ECON Midterm 3 Joe Price

Screening

Done by the less-informed party to learn about the other side. Example: An employer uses tests or interviews to identify productive workers.

Signaling

Done by the more-informed party to reveal their type. Example: A worker gets a degree to show they are competent.

Adverse Selection

Occurs BEFORE the transaction. ○ Problem: one side is hiding information (HIDDEN INFORMATION) about themselves in order to get a better price. ○ Ex: The market for insurance → Insurance companies cannot tell who has issues and who doesn’t (those with issues are probably HIDING the fact that they have issues in order to get a better insurance price). As a result, they raise the prices of insurance for everyone, not just for the people with issues. ○ You don’t know who you are dealing with!

Moral Hazard

Occurs AFTER the transaction. ○ Problem: one side takes less precaution (HIDDEN ACTION) because the consequence won’t fall on them. ○ Ex: The market for insurance → After getting insurance, people take fewer health precautions because insurance pays if they get hurt. ○ You can’t monitor behavior!

Coase Bargaining

If property rights are well-defined and transaction costs are low, private parties can negotiate to resolve externalities efficiently on their own, regardless of who initially has the rights. Example: A factory pollutes a river. If affected fishermen can negotiate with the factory, they can reach a deal that maximizes total welfare.

Private Good

Excludable & Rivalrous
Ex. Food, Clothing, Smartphones

Club Good

Excludable but not rivalrous
Ex. Subscriptions, private parks, gyms

Common Good

Not excludable but rivalrous
Ex. fish in the ocean, timber in a forest

Public Good

Not excludable and not rivalrous

Ex. national defense, public fireworks

Positive externality

The market will produce less than the optimal quantity because the social benefits are larger than the private benefits. You can fix this with a subsidy or mandate.

Negative Externality

The market will produce more than the optimal quantity because the social costs are larger than the private costs. You can fix this with a tax or permit.

DWL with Externalities

Your DWL triangle points towards the socially optimal point!

Government Failures: Restriction on choice

Limits on what people can buy, sell, or do, reducing freedom and efficiency.

Government failures: Rent-seeking

Using resources to gain wealth through political or legal favors rather than creating value.

Government failures: Bereaucracy

Complex administrative procedures that can slow decision-making and reduce efficiency.

Government failures: Limited information

Decisions are constrained because people don’t have full knowledge about prices, quality, or outcomes.

Perfect competition

Many firms

Homogenous products

No barriers to entry

Monopolistic Competition

Many firms

Differentiated goods

No barriers to entry

Oligopoly

A few firms

Homogeneous or differentiated products

Yes barriers to entry

Monopoly

One firm

Unique product

Yes barriers to entry

Monopoly Graph

Profit Maximizing Monopolist

A monopolist profit maximizes by choosing to produce at the largest quantity for which MR >= MC ○ A profit-maximizing monopolist will always want their price to be greater than the MR (price is at Demand line)

Natural Monopoly

Has very high fixed costs and very low marginal costs. These high fixed costs are a barrier to entry. This means that one firm can supply output at a lower cost than two firms. Competitors are excluded using cost structure rather than legal rules. Does NOT necessarily mean that a firm has exclusive ownership of a natural resource (a good example is a sewer company).

Oligopoly

Multiple firms aim to mimic monopoly behavior as a group. They collude (which is illegal) to do this.

Price Discrimination

Increases a firm's profits by attracting price-sensitive customers without lowering the price for others (student discounts, for example).

GDP

Y = C + I + G + NX

CPI

= (cost current year/cost base year) * 100

GDP Deflator (price level)

= (nominal GDP/real GDP) * 100

Real GDP per capita

= Real GDP/Population

Nominal GDP

= ∑Current Price * Current Quantity

GDP

The total value of all goods and services a country produces in a year. It shows how big the economy is.

Nominal GDP

The total value of everything the country makes, using the prices that actually exist right now. It goes up if prices go up, even if we don’t make

Real GDP

The total value of everything the country makes, but using constant prices from a base year. This shows how much the country actually produced, ignoring price changes.

GDP Deflator

A measure of how much prices for all goods and services in the economy have changed compared to a base year. It’s like a big-picture inflation number.

CPI (Consumer Price Index)

A measure of how prices for everyday items that people buy (food, clothes, rent, etc.) have changed. It shows how much the cost of living is going up.

Inflation Rate

= [CPI(x) - CPI(y) / CPI(y)] ×100

CPI (year x)

= [Cost-of-basket(year x) / Cost-of-basket(base year)] x 100

Real Interest Rate (purchasing power)

= Nominal Interest Rate - Inflation Rate

Real Value in Year X dollars

= Nominal Value in Year Y dollars x (CPI-Year-X / CPI-Year-Y).

Real Value (higher real value = higher purchasing power)

= (Nominal / CPI)*100

Finding the value of a dollar in the past:

Dollar past = Dollar today * (CPI past/CPI today)

CPI Biases: Introduction of new goods

Bias arises if new products aren’t in the basket

CPI Biases: Income bias

Changes in consumer behavior due to changes in real income.

CPI Biases: Unmeasured Quality Change

Bias from improvements in quality.

CPI Biases: Substitution Bias

CPI fails to account for consumers switching to cheaper alternatives.

Catch-up Effect

Poor countries sometimes grow faster than wealthy countries because additional capital will increase production more when the capital stock is smaller.

Savings Mechanisms

Other things the same, a country that increases its savings rate will decrease current consumption, increase future capital, and increase future consumption.

Policies that Discourage Growth

High income tax rates

A lack of property rights

Discouraging trade (tariffs)

A lack of investment

Taxing investment

Corruption in legal systems

Declines in school attendance

Forbidding foreigners from owning property

Unemployment Rate

U/(U+E)

Labor Force Participation Rate

(U+E)/(U+E+N)

Unions and Minimum Wage Laws

Force wages above market value against the firm’s will.

Firms choose to set an efficiency wage above market value to attract better workers. Any wage above market value causes unemployment (quantity supplied exceeds quantity demanded of labor).

Structural Unemployment

Occurs because wages are higher than the competitive wage.

Any reduction in unemployment must come through lower wages.

Frictional Unemployment

Comes from the difficulty in matching skills or switching between sectors.

Unionization

An increase in ______ in the US would tend to increase the unemployment rate and increase the labor-force participation rate (More unionization would decrease e, increase u, and decrease n).

Efficiency Wages

Higher-than-market wages that employers pay to motivate workers to be more productive, reduce turnover, and discourage shirking.