All Cases For Microeconomics Case Studies and Applications, 3rd Edition by Jeff Borland

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.

$US per 1$AU

1

S $AU in US 2

S $AU in US

er1

er2 1

D $AU in US 2

D $AU in US Q$AU

3

An article in The Age newspaper (O’Shaughnessy, 2008) described a dramatic fall in the value of the Australian dollar (US$/AU$ exchange rate) over the previous 24 hours. The fall followed a decision by the Reserve Bank of Australia to cut its official cash rate, a move that was regarded by investors as signalling future interest rate cuts were also likely.

Use the demand/supply model of the US$/AU$ exchange rate to explain why the value of the Australian dollar would have fallen.

That interest rates in Australia have decreased relative to the United States 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 AU$ in the US (reflecting lower investment in Australia by US investors); and (ii) An increase in supply of AU$ 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$/$AU exchange rate; that is, since $1AU will now buy a smaller amount of US currency, it is said that the value of the Australian dollar depreciates.

$US per 1$AU

1

S $AU in US 2

S $AU in US

er1

er2 1

D $AU in US 2

D $AU in US Q$AU

Case 8.4 Using prediction markets in business and public policy Summary This case study introduces prediction markets. It describes how this type of market works, and gives examples of how prediction markets have been used by business and government to reveal information of value to them.

Suggested answers 1

Can you think of other possible applications of prediction markets?

The case study describes a variety of applications. For example, the Iowa Electronic Market has since the late 1980s run a prediction market for US Presidential elections.

There are also the Hollywood Stock Exchange (www.hsx.com), which conducts prediction markets for the success of newly released movies, and outcomes of events such as the Oscars; and Goldman Sachs and Deutsche Bank, which have launched markets that allow trade on future outcomes of key financial statistics such as employment and business confidence.

2

Are there situations where you think it is possible that prediction markets might not accurately forecast future events?

In order for prediction markets to accurately forecast future events it is important that market participants have information that is valuable for predicting the outcome of the event. Generally, we think that markets – such as prediction markets – will work well where they have characteristics such as there being a relatively large number of buyers and sellers, market participants being experienced in trading the item that is being bought/sold in that market, and that market participants act in an independent manner in deciding on their trading strategies.

3

Do you think there might be any ethical issues associated with prediction markets?

One ethical issue might be where ‘insider trading’ was possible; that is, where some participants in a prediction market have an information advantage over other participants that it would be regarded as improper for them to benefit from. For example, contestants may have information that is valuable for predicting the outcome of a sporting contest that would not be available to others, and generally it would be regarded as unethical for those contestants to use their information by participating in the prediction market. Another example of an ethical issue might be where a participant in a prediction market seeks to influence the outcome of the event that is the subject of the prediction market.

Case 8.5 What’s ours is ours: Putting a stop to exports Summary This case study describes some ways in which countries seek to limit exports of products that they produce, and evaluates the welfare consequences of those policies.

Suggested answers 1

An article in The Economist (2008a) describes how Argentina has imposed a tax on exports on beef. How would you represent the effect of the export tax in the perfect competition model with international trade? What do you expect would be the effect of the tax on the price paid for beef by consumers in Argentina and the quantity of beef produced by suppliers in Argentina? How would Argentina’s national wellbeing be affected by the imposition of the export tax?

The introduction of an export quota imposes a limit on the quantity of beef produced

by Argentinian suppliers that can be exported to international buyers. The diagram below shows that the effects on the market outcome of introducing an export quota will be: i

a decrease in the price of beef in Argentina (from the world price to P*quota)

ii a decrease in the quantity of beef exported (from export1 to export2), an increase in the quantity of beef consumed by Argentine consumers (from Q1D to Q2D), and a decrease in the total quantity of beef produced by Argentine suppliers (from Q1S to Q2S). $ SARG Pworld

A

export quota B

C

*

P quota H

D

F

E

I

World price

G

K

J

DARG (export quota)

DARG 1

QD

2

2

QD

QS

export export

1

QS

2

1

Consumer surplus of Argentine consumers is increased, producer surplus of Argentine suppliers is decreased, and total surplus decreases in Argentina.

Free international trade

With export quota

Change

Consumer surplus

A

A+B+C

+B+C

Producer surplus

B+C+D+E+F+G+H+I+J+K H+I+J+K

–B–C–D–E–F–G

Revenue from export quota

Zero

E+F

+E+F

Total surplus

Sum of A to K

A+B+C+E+F+H+I+J+K –D–G

Note that – after the introduction of the export quota – it is necessary to take into account that the price for units exported will be the world price, and not P*quota, the price at which beef sells in Argentine. This is why the area E+F is added to the surplus derived by suppliers from selling at P*quota.

The DWL from introduction of the export quota is the areas D and G. The area D represents that the amount of consumption by Argentine consumers is greater (by the amount Q2D – Q1D) than is efficient – since it would provide more value to Australian society to sell these units at the higher world price than at P*quota. The area G represents that the amount of production by Argentine suppliers is less (by the amount Q1S – Q2S) than is efficient – since these units can be supplied at an opportunity cost less than the world price but are prevented from doing this by the export quota.

2

An article in The Economist (2008b) describes concerns that restrictions on trade in food (such as export bans) that are justified by claims of the need for ‘self-sufficiency’ may cause higher average prices for food and reduce the extent of access to food products. a

Try to make up a numerical example with two countries and a single type of food product (such as rice) where you consider (i) a situation where the two countries do not trade, and (ii) a situation where the two countries trade freely. Make up the example so that the total quantity of rice consumed by buyers in both countries is increased with free trade and there is a lower average price with free trade. How do you think your analysis relates to the discussion in the article of the effects of barriers on international trade in food?

