SL354 Intermediate Microeconomics

1. SL354 Intermediate Microeconomics Monday Tuesday Thursday Friday Week 1 Introduction Varian, 1 Budget Constraints Varian, 2 Preferences Varian, 3 Utility Varian, 4 Optimal Choice Varian, 5 Consumer Demand Varian, 6 [7] S. & I. Effects Varian, 8 Cooperation, etc. Thaler, 2 – 3 Week 2 Exam 1 Buying & Selling Varian, 9 Intertemporal Choice Varian, 10 Endowment Effects Thaler, 6 – 8 Week 3 Consumer Surplus Varian, 14 Surplus, Demand Varian, 14 & 15 Demand, Equilibrium Varian, 15 & 16 Equilibrium Varian, 16 Week 4 Exam 2 Asset Markets Varian, 11 Uncertainty (Risk) Varian, 12 Uncertainty (Risk) Varian, 12 Week 5 Risky Assets Varian, 13 Diversification Varian, 13 Behavioral Finance Thaler, 9 – 10 Real Financial Markets Thaler, 11 – 12, 14 Week 6 Exam 3 Pure Exchange Varian, 31 Pure Exchange Varian, 31 Technology Varian, 18 Week 7 Production Varian, 32 General Equilibrium TBD Welfare Varian, 33 Welfare Varian, 33 Week 8 Exam 4 Auctions Varian, 17 Auctions Thaler, 5 No Class Week 9 Externalities Varian, 34 Asymmetric Information Varian, 37 Asymmetric Information TBD Exam 5 Week 10

2. Externalities Rural Neighbors and the Right to Farm Before you build your dream house in the country, thoroughly investigate the surroundings. During the last several decades, more and more city people have migrated to rural areas to pursue their modern American dreams. They seek a peaceful place in the country, away from the noise and crime of cities. Many choose homes in modest (or not so modest) subdivisions that press into formerly agricultural lands. This intrusion of urban life into rural life results in an inevitable conflict. How surprised some neighbors are to wake up one spring morning to roaring machinery, buzzing flies, the stench of manure and a mist of pesticides in the air. And how angry many become when they learn that they can't do anything about it. The Legal 'Right to Farm' States now give farmers a basic "right to farm" without the fear of lawsuits brought by offended neighbors. As one judge remarked while dismissing a lawsuit against a hog farmer, "pork production generates odors which cannot be prevented, and so long as the human race consumes pork, someone must tolerate the smell.“ Before the right-to-farm laws were enacted (most of them in the 1980s), courts shut down many a farmer's operation because it was a nuisance to the neighbors. For example, a group of annoyed neighbors, whose homes had sprung up around a Massachusetts hog farm, sued and closed it in 1963. Some judges tried to strike a middle ground and ended up applying restrictions that would let the farming operation continue. A Florida court, for example, allowed a hog farm to stay in business but limited how many hogs the farmer could have. The judge also issued instructions on how to store and feed the garbage the hogs were accustomed to eating.

3. Pure Exchange and Externalities B · · X’ Good 2 (Externality) · X · A Good 1 (Income)

4. Pure Exchange and Externalities : The Coase Theorem B · · X · X’ Good 2 · A Good 1

5. Production Externalities S’ = S +MSC [= Marginal Private Cost] P’ [= Marginal Private Benefit] MSC [Marginal Social Cost] Q’ Optimal Output -- Society’s View Optimal Output -- Private Market’s View P S P* D Q Q*

6. The Coase Theorem Again The Coase Theorem: In the absence of transaction costs, all government allocations of property rights are equally efficient, because interested parties will bargain privately to correct any externality. Implication: Any market plagued by externalities can be made efficient if property rights are clearly defined and assigned, and if transaction (bargaining) costs are negligible. Coase, “The Problem of Social Cost” (1960) “It is strange that a doctrine as faulty as that developed by Pigou should have been so influential …” “The traditional approach [to the externality problem, the ‘Pigovian’ approach] has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B. But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would be to inflict harm on A … The problem is to avoid the more serious harm.” Ronald Coase 1910 -

7. Carbon Tax vs. Cap & Trade S’ P’ P S S’ = S + tax P* D P’ Q Q* Q’ Q’ Surplus Analysis Carbon Tax Cap & Trade P S P* D Q Q*

8. Markets with asymmetric information Varian’s “market for plums and lemons” P Q Adapted from Varian, Intermediate Microeconomics, 7th 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.

9. 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.

10. Agency costs What is the “agency problem” and what are agency costs? • Efficiency costs which arise when there is a divergence of interests between parties to a transaction. • When one party to a transaction cannot observe the effort of another party, upon whose effort the value of the transaction depends, we say there is a principal-agent problem. Examples: • In such cases, the principal cannot determine whether a bad outcome was the result of the agent’s low effort or due to bad luck. • Shareholders (principal) cannot perfectly monitor the efforts of a CEO (agent) • CEO (principal) cannot perfectly monitor the efforts of managers (agent)

11. Agency costs and Governance of Economic Transactions What is the “agency problem” and what are agency costs? “In the absence of agency problems, all individuals associated with an organization can be instructed to maximize profit or net market value or to minimize costs. Individuals will be prepared to carry out their instructions since they do not care per se about the outcome of the organization’s activities. Effort and other types of costs can be reimbursed directly and so incentives are not required to motivate people. Also no governance structure is require to resolve disagreements, since there are none.” Oliver Hart, “Corporate Governance: Some Theory and Implications.” The Economic Journal 105 (May 1995): 678 – 689..

12. Basic Principal-Agent Model Principal’s Share Uncertainty Payoffs Observable Outcome Agent’s Share Agent’s Actions Contract The Agency Challenge. To structure a contract that specifies division of payoffs in such a way that the agent’s actions will maximize those payoffs, given two complicating factors: • Uncertainty • Unobservability of effort

13. The “Canonical” Agency Model Assumptions

14. The “Canonical” Agency Model Illustrative Example

15. The “Canonical” Agency Model Illustrative Example (continued)

16. The “Canonical” Agency Model Summary • Inability to observe effort entails efficiency costs (in terms of lower utility or surplus generated from the transaction. • The difference in utility outcomes may be interpreted as the cost of inducing a risk-averse agent to accept some risk • There is an implicit tradeoff between efficient risk bearing and creation of incentive effects.