What is the basic assumption of economics?
Man is a rational maximizer of his ends in life; and rational people respond to incentives
Explain three basic
principles of economics.
- 1- Law of demand: Inverse relation of
- price and quantity (know how it is graphed)
- 2- Cost (Supply) -
- Opportunity Cost: the cost of the alternative that must be forgone in order to pursue an action;
- Sunk Cost: an incurred cost/one that you have already invested and cant get; and
- Transaction Costs- costs resulting from information asymmetry (note- these are different from admin costs- the costs of administering regulations)
- 3- Voluntary exchange: a transaction that
- occurred b/w a willing seller and a willing buyer.
Explain the Coase Theorem.
- When property rights are well-defined
- and transaction costs are low, the allocation of resources will be efficient regardless of the initial assignment of property rights. If transaction costs are high, then an initial assignment of property rights does matter in economic
- efficiency. When transaction costs are high, free negotiations cannot take place, when transaction costs are low, free negotiations will occur.
See Shanghai Dilemma which provides: Use Property Rule when transaction costs (TC) are low and Liability Rule when TC are high.
What is opportunity cost?
cost of alternative that must be foregone
Where is economic rent?
- Revenue without production costs
- A positive difference b/w total
- revenues and total opportunity costs.
Explain the impact of price
Price ceiling- results in a shortage and creates a queue because the price ceiling is placed below equilibrium; may lead to black markets; Examples of price ceiling: rent control or control of adoption.
- Price floor- results in a surplus because minimum price is set above equilibrium
- Example of price floor: minimum wage.
Explain risk-averse, risk
neutral and risk seeking
- Risk averse: you fear risk;
- risk neutral: not taking risks, but not fearing them
- risk seeking: choosing to take risks
most people are risk seeking in some respects and risk averse in others
What’s the difference
between Pareto Efficiency and Kaldor-Hicks Efficiency?
- Pareto Efficiency: At least one party
- is better off and no one is worse off.
- it is the overlap between the seller's asking price and the buyer's potential purchase price. Potentially BOTH parties may be made better off
- Kaldor-Hicks: those individuals made better off by the policy or change would have to be sufficiently better off that they could compensate those who are made worse off. The key is that the compensation is “potential” not actual.
- Example: I take your land w/out compensation that is worth 10K and then I grow strawberries and I make 8K. Is that efficient? No, I have to make enough money to compensate your loss, but I’m not required to. I have to be enriched enough to compensate your loss.
Explain the realism of the
People are rational. It is objective and is ability to use instrumental reasoning to get on in life.
How to understand cognitive
- a- Sunk costs fallacy:idea of throwing good money after bad; you have already spent the money, so you feel like to have to continue to spent money on it
- b- Endowment effect: subjective value; you value what you have more than you would value the same thing if you didn’t have it
- c- Mirror imaging: assuming that other
- people will react the same wayas to value, reasoning, etc.
- d- Hyperbolic discounting: weighting present pains and pleasures more heavily than future ones; you discount future value (i.e., get drunk now and don’t worry about the consequences)
- e- Undue weight to immediate vivid impressions: relative to what we merely read or hear (ex: PTSD)
- f- Excessively optimistic: when one greatly
- underestimates the probability of something occurring. (i.e., every day people are
- killed in auto collisions but we drive crazy anyway)
- g- Preconceptions (stereotype): interpreting
- evidence to support a preconception even when it doesn’t
What’s the prisoner’s dilemma?
Without cooperation, they will each assume that the other will act selfishly to save his own skin. The result will be that they will both confess and receive 5 years. The key for Prisoner’s Dilemma to work is “without cooperation.”
How does the game theory change the conventional
- Game theory assumes a higher degree of
- rationality and it does not substantially change the fundamental assumption of economics.
- in game theory you consider the actions of other for your own decisions, but this is done without cooperation
Assume there are 25 (rational) lions and one lamb on an island. Any lion who eats the lamb
will fall asleep for an hour, during which time he can be eaten by any lion who
chances upon him. Will the first lion to come upon the lamb eat the lamb?
If even number of lions then no, if odd number then yes.
