Economics 160 – Test #1 Review
(Intro). Cheung, “Why Are Better Seats Underpriced”: Cheung suggests that theatre owners might
sensibly choose to underprice better seats in order to reduce their policing costs. If there were not a
lineup for the better seats, and if these seats were not sold quickly, theatre patrons who purchase
cheaper seats would have an incentive to move to the more expensive seats once the movie starts. By
ensuring that these better seats are sold first, theatre owners are able to force theatre patrons to self-
police the allocation of seats. As a result, there is no need for the theatre owners to hire someone to make
sure that everyone sits in their assigned spot. Hence, underpricing the better seats is consistent with profit
maximization, once we consider all the costs involved in running a movie theatre. Enforcement costs are
COASE THEOREM .
1. Cheung, “Fable of the Bees”: Cheung describes a powerful implicit contract, “Custom of the Orchard.”
The custom of the orchard is an understanding that a certain number of hives are required to pollinate
some fixed area, on average. It is true that some bees from farm A will end up on neighboring farm B, and
vice versa, in what look like random search patterns. But if both farmers purchase the correct average
number of hives and the bees randomly search for pollen and nectar, then the externality is entirely
internalized. My bees pollinate some of your trees, and yours some of mine, but the average and marginal
allocations of resources are fully optimal! If there is money to be made, and transactions costs are not too
high, people will figure out something on their own. In apple orchards, the farmers pay the beekeepers.
2. Wolfers, “Did Unilateral Divorce Laws Raise Divorce Rates”: After unilateral divorce was imposed there
was an upward shift in hypothetical response of the divorce rates.
Dramatic rise in divorces as courts deal with higher demand.
Eventually the court controls this demand and demand steadies out.
The annual flow of new divorces is driven by the dynamics of marriages forming and dissolving as
couples find incompatibility. Gruber found that the proportion of the population that is divorced at a point in
time rises by about 1 percentage point following the adaption of unilateral divorce laws.
Application of the Coase Theorem suggests that shifting from a consent divorce regime to no-fault
unilateral divorce laws should not affect divorce rates. Taking explicit account of the dynamic response of
divorce rates to the policy shock, I find that liberalized divorce laws caused a discernible rise in divorce
rates for about a decade, but that this increase was substantially reversed over the next decade.
OPTIMAL CONTRACTUAL CHOICE.
1. Raff and Summers, “Did Henry Ford Pay Efficiency Wages?” Ford's introduction of the five-dollar day in
1914 was an effort to evaluate the relevance of efficiency wage theories of wage and employment
determination. Ford’s decision to increase wages so dramatically (doubling for most workers) is most
plausibly portrayed as the consequence of efficiency wage considerations, with the structure being
consistent, evidence of substantial queues for Ford jobs, and significant increases in productivity and
profits at Ford. Concerns such as high turnover and poor worker morale appear to have played a
significant role in the five-dollar decision. Given low monitoring costs and skill levels on the Ford
production line, such benefits (and the decision itself) appear particularly significant.
(Concluded the Ford experience supports efficiency wage interpretations)
2. Allen, “A theory of the Pre-Modern British Aristocracy”: Function was to serve as a civil service but had
a bad reputation. The main problem was principal-agent problem and how monitoring at the time was very
costly and difficult. P-A problem in the sense the agent has the inside scoop. Economists will tell you to
create a relationship framework in which your agent finds it far more valuable to stay in your good graces,
than to betray your trust and profit in the short term. Allen argues the Aristocracy was a classic example of
that. Nobles served as the King’s pleasure and could be dismissed at any time. Expensive educations in
impractical subjects, large homes away from the rest of society were both examples of ‘hostage capital’
that displayed your willingness to abide by the rules because breaking the rules was very costly. The upshot was that the kings of England had access to a class of loyal servants whose dedication was nearly
unquestioned. Sunk investment (no guarantee of having value back) was land not allowed being close to
anything with a lot of restrictions on how the estates were to be used. Nobelesse Oblige: with privileges
came responsibilities. Hostage capital, signal trust, has to be a sunk investment which is an observable
investment that cannot be easily redeployed. This is how principle can trust agent.
3. Allen, “Compatible Incentives and the Purchase of Military Commissions:”
Ideas behind it: Self-selection; military officers can best be paid in terms of output as residual claims, self-
selection of what fighting they were suited for. Incentives to fight; rewarded through residual claims,
paying with prize money gave incentive to engage in battle with rewards being based on performance
with minimal monitoring for the regiment.
Commissions could only be purchased in cavalry and infantry regiments (and therefore up to the rank of
There were several key reasons behind the sale of commissions:
a. It preserved the social exclusivity of the officer class.
b. It served as a form of collateral against abuse of authority or gross negligence or incompetence.
Disgraced officers could be cashiered by the crown (that is, stripped of their commission without
c. It ensured that the officer class was largely populated by persons having a vested interest in
maintaining the status quo, thereby reducing the possibility of Army units taking part in a
revolution or coup.
It ensured that officers had private means and were unlikely to engage in looting or pillaging, or to cheat
the soldiers under their command by engaging in profiteering using army supplies.
Social connections and patronage were all-important in the application process: entry was usually
restricted to those of wealthy means. It was rare for an individual to receive promotion from the ranks. The
financial transactions were handled by Army Agents. There were set prices for commissions, which in
theory were meant to give some protection for the less well-off; but the normal practice was to demand
considerably more than the official price. One factor which influenced the size of additional payment was
the desirability o