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Game theory v. price theory Game theory Focus: strategic interactions between individuals. Tools: Game trees, payoff matrices, etc. Outcomes: In many cases the predicted outcomes are Pareto inefficient. But remember the Coase Theorem! Price theory

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Game theory v. price theory


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game theory
Game theory
  • Focus: strategic interactions between individuals.
  • Tools: Game trees, payoff matrices, etc.
  • Outcomes: In many cases the predicted outcomes are Pareto inefficient.
  • But remember the Coase Theorem!
price theory
Price theory
  • Focus: market interactions between many individuals.
  • Tools: supply and demand curves
  • Outcomes: In many cases the predicted outcomes are Pareto efficient. (This is the working of the invisible hand.)
  • But remember the underlying assumptions and what can go wrong…
assumptions of price theory
Assumptions of price theory
  • Each buyer and seller is small relative to the size of the market as a whole, and so each buyer and seller is a price-taker who takes the market price as given.
  • Complete markets: there are markets for all goods (and therefore no externalities).
  • Complete information: Buyers and sellers have no private information.
price taking assumption
Price-taking assumption
  • Each buyer and seller is small relative to the size of the market as a whole, and so each buyer and seller is a price-taker who takes the market price as given.
  • If this assumption is not met, some buyers and/or sellers have market power, e.g., monopoly, monopsony, duopoly, etc.
  • Resulting inefficiencies?
complete markets assumption
Complete markets assumption
  • Complete markets: there are markets for all goods (and therefore no externalities).
  • If this assumption is not met, there are externalities, either positive or negative.
  • Resulting inefficiencies?
complete information assumption
Complete information assumption
  • Complete information: Buyers and sellers have no private information.
  • If this assumption is not met, there can be asymmetric information.
  • Resulting inefficiencies?
  • Example: the market for lemons (from Akerlof’s Nobel Prize-winning paper)
the market for lemons
The market for lemons
  • Consider a used car market in which sellers know the quality of their car, but buyers cannot tell if a given car is a peach or a lemon.
  • What is the effect of this asymmetric information on the market?
  • Until Akerlof’s paper, economists thought that there was no major effect.
a numerical example
A numerical example
  • Imagine that sellers’ cars are equally divided among 4 values: $4800 (the peaches), $2300, $1500, and $1000 (the lemons).
  • Buyers cannot distinguish between them, so they’re only willing to pay the average value (i.e., expected value) for a used car.
  • What is the expected value if all 4 types of cars are sold?
a numerical example11
A numerical example
  • Sellers’ cars are equally divided among 4 values: $4800 (the peaches), $2300, $1500, and $1000 (the lemons).
  • If all 4 types of cars are sold, buyers are only willing to pay the average value (i.e., expected value) for a used car: $2400.
  • But sellers of $4800 cars (the peaches) won’t sell for this amount!
a numerical example12
A numerical example
  • We can’t have a market where all 4 types of cars are sold, but maybe we can have a market where 3 types are sold: $2300, $1500, and $1000 (the lemons).
  • Again, buyers are only willing to pay the average value (i.e., expected value). What is that value if cars are equally divided between these 3 types?
a numerical example14
A numerical example
  • We can’t have a market where even 3 types of cars are sold, but maybe we can have a market where 2 types are sold: $1500, and $1000 (the lemons).
  • Again, buyers are only willing to pay the average value (i.e., expected value). What is that value if cars are equally divided between these 2 types?
the market for lemons16
The market for lemons
  • In the numerical example, we have complete unraveling and only the worst-quality cars (the lemons) are sold. This is called adverse selection because the cars that are sold appear to be selected adversely.
  • A more important example of adverse selection: health insurance.
a numerical example17
A numerical example
  • Imagine that consumers’ likely health care expenditures are equally divided among 4 values: $200, $2700, $3500, and $4000.
  • Insurance companies cannot distinguish between them, so in order to avoid losing money they have to charge at least the average cost for health insurance.
  • Who are the peaches and who are the lemons?
who are the peaches and who are the lemons
Who are the peaches and who are the lemons?
  • Peaches are $200, lemons are $4000.
  • Peaches are $4000, lemons are $200.
a numerical example19
A numerical example
  • Consumers’ likely health care expenditures are equally divided among 4 values: $200, $2700, $3500, and $4000.
  • If all 4 types of consumers buy health insurance, companies have to charge at least the average cost, ¼(200)+¼(2700) +¼(3500)+¼(4000) = $2600.
  • But the peaches won’t pay that much!
a numerical example20
A numerical example
  • So maybe we can have a market where 3 types buy insurance: $2700, $3500, and $4000.
  • Again, insurance companies have to charge at least the average cost, which is 1/3(2700)+1/3(3500)+1/3(4000)=3400.
  • Again, the low cost buyers will choose to self-insure.
a numerical example21
A numerical example
  • We can’t have a market where even 3 types of consumers buy insurance, but maybe we can have a market with 2 types are sold: $3500 and $4000 (the lemons).
  • But insurance companies must charge at least the average cost ($3750) and at this price the lower-cost consumers will self-insure, leaving only the lemons.
assumptions of price theory22
Assumptions of price theory
  • Each buyer and seller is small relative to the size of the market as a whole, and so each buyer and seller is a price-taker who takes the market price as given.
  • Complete markets: there are markets for all goods (and therefore no externalities).
  • Complete information: Buyers and sellers have no private information.