Solution Manual For Microeconomics Case Studies and Applications, 3rd Edition Jeff Borl Chapter 8.1-8.10
Case study 8.1 How incentives make the world go round
Summary This case study describes examples of behaviour responding to incentives – that is, changes to the benefits and/or costs associated with alternative choices. Changes to the cost and benefits of whether we have paid work, how hard we work in our jobs, and different ways of spending our money are shown to have affected behaviour.
Suggested answers 1
What are examples of how your own behaviour is influenced by incentives?
Think about examples such as how you allocate your time between alternative activities such as study, part-time work, sport and socialising; how you decide where to go on holidays; or whether to do an Honours year or a postgraduate degree. 2
In 1995 FIFA made a major change to the system for allocating points to soccer teams that would determine their finishing positions in league competitions such as the EPL and La Liga. Previously teams were awarded 2 points for winning a match, 1 point for a draw, and zero points for a loss. Subsequently teams winning a match were awarded 3 points, and the points for a draw and loss were unchanged. How do you think that the rule change made by FIFA affected the incentives for attacking play and defensive play – and how might that effect have varied depending on the game score? Can you make a prediction of how the rule change would affect the distribution of final scores (for example, game is drawn versus one-goal winning margin to a team)?
The new points system raises the size of the gain from winning compared to drawing a match. This would be expected to have two effects: (a) When a match was level (for example, 1–1, 2–2) there would be a greater incentive for teams to adopt attacking play to seek to win the match; and (b) When a team is ahead in a match it has greater incentive to adopt defensive play in order to seek to retain its lead. Both of these effects would be predicted to affect the distribution of final scores in the same way – making it less likely that a match would be drawn and more likely that it would be decided by a small margin (such as 2–1 or 3–2 etc.). These predictions have been confirmed in research by the game theorists Ignacio PalaciosHuerta and Luis Garicano. They compared outcomes in matches played in a season of La Liga before the FIFA rule change and a season after the rule change. Their results showed that the share of matches that was drawn fell by five percentage points after
the rule change, and the share of matches won by a one-goal margin increased by about the same amount. 3
Do you think that monetary incentives can always be successful in motivating behaviour? What might be some limitations or disadvantages to providing monetary incentives?
There are different forms of incentives. While monetary incentives may induce people to act in a way we desire, it is important to be aware that other non-monetary motivation may be an equally important source of incentives. For example, are you trying to do your best in tutoring just because you want to be able to keep earning money from this job, or because of the intrinsic satisfaction you get from feeling you have done a good job and helped students to learn? Sometimes, providing monetary incentives may even have an adverse effect on overall incentives. For example, Richard Layard quotes the following example in his recent book Happiness (2005, p. 159): ‘… the psychologist Edward Deci gave puzzles to two groups of students. One group he paid for each correct solution, the other he did not. After time was up, both groups were allowed to go on working. The unpaid group did much more extra work – owing to their intrinsic interest in the exercise. But for the group that had been paid, the external motivation had reduced the internal motivation that would otherwise have existed. They did half as much additional work on the puzzles.’ 4
Recently there has been much discussion about whether some part of teachers’ pay should be related to performance. The Commonwealth Government has proposed a trial of a national pay system that would involve teachers’ pay varying with student performance on tests ‘as a motivator to achieve specific results’ (Lisa Martin, 2007, ‘A question of merit’, The Age, June 25, Education p. 16). Can the idea of introducing performance pay be related to the idea of incentives? What do you think are likely to be the strengths and weaknesses of such a scheme?
If teachers’ pay were to vary with student performance on tests, the marginal benefit to teachers of having their students perform well on those tests would increase; hence the intention is to provide an incentive for teachers to devote extra attention and resources to having students perform well on the tests. A strength of the scheme is that by giving teachers an incentive to improve student performance on the tests, it will improve student learning of the core knowledge and skills that are required to do well on the tests. Some possible weaknesses of the scheme are that: i
the monetary payments may not affect teachers’ incentives (see discussion of extrinsic and intrinsic motivation in question 2)
ii there may be perverse effects on incentives. Rather than seeking to improve students’ test performance by improving their learning, other means (such as helping students to cheat on the tests) might be used (see for example the discussion in chapter 1 of Freakonomics), or teachers may end up focusing too much on the narrow set of knowledge or skills that is examined in the tests.