How does the tragedy of the commons occur? give at least one real world example.
- Without property rights, the rational
- participant will maximize his profits and that rational behavior will lead
- to the depletion of the commons. The key condition for TOC is the lack of
- property rights. Example: overfishing,
- global warming, pollution, driving a big car.
What is the main purpose of a property right system?
- Acheive efficiency and save the commons;
- You avoid the problems created by moral hazard and tragedy of the commons to achieve economic efficiency.
Why are property rights less extensive in primitive than in advanced societies?
- In a primitive society the transaction costs of having property rights outweigh the advantages because there is no scarcity; is not a problem so that maintaining property rights is not beneficial compared with the cost. To make the demand
- curve work there is a limitation of resources.
Propose solutions to over-fishing
- 2 kinds of solutions:
- 1. Haveregulation by the state; or
- 2. Privatization
Use treasure-hunt as an example and explain how a lack of property rights could lead to wasteful use of resources.
Over compensation without well defined property rights will lead to economic inefficiency
What economic sense does a
durational limitation on copyrights make?
- 1. You want to promote the creativity/innovation to a certain degree, not encourage monopoly for perpetuity; and
- 2. the duration will enrich public domain.
Explain the economic function of trademarks
- There is no durational limitation of a
- trademark. The economic sense:
- 1. It ensures consumer protection so that consumer can identify product quality – this reduces transaction costs for consumers; and
- 2. You want to
- protect the goodwill of the trademark to prevent moral hazard. (Trademark defines property
What’s the difference
between property rule and liability rule?
both involve compensation, but property rule involves consent
Explain the difference between
injunctions and damages as methods of protecting property rights.
- injunction is based on property rule and damages are based on liability rule.
- Damages- one person gets money, but cannot ask the other to stop
- injuction- plaintiff get an ultimate right to make the other person stop
What’s bilateral monopoly?(hold-out and free-riding)
- Is the center of transaction costs. TC is the cost prohibiting negotiation from taking place. There are two kinds of costs:
- 1) is hold out/boycott not willing to deal w/; and
- 2) free rider – you rely on someone else to do the work and eventually you will benefit from their work. These increase TC.
How does bilateral monopoly affect the Coase Theorem?
High transaction cost can cause market failure, demanding government intervention
What is market price?
- determined by the consensus of a willing buyer and a willing seller
- in a takings instance you have a willing buyer, but
- not a willing seller. Who decides the price? Market value is set by willing buyer and willing seller but what about price of condemning/taking?
- The government decides and its non-negotiable, and subjective value is left out. (See graph on Chapter 3
- Property Powerpoint slides) The administrative
- cost is for free negotiation, and this cost increases the chances of free
- negotiation because the condemnor will have to increase the opportunity costs. (KNOW
- THIS AND BE ABLE TO EXPLAIN WHY THE LINE (RED) INCREASES) It increases because we left out
- subjective value and so we increase the line a little bit. 3 factors increase line 1) subjective
- value; 2) secondary rent seeking; and 3) market bypass. Secondary rent seeking is whether or
- not the condemned property owner should have a fair share of projected profit
- deriving from proposed project on the condemned property. Secondary rent seeking is factoring in
- this consideration. So if you
- allow secondary rent seeking that increases the administrative costs. Market bypass is when the government either
- intentionally, negligently, or recklessly misses the best market to acquire the
- land. This is govt. inaction in
- preparing for the project and this law will require the government to plan
- ahead and acquire land at an efficient price. If you increase the red line then we will force the
- condemnors to purchase from the open market instead of using taking.
How is the price of condemned property determined?
it is determined by the government without the consent of the property owner
Merrill, the Economics of Public Use
- Basic Model- Pg 107 –This graph shows bilateral monopoly
- The Refined Model- Raising the price the government pays in a taking
Liu, Informal Rules, Transaction Costs and the Failure of the Chinese Takings Law: describe the relationship between formal and informal rules.
- whether the law can be followed depends on the informal rules/non-legal rule (the culture of the whole) and the formal rule is the law.
- Ideology is a part of the informal rule and so sometimes the informal rules knock over the formal law.
