (1874) “

14. General Equilibrium and Welfare Economics Kenneth Arrow 1921 – Paul Samuelson 1915 – Gerard Debreu 1921 – Arthur Pigou 1877 -- 1959 H ow do we evaluate alternative social organizations? There are many possible arrangements for meeting the needs of society and they satisfy many different needs … we use the notion of efficiency or optimality that is associated with the name of Vilfredo Pareto … Now, within this context, and under certain very special assumptions … efficiency can be achieved through a particular kind of social system, the price system.” Kenneth Arrow, The Limits of Organization (1974) “

15. All market equilibria are Pareto efficient. Every Pareto efficient allocation can be achieved as a competitive equilibrium (given an appropriate initial endowment and convexity of preferences). 1. 2. First and Second Theorems of Welfare Economics “With such a definition it is almost self-evident that this so-called maximum [Pareto-optimality] obtains under free competition … But this is not to say that the result of production and exchange will be satisfactory form a social point of view or will, even approximately, produce the greatest possible social advantage.” Knut Wicksell, “On the Problem of Distribution” (1902) “[Pareto optimality] does not define, uniquely, a best situation in any sense of the word … Other criteria – roughly speaking, those we associate with the term ‘distributive justice’ – have to be called into play.” Kenneth Arrow, The Limits of Organization (1974)

16. Command & control approaches Internalization of external costs The “missing market” interpretation  Positive vs. negative externalities  Consumption vs. production externalities  The “tragedy of the commons”  Adverse selection as a result of externalities Externalities Assignment of property rights The Coase Theorem

17. A B Good 1 Good 2 · Pure Exchange and Consumption Externalities · · · X X’X’

18. A B Good 1 Good 2 · Pure Exchange and Consumption Externalities · · · X X’X’

19. D = MPB (Marginal Private Benefit) S = MC = MPC + MSC MSC (Marginal Social Cost) Optimal Output -- Supplier’s View Optimal Output -- Society’s View P* P** P Q MPC (Marginal Private Cost) Traditional (“Pigovian”) Analysis of a Negative Externality

20. q P Q P The Market D q* The Firm Externalities – Internalizing the social costs… Effects of a tax on suppliers (The so-called “Pigovian” solution)

21. Suppose that two utilities each release 10 tons of sulfur dioxide into the atmosphere, and that the government wants to reduce the total amount of sulfur dioxide emissions to 16 tons. Further, assume that it costs utilities different amounts to reduce their emissions: How much will the reduction to 16 tons cost if the government simply limits each utility to 8 tons of sulfur dioxide emissions? If the government issues each utility the “right” to release 8 tons of sulfur dioxide, and further allows the utilities to sell these rights, what will happen and how much will reduction to 16 tons cost? Establishment of a Pollution Rights Market Utility A B 9 Tons $50,000 $100,000 8 Tons $125,000 $250,000 7 Tons $225,000 $450,000 Total Cost to reduce emissions to …

22. Markets with asymmetric information Varian’s “market for plums and lemons” Q P Adapted from Varian, Intermediate Microeconomics, 7 th ed., 695 – 696. His example is itself an adaptation from a famous paper by George Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 (1970): 485 – 500.

23. Markets with asymmetric information General categories of problems of asymmetric information:  Adverse Selection: A situation in which individuals possess hidden information, leading to a market selection process that results in a pool of individuals with economically undesirable characteristics.  Moral Hazard: A situation in which one party to a contact takes a hidden action that creates benefits at the expense of another party to the contract. Social institutions that help solve these market inefficiencies: Private agent responses to problems of asymmetric information:  Signaling – the party possessing private information takes action to generate a credible signal.  Screening – the party with imperfect information takes action to induce a advantageous sorting of the market. Public / Private sector responses to problems of asymmetric information:  Compulsory purchase plans (insurance markets)  Licensing and certification (note that this may also be done by private agents).  Market regulation, including “truth” laws and “insider trading” laws.

24. Two used car dealerships compete side by side on a main road. The first, Harry’s Cars, sells high-quality cars that it carefully inspects and, if necessary, services before putting them up for sale. On average, it costs Harry’s $8,000 to buy and service each car it sells. The second dealership, Lou’s Motors, sells lower-quality cars. On average, it costs Lou’s $5,000 to acquire and resell each car on its lot. Generally, as far as appearance is concerned, the vehicles at Harry’s are indistinguishable from the cars at Lou’s. If consumers knew the quality of the used cars they were buying, they would gladly pay $10,000 on average for high-quality cars, but be willing to pay only $7,000 for a low-quality car. The dealerships, however, are too new to have established reputations, so consumers do not know the quality of each dealership’s cars. Consumers shopping at these dealerships figure that they have a 50-50 chance of ending up with a high-quality car, no matter which dealership they go to, and hence are willing to pay, on average, $8,500 for a car. Harry Offer Don’t Offer Lou OfferDon’t Offer Markets with asymmetric information: warranties as signals Harry has an idea -- offer a warranty on all the cars he sells. He knows that a warranty lasting Y years will cost, on average, $500Y. He also knows that if Lou tries to offer the same warranty, it will cost Lou an average of $1000Y (why?). If Harry offers a one-year warranty, will this generate a credible signal of quality?

25. Markets with asymmetric information: job market signals Adapted from Varian, Intermediate Microeconomics, 7th ed., 703 -- 705. His treatment is itself adapted from Michael Spense, “Job Market Signaling.” Quarterly Journal of Economics 87 (1973): 355 – 374, and Market Signaling (1974).