Case study 8.2 Does equilibrium exist? Evidence from experiments Summary This case study describes why economists use the concept of equilibrium as a way of predicting outcomes in markets, and reviews some experimental evidence on whether equilibrium is an accurate prediction of outcomes from trade in competitive markets.
Suggested answers 1
Suppose that groups of buyers and sellers participate in the same double oral auction as in Vernon Smith’s experiment. After five rounds with demand and supply as shown in Figure 8.2.2, the same group of buyers and sellers trade for five more rounds, but the buyers are assigned new values from the demand curve in Figure 8.2.2 and the suppliers are assigned new values from a supply curve that extends from $1.50 to $4.25 instead of from $0.75 to $3.50 (as in Figure 8.2.2). What would be your prediction about the average prices at which trade occurs over the extra five rounds?
In this situation there is the same market demand schedule and a revised market supply schedule. The equilibrium will now be for four units to be traded and the price to be between $2.25 and $2.50. (That is, at any price between $2.25 and $2.50 there will be four buyers and four sellers who can engage in mutually advantageous trade.) Given the results from the experiment described in the case study, we would expect that the average price should converge to the equilibrium price – between $2.25 and $2.50. However, this may take a little time to occur. We might expect that, with buyers’ and sellers’ behaviour initially being conditioned by demand and supply conditions in the first five rounds, the average price might begin at a price close to $2. However at this price it is likely that there will be less trade than in the first five rounds. Suppliers’ reservation prices have increased so there will be fewer suppliers willing to trade at this price. Hence buyers will be induced to start offering higher prices in order to draw greater supply onto the market. Over a couple of rounds this should shift the average trade price to within the equilibrium range, and at the same time the quantity traded will increase to the new equilibrium quantity. 2
Suppose that groups of buyers and sellers participate in the same type of double oral auction as in Vernon Smith’s experiment. The only difference is that sellers are given the exclusive right to propose prices at which trade can occur, and buyers are only able to accept or reject to trade at the prices that are offered. What do you think might be the effect on the market outcome?
Generally we would expect that the right to propose prices would give sellers greater bargaining power and buyers less bargaining power than where both can make price offers. Buyers are to some degree forced to accept the terms on which sellers propose that trade should occur, and hence we would expect prices to be on average higher
than in the double oral auction used in Vernon Smith’s experiment. This is also likely to depend, however, on the extent of competition between sellers. Competition between sellers can substitute for the right of buyers to propose prices; hence, the greater the degree of competition between sellers, the smaller the effect on price of giving sellers the exclusive right to propose prices.
Case 8.3 The great economic spectacle: The ups and downs of the US$/AU$ exchange rate Summary This case study shows how the demand/supply model can be applied to interpret changes that occur in the exchange rate for the Australian dollar.
Suggested answers 1
Suppose that there is an increase in demand by US tourists to visit Australia. How would you predict that this will affect the US$/AU$ exchange rate?
An increase in demand by US tourists to visit Australia should increase demand for AU$. This is because the US tourists will need to buy AU$ to spend when they are in Australia. An increase in demand for the AU$ will cause an increase in the US$/AU$ exchange rate; that is, since $1AU will now buy a larger amount of US currency, it is said that the value of the Australian dollar appreciates.
2
Suppose that the expected future profitability of US businesses improves so that the expected future return earned on owning shares in US businesses increases. How would you predict that this will affect the US$/AU$ exchange rate?
That the profitability of investing in US businesses has increased relative to the return from investing in Australian businesses implies that the returns to investing in the US relative to Australia have now increased. Hence there will be: (i) A decrease in demand for AUS$ in the US (reflecting lower investment in Australia by US investors); and (ii) An increase in supply of AUS$ in the US (reflecting Australian investors seeking to buy US$ in order to be able to invest in the US). The effect of both of these changes will be to reduce the US$/$AUS exchange rate; that is, since $1AUS will now buy a smaller amount of US currency, it is said that the value of the Australian dollar depreciates.