MicroEconomics theory and application 12th by browning an zupan chapter 14

 Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers...  Show how limited price information affects price dispersion for a

MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

Learning Objectives

 Understand the basics of game theory: a mathematical technique to

study choice under conditions of strategic interaction

 Describe the prisoner’s dilemma and its applicability to oligopoly

theory as well as many other situations

 Explore how the outcome in the case of a prisoner’s dilemma differs in

a repeated-game versus a single-period setting

 Analyze asymmetric information and market outcomes in the case

where consumers have less information than sellers

(continued)

Learning Objectives (continued)

 Explain how insurance markets may function when information is

imperfect and there is the possibility of either adverse selection or moral hazard

 Show how limited price information affects price dispersion for a

product

 Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities

14.1 GAME THEORY

Understand the basics of game theory: a mathematical technique to study choice under conditions of strategic interaction

Game Theory

 Game theory – a method of analyzing situation in which the outcomes

of your choices depend on others’ choices, and vice versa

 Players – decision makers whose behavior we are trying

to predict and/or explain

 Strategies – the possible choices of the players

 Payoffs – the outcomes or consequences of the strategies

chosen

Determination of Equilibrium

 Payoff matrix – a simple way of representing how each combination of

choices affects players’ payoffs in a game theory setting

 Dominant strategy – a case where a player is better off adopting a

particular strategy regardless of the strategy adopted by the other player

 Dominant-strategy equilibrium – the simplest game theory outcome,

resulting from both players having dominant strategies

Table 14.1

Nash Equilibrium

 Definition: a set of strategies such that each player’s choice is the best

one possible given the strategy chosen by the other player(s)

 All dominant-strategy equilibria are Nash equilibria

 Not all Nash equilibria are dominant-strategy equilibria

 Not all games have a Nash equilibria

 Nash equilibrium is closely related to the analysis of the Cournot

oligopoly model

Table 14.2 - Nash Equilibrium

14.2 THE PRISONER’S DILEMMA

GAME

Describe the prisoner’s dilemma and its applicability to oligopoly theory

as well as many other situations

The Prisoner’s Dilemma Game

 The most famous game theory model in which self-interest on the part

of each player leads to a result in which all players are worse off than they could be if different choices were made

Table 14.3

The Prisoner’s Dilemma and Cheating

by Cartel Members

 Outcome: each party acts in their own self-interest, resulting in all

parties being worse off

 Alternative plan: all parties agree to collude

 Two strategies for each party:

 Comply – maximizes combined profit for parties

 Cheat – stronger incentive for each party with potential

for larger individual profit but lower combined profit

 Success of collusive agreement depends on:

 Enforceability

 Number of parties

Table 14.4

Table 14.5

14.3 REPEATED GAMES

Explore how the outcome in the case of a prisoner’s dilemma differs in a repeated-game versus a single-period setting

Repeated Games

 Repeated Game Model – a game theory model in which the “game”

is played more than once

 “Tit-for-tat” – a strategy in which each player mimics the action

taken by the other player in the preceding period; 2 alternatives:

Table 14.6

Do Oligopolistic Firms Always

Collude?

 Restrictive assumptions underlying Repeated Prisoner’s Dilemma

Game:

 No entry into the market

 Firms have identical costs

 Firms produce the same product

 Each firm has complete knowledge of both firms’ payoffs for all strategy combinations

 Demand and cost conditions do not vary over time

 The game is repeated indefinitely

 Relaxing any assumption weakens the stability of collusive behavior in

Game Theory and Oligopoly: A

Summary

 Game theory – provides a technique that is suited to investigate

strategic interactions between oligopolies

 No general theory of oligopoly exists

14.4 ASYMMETRIC INFORMATION

Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers

Asymmetric Information

 Imperfect information – the case when market participants lack some

information relevant to their decisions

 Asymmetric information – a case in which participants on one side of

the market know more about a good’s quality than do participants on the other side

 The “Lemons” Model

The “Lemons” Model

 Market application: pre-owned cars

 Long-run outcome: low-quality cars tend to drive out high-quality cars

in the presence of asymmetric information

 Market responses:

 availability of information can increase market

efficiency

 information is scarce and, consequently, costly

 Benefit from information will not always be worth the cost

 it might be efficient for consumers to be less than fully

14.5 ADVERSE SELECTION AND

MORAL HAZARD

Explain how insurance markets may function when information is

imperfect and there is the possibility of either adverse selection or moral hazard

Adverse Selection

 Adverse selection – a situation in which asymmetric information

causes higher-risk customers to be more likely to purchase or sellers to

be more likely to supply low-quality goods

 Application – insurance markets in which the assumption of full

information (both firms and customers know the risks) is modified

 Possible outcome – higher-risk customers tend to be insured and

lower-risk customers choose to remain uninsured

Market Responses to Adverse Selection

 Outcome is mitigated: there are potential gains to market participants from adjusting their behavior to account for the adverse selection

problem

 Lower benefits, reduce costs, spread risk

 Upper limit on insurance coverage

 Requirement of physical exams and/or a waiting period

 Group plans covering all employees

Moral Hazard

 Moral hazard – a situation that occurs when, as a result of having

insurance, an individual becomes more likely to engage in risky

behavior

 The problem arises when insurance companies lack

knowledge of the actions people take that may affect the occurrence of unfavorable events.

 Another problem: lower cost to the insured individual increases the

demand for services which raises the cost of health care and insurance premiums

Market Responses to Moral Hazard

Application: medical insurance market

 Limitation on the services covered by insurance

 Requirement of the insured person to pay part of the

costs:

 Coinsurance rate – the share of the cost borne by the

patient

 Deductibles – the amount that the patient must pay

before insurance coverage is effective

14.6 LIMITED PRICE INFORMATION

Show how limited price information affects price dispersion for a

product

Limited Price Information

 Price dispersion – a range of prices for the same product, usually as

a result of customers’ lacking price information

 Search costs – the costs that customers incur in acquiring

information

 Price dispersion will fall when the benefit from search is higher than the cost

14.7 ADVERTISING

Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities

 Firms advertise to attempt to increase the demand for their product:

 Advertising as information about availability, price, and quality

 Artificial product differentiation: the use of advertising to

differentiate products that are essentially the same

 Demand curve might also become less price elastic

 Effects of advertising:

 Reduce price dispersion and lower the average price

 Solve the lemons problems by giving high-quality sellers an

advantage over low-quality sellers

Figure 14.1 – Advertising and a Firm’s Demand Curve

Advertising, the Full Price of a Product, and Market Efficiency

 Full price – the sum of the money price and the search costs that