Why can household be a production unit?
- specialized labor division and efficient alloation of resources
- economies of scale
- leads to economic efficiency.
What economic sense does “positive assortative” mating make?
- you choose someone who is best for you
- reduce costs/reduce conflicts esp due to conflicts.
How does the strict divorce regime (forbidding divorce) protract marital search? Would the opposite regime (no fault divorce) discourage marital search?
same answer for both: search will be prolonged.
According to Posner, how does the prohibition of parental rights transfer contribute to “baby shortage”?
- The market price is (X), defined by demand and
- supply, (look up graph) and the restrictive measures contribute to shortage. Another factor Posner observed is the black market. The
- black market price is high because transaction costs in the black market is high.
- SHORT ANSWER: The quantity of the competitive market is reduced to the quantity of a restrictive market and the supply does not meet
- the demand. (make sure and be able to graph this out)
- should bring down the transaction costs and let the market take care of supply and demand
- legalization is the answer to this
Why should surrogate motherhood contracts be enforceable?
- Because it increases the supply and is
- consistent w/ contract law. it is, in a way, legalizing the baby market
Why regulate sexual behavior?
- External costs. You produce babies and transmit
Might parents ever overinvest in their children’s education from the child’s standpoint? Why?
(marginal revenue and marginal cost) overinvestment
How to graph the Hand Formula?
- Left side of the graph
- is negligence because B < PL à Liability
- Right side not negligent
- because B > PL à No liability
- equilibrium is the due care point
Why are transaction costs with potential victims in torts context prohibitive?
because there is no consent in tort
What economic sense does “reasonable prudent person standard” make?
- For the purpose of achieving efficient enforcement
- of law and reduce transaction costs. 3 type of tort costs:
- 1) cost to plaintiff;
- 2) societal costs; and
- 3) cost of maintaining the tort system.
- So by a reasonable prudent person standard (RPPS), that can keep these costs low because a reasonably prudent person is exercising due care (equilibrium).
- lower transaction costs and
- efficient enforcment of the law
Under what circumstance could the standard fail to deter a certain group of persons from acting negligently?
The RPPS treats everyone the same; it leaves out persons with exceptional abilities (whether they are genius or idiots)
Why the law does not recognize
custom as a defense?
- If it is a defense then participants of the industry will not have incentive to improve. The one who improves the technology incurs the cost and
- will make his business inefficient and will be undercut by competitors.
Why tort damages are not always fully compensatory?
- Because the transaction costs for measuring the
- pain/value of human life are prohibitively high.
How could a contributory negligence rule induce both parties to exercise due care? Famer and railroad example, game theory application
- 3 step calculation.
- 1) the railroad does nothing
- 2) Farmer will take precautions only to the extent that he will not be found negligent and so he will move straw only 75 ft away/$50; 3) RR will take some precaution but not full precaution because farmer moved the straw and RR will only put $24 into spark arrester. By adding this up $75 will be spent and not everyone will take full care.
How could a comparative negligence rule achieve the same the result?
same as contributory negligence
How does this rule make economic sense?-- landowner is not liable for negligent injuries to trespassers
Because the trespasser is the efficient avoider of the accident because his burden is zero or below zero.
Graph strict liability curve
How does strict liability
compel injurers to take consideration of possible changes of activity level?
- reduction in quantity (activity level) and increase in price.
- because the activity is reduced because running 10 trains b/w point A and B. The regulation increases the line and implication is that reduction in quantity increases price. Consumers will bear the burden of Strict Liability (increased price). Theory of strict liability is prevention, compensation, and spread of losses.
Why strict liability rule does not apply to zoo animals?
Social Utility is high.
Why strict liability rule applies to abnormally dangerous activities?
- Defendant is the efficient avoider
- asymmetrical information (only the producer can take care, so you can’t make the plaintiff take care because they don’t know anything)
- Utility is low
Why there is a tendency to apply the “ultrahazardous” label to new activities?
- Because there is asymmetrical information, because
- there is no information available.
In the context of product liability, in which way does strict liability reduce accidents?
reduces activity level, increase price.
