9. Epistemology

epistemology

a branch of philosophy that studies knowledge, what it is, how we get it and how we know its reliable

economics has moved from

domain (the study of a specific domain of phenomena of interest) to approach (study of how changes in circumstances of scarcity affect optimal choice)

instrumentalism

unrealistic assumptions are not a flaw what matters is the accuracy of the prediction (Friedman)

realism

assumptions are important to understand causal mechanisms, prediction is not everything

example of normative assumptions in positive models

welfare criteria → using pareto efficiency → distribution does not matter → moral stance not a neutral fact

consequences of normative assumptions

• policy recommendations inevitably follow from these assumptions

• hidden normativity disgusts political choices as technical facts

Impact of economics on law

US federal judges were given an economics trining cause → longer prison sentences and less imposition of anti trust laws

private value auction

Each bidder knows their own valuation of the item (due to personal preferences) and this does not change when other bidders bid’s are revealed

common value auction

there is one underlying value of the object, but each bidder has different information or estimates about what the value is

example of common value auction

drilling rights, takeover bids

winners curse

in common value auctions bidders face the winners curse

→ winning means you were the most optimistic → likely wrong and end up overpaying

English auction

open, ascending price auction in which the highest bidder pays their final bid

advantages of the English auction

an English auction with a reservation price guarantees Pareto efficiency

what does the winner pay in an English auction

second highest valuation + minimal bid increment (the opportunity cost of winning not profit max)

dutch auction

open, descending price auction where the auctioneer starts at a high price and gradually lowers it until a bidder accepts the price

advantage of dutch auction

speed

Sealed bid auction

each bidder submits one private bid without seeing anyone else’s bid and the winner is deterred by a fixed rule

Vickrey auction

second price sealed bid auction in which the winner pays the second highest price

advantage of Vickrey action over sealed bid

Incentives are aligned as bidding your true valuation is the dominant strategy

which auctions have a non Pareto efficient outcome

Dutch - hide information and amplify the winners curse

Sealed Bid - optimal bid depends on the bidders belief about the values of other bidders

Pareto efficiency in an auction occurs when

the bidder with the highest valuation of the good receives it

which two types of auctions have the same outcome

Vickrey and English

why is the dominant strategy to bid the true valuation in a Vickrey auction

v₁ = value of player 1

v₂ = value of player 2

b₁ = bid of player 1

b₂ = bid of player 2

suppose v₁ > b₂ → player one will win for sure by truthful bidding and there is a surplus

suppose v₁< b₂ → player one will loose but there would be a loss if they set their bid greater than the value

practical challenges to the implementation of auctions

• collusion between bidders

• too few bidders

• incorrect reserve price

• credibility of the rules

• market structure