ECMC37 - Chapter 2.docx

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University of Toronto Scarborough
Economics for Management Studies
Michael Krashinsky

ECMC37 | Law and Economics Chapter 2: A Brief Review of Microeconomic Theory  Economists assume that each actor maximizes something; o Consumers; utility, firms; profits, politicians; votes, charities; social welfare etc.  Economists choose best alternatives subject to constraints to reach equilibrium of maximizing forces o Equilibrium: pattern of interaction that persists unless disturbed by outside forces  A production process is said to be efficient if inputs are being used to capacity or production is at lowest marginal cost  Pareto/Allocative Efficiency exists if it is impossible to change a situation to make one person better off without making another worse off (by their own estimations)  Maximization, equilibrium, and efficiency are fundamental in explaining economic behavior  Consumers are assumed to know what they like and dislike and should be able to rank preferences  In order for rankings to be rational, they must be complete, transitive, and reflexive o Complete: consumer is able to tell us how they rank all possible combinations of goods and services o Transitive: If A is preferred to B, and B is preferred to C, then A must also be preferred to C o Reflexivity: Any bundle of goods is at least as good as the good itself  Consumer preferences are subjective, and therefore exogenous – determined outside economic system  We are unable to make interpersonal comparisons of well-being; can’t measure the strength of preferences  A constrained maximum, or any other economic optimum, is where marginal cost equals marginal benefit o There’s costs associated with increase in benefit – when benefits no longer exceed costs  optimal  There is a marginal cost of budget reallocation when you decrease one good in favour of another o If one good gives indefinitely more utility than another, a rational consumer goes towards that good  In 2.7, the downward slope of MB signifies that the very first efforts of pollution reduction have great benefits to society, but they become incrementally less positive as efforts increase  The upward slope of MC signifies the social costs that individuals must incur to reduce pollution – successive levels of pollution reduction have higher costs than initial levels  The optimum for nearly all economic decisions occurs when marginal benefit = marginal cost  The most important factor for price elasticity of demand is the availability of substitutes o The greater the number of substitutes, the greater is e  A profit maximizing firm will produce only until marginal cost of production = marginal revenue o When marginal revenue exceeds marginal costs, expand production  Firms operate in two time frames: the short run and the long run o In the short-run, at least one input is fixed all others being variable o In the long-run, all factors become variable and prices are adjusted until economic profit equals zero 1 ECMC37 | Law and Economics  A monopoly can arise from one of two sources: 1. From statutory or other legal restrictions creating barriers of entry 2. From technological conditions of production called economies of scale (natural monopoly)  Typically government regulated  Opportunity Cost: the economic cost of foregone alternatives  Comparative Advantage: having a lower opportunity cost relative to others  Game Theory deals with any situation in which strategy is important – must specify: Players, strategy of each player, and payoffs to each player for each strategy o Payoff matrix is referred to as the strategic form of the game o A decision tree is the extensive form of the game  Above represents strategic and extensive form for the strategies of the prisoners dilemma  Because suspects will weigh the alternatives of confessing and keeping quiet, they will arrive at the following: o If 1 keeps quiet and 2 confesses, suspect 1 will spend 7 years in prison, therefore she’ll confess o If 2 keeps quiet and 1 confesses, suspect 1 will only spend half a year in prison, so she’ll confess o Thus, suspect 1 will always confess, which means confessing is the dominant strategy o Dominant Strategy: The optimal move for a player is the same, regardless of the other players move o Because suspect 2 will go through the same calculations, they will also confess –Nash Equilibrium o Nash Equilibrium: No individual player can do any better by changing behavior so long as the other
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