What economic sense does “respondeat superior” rule make?
- 1) employer’s ability to pay a judgment is greater
- than employee;
- 2) employer can be efficient avoider of the accident by inducing the employee to be careful and training employee; and
- 3) employer can reduce
- the activity level.
How does Good Samaritan liability affect rescue efforts? Would restitution work in promoting rescue
GS statute protects the person giving aid and insulates them from liability for negligence, making people more likely to help. Having lability would reduce rescue efforts. Restitution Work? No. (providing money to give incentive to public to provide assistance will not increase rescue because some people just do something from their own motivation, not by money, and so if you give money, then they will feel like their good will is being commercialized and thus reduce the rescue efforts.
Put in graph: “people will demand much more money to take a large risk than the amount computed by
multiplying the money demanded to take a small risk by the increment in risk.
What’s the impact of liability insurance?
Will cause more accidents because there is a disconnection b/w the cost of the accident and cost on the part of the victim.
Posner claims that capping malpractice judgment may not be a solution for the increase of premiums for medical malpractice liability insurance, why?
- 1) premium is not experience based . . . (long answer for 1): current system is based on average doctors so the premium is based on average professional standard and not on individual
- 2) medical malpractice judgment is only served as a wealth transfer and not an increase of overall cost of healthcare;
- (part of litigation, lawyering cost, is cost of maintaining tort system and doesn’t
- increase overall cost of healthcare); and
- 4) the high price of healthcare has to do w/ the investment portfolio of the insurance company.
How does medical malpractice insurance increase quality too much?
- because the professionals become risk
- averse and practice preventative medicine and result in the overuse of medical resources (high costs)
Discuss the relationship between “B” and “PL” in intentional torts and its implications.
- B is equal or below zero and if burden is low and
- injurer still does it and this implication justifies high punitive damages.
If a newspaper publishes a defamatory article, and a second newspaper merely reports the contents of that article, should the second newspaper be liable or only the first?
- The law is that both should be liable.
- What economic sense does this rule make?
- It will punish the free rider and primary tortfeasor. To prevent strategic behavior and increase efficiency.
Understand the following statement: “In the case of crimes that cause death or even just a substantial
risk of death, optimal damages will often be astronomical.”
Because the Loss to the victim/society should be high, so the punishment should be high (see the formula)
How to understand D=L/p?
D is optimal punishment. D has a relationship with P (probability of getting caught) and L (loss to victim/ society). So you understand the punishment with the probability of being caught. If there is an increase in the probability of being caught, then that justifies a lower punishment, which will save judicial resources. And Vice versa: if you decrease the probability of being caught then that justifies a higher punishment.
Comment on “all crimes should be punished by a uniformly severe fine.” Do you agree? Why?
- It disregards marginal deterrence of criminal system.
- Marginal deterrence- additional deterrence for additional punishment
- if people were going to be punished the same for theft and for murder, they might as well just murder
Why is the economic argument for capital punishment strongly supported by considerations of
- The marginal deterrence works in a way
- that if there is no capital punishment certain crimes cannot be deterred. For example, in prison murder cannot be deterred. Short answer: certain horrendous crimes cannot be deterred.
A conspiracy that does not succeed is still punished. How does this rule make economic sense?
- raises expected punishment cost for completed
- crime. it increases opportunity costs.
- rationale: we want to prevent criminal enterprises
Premeditated murder is punished more severely than murder committed in a fit of anger. What economic
sense does this rule make?
- 1) the probability of being caught in
- premeditated murder is low, so high punish is justified
- 2) impulsive
- criminal is less likely to be deterred. (also impulse crimes are not planned--no escape plan)
“I am starving and beg a crust of bread from a wealthy gourmand, who turns me down. If I go ahead and snatch the bread from his hand, I am guilty of theft and cannot interpose a
defense.” Whereas, I can defend myself on the ground of necessity, if I am starving and steal food from an unguarded cabin in the woods. What economic sense do the two rules make?