Here is an example: Country A: QDA = 100 – PA QSA = PA Country B: QSB = 50 – (PB / 2) QSB = 2PB i

Where the countries do not engage in trade, then: P*A = 50, Q*A = 50; P*B = 20, Q*B = 40.

ii Where the two countries trade, then: QD = 150 – 3P QS = 3P Hence: P* = 33 1/3 => QDA = 66 2/3; QSA = 33 1/3; QDB = 33 1/3; QSB = 66 2/3.

It can be seen that international trade has the effect of lowering the price for country A and raising the price for country B. Therefore consumers in country A will buy more and suppliers will produce less, and the difference is made up by imports (33 1/3) from country B. Whereas consumers in country B will consume less, suppliers will produce more, and the difference is exports (33 1/3) to country A. Where the countries do not trade then the average price is 36 2/3, and the total quantity traded is 90 (50+40). However, where trade occurs then the price is 33 1/3, and the total

quantity traded is 100. Hence allowing trade lowers the price and increases the total quantity traded. b Use your numerical example to analyse the consequences of free trade compared to no trade for: (i) Consumer surplus for consumers in each country; (ii) Producer surplus for suppliers in each country; and (iii) Total surplus in each country.

No trade: PA

PB

SA CSA

100

100 CSB SB

50

20

PSA

PSB

DA 50

Country A: CS = (50  50)/2 = 1250 PS = (50  50)/2 = 1250 => Total surplus = 2500 Country B: CS = (80  40)/2 = 1600 PS = (20  40)/2 = 400 => Total surplus = 2000 Free trade:

DB QA

40

50

QB

PA

100

PB CSA

SB

100

33.33

33.33

PSB DA 66.67

100

QA

33.33

QB

Country A: CS = (66 2/3  66 2/3)/2 = 2222 2/9 PS = (33 1/3  33 1/3)/2 = 555 5/9 => Total surplus = 2777 7/9 PA

100

PB CSA

100

PSB

SB

33.33 33.33

DA 33.33

50

QA

Country B: CS = (66 2/3  33 1/3)/2 = 1111 1/9 PS = (33 1/3  66 2/3)/2 = 1111 1/9 => Total surplus = 2222 2/9

66.67

QB

Allowing free trade between the countries raises total welfare in both countries.

Consumers in country A are made better off by being able to buy the product at a lower price than otherwise; and although producers in country A are made worse off, overall the total surplus in country A is increased. Producers in country B are made better off from being able to sell to country A (and at a higher price); and although consumers in country B are made worse off, the overall effect is to increase total surplus in country B. Hence this example illustrates how allowing free trade raises global wellbeing.

Case 8.6 Should you make or should you buy?

Summary This case study discusses the decision that firms must make regarding whether to ‘make or buy’ the inputs that they require to produce output. A ‘check-list’ of advantages and disadvantages of producing inputs internally or procuring those inputs from an external supplier is presented, and examples of these advantages and disadvantages are presented.

Suggested answers 1

Think of a part-time or vacation job you have had, and what service or good that your employer provides its customers with. What is an example of an input used by the organisation that it contracted with an external supplier to provide? Given the set of factors described above, do you think the organisation was making the right decision to have this input supplied from outside?

Some examples are: Production activity

Make-or-buy decision

Advantage of external supply

Disadvantage of external supply

Clothing shop

Clothing – design and manufacture own clothing or buy from external suppliers

Brand name of external suppliers

• Cannot match designs to customers • Quality control

Brewer

Hops – produce or buy externally

Lower costs due to specialisation and economies of scale

• Lack of security in supply (Switch in production to biocrops by external suppliers)

Bicycle shop

Bike frame – produce or buy externally

Lower costs due to specialisation and economies of scale

• Scope for hold-up by external supplier • Quality control

Ice-cream store

Ice cream – produce or buy externally

Lower costs due to specialisation and economies of scale

• Cannot match flavours of icecream to customers • Quality control

Cricket bat manufacturer

Wood for bats – produce or buy externally

• Specialised knowledge needed to produce wood of appropriate quality • Economies of scale in production

Predictability of supply

2

An article in The Economist (2009) has described the new world of the ‘virtual’ hotel.

You stay at a hotel with a famous brand name, and you are surrounded by that brand – on the staff uniforms, the crockery, the stationery and perhaps even the toiletries.

But it is quite possible that the hotel is owned by a business that has simply taken a franchise on the brand name. The building that constitutes the hotel is likely to be leased from a property investment business, and the culinary and cleaning services may be provided by external suppliers. a

What do you think are the main advantages for hotel chains of not owning the buildings from which they operate?

The article suggests that the main advantage in the present economic environment is that hotel chains have been able to negotiate contracts with the owners of hotel buildings that protect them to a significant degree against falls in revenue from decreases in demand for hotel accommodation (that is, hotel owners are bearing most of the risk of fluctuations in revenue).

More generally, hotel chains may believe that the opportunity cost of income foregone by having funds invested in ownership of hotel buildings is greater than the cost of leasing the hotel buildings from an owner. Or alternatively, the return that the hotels firms can get by selling their buildings and investing those funds elsewhere is greater than the return earned from the business that can be attributed to ownership of the building. b Do you think the hotel chains should have any concerns about the outsourcing of ownership of the buildings from which they operate?

•

One potential problem is hold-up. That is, if the hotel building is essential to operation of the hotel, the owner of the building may be in a very strong bargaining position compared to the operator of the hotel, and by threatening to not allow the hotel to operate, may be able to force a very high lease fee from the hotel operator. This will be mitigated somewhat where a hotel operator is likely to be able to find other substitute buildings from which to operate the hotel, and this reduces the capacity of the owner of the building in which they were originally located to charge them a very high lease fee.

3

•

A second problem could be if there are aspects of provision of the building for the hotel that it is