- The transaction costs. In the first scenario there
- is a possibility to have a voluntary exchange whereas in the second scenario there is no such negotiation taking place because there is no party (thus, transaction costs are high). Transaction Costs in first scenario is lower than in second scenario because free negotiation is more likely in the first scenario than in second
Comment on this statement: “some argue that it is to legalize the drugs, because the demand for drugs is
inelastic and therefore drug usage wouldn’t increase much.” Do you agree? Why?
- I don’t agree because even in the drug
- market the law of demand works so people will behave rationally and buy cheap drugs if the price is lower. The law of demand still works in the drug market and rational behavior entails the purchase of lower price drugs.
Why education is not likely to reduce overall drug use?
- the middle class will not demand as much as they are educated, and this will
- increase supply, decreasing cost, making it easier for lower class to afford it. The lower class will then demand more.
Graph monopoly curves.
- 1) demand curve, price goes up, quantity goes down
- 2) Marginal revenue
- 3) Marginal Costs/Average
- 4) Monopoly- quantity is low and prices are high Consequence is
- 1) if it is under
- perfect competition (PC), above the PC line will be the welfare for consumers (welfare transfer) because it now belongs to the monopolists;
- 2) implication is as a result of the movement you see the black triangle and that is not utilized by monopolists nor the consumers and is wasted
- because monopoly created inefficient production because price is not decided by market and the price is high while quantity low. As a result, you get dead weight loss.
- 3) it justifies govt regulation in form of antitrust law. So push up the price to where it belongs. It is not a price cap, because govt returns the market to somewhat of a competitive market.
Explain dead weight loss caused by monopoly pricing
- created by the movement as a result of
- monopoly and consequences is sheer waste of resources not captured by consumers nor the monopolists.
Why the fewer the number of firms, the lower the cost of coordinating price fixing?
because transactions costs are high. The more number of players in the market the harder to monitor your competitors. Price fixing takes coordination and monitoring and this cost can be high if number of participants are great. The fewer players, then the lower costs to monitor. Price fixing is a cartel and everyone plans to raise price (which quantity of sale will drop) but everyone won’t cooperate. Only way to enforce cooperation is to monitor, and if one is lying, then others will come together and enforce by dropping price lower than cheater and will kick him out of market.
How does homogeneity of product affect price fixing?
the more homogenous the market is then the more likely the market is monopolized.
How does elasticity of demand affect price fixing?
more inelastic the market is then the more likely the market is monopolized.
How do barriers of entry affect price fixing?
the higher the barrier to entry then the more likely the market is monopolized. Low barrier to entry, monopolies wont work because someone new will come in and undercut their prices.
Why does a falling industry contribute to price fixing?
- falling industry is more likely to be a monopolized market and rising industry does not, because a rising industry is booming and is hard to detect who is cheating. Cartels calculate their own costs
- and want to keep it up and they know the players in a falling industry.
How the ratios of fixed to variable costs affect price fixing?
the higher the ratio the more likely the market is monopolized. This is like the barrier to entry situation. In a fixed cost, the barrier to entry is high and more likely to have price fixing.
Explain the changes of attitude toward resale price maintenance. See the Leegin case
- It boils down to interbrand competition and
- intrabrand competition. RPM started w/ Doctor Miles case which held that RPM is per se illegal, which is like a summary judgment. If manufacturer is found to RPM then it is per se illegal as a matter of law, with no defense. And the court rationalized this rule with price fixing and did not consider any other relationship. The change was in 2007 where court found that RPM is a Rule of Reason. There is no bright line rule. Whether or not RPM is legal or not we can balance equities b/w interbrand competition and intrabrand competition. Pro-competitiveness (want to enhance interbrand competition--competition with other brands)
Intrabrand competition and how does RPM facilitate?:
- if no rpm then any of the distributors can cheat by cutting down their services, lowering price to
- undercut their distributors so that . . . good thing is that it increases strength of particular brand. If a
- brand has monopoly power that means resale price that restrict competition b/w dealers will reduce consumer choice. So it can be bad and good.
Explain the dichotomy between interbrand competition and intrabrand competition.
RPM strengthens a particular brand. (Benefit to balance equities b/w inter and intra brand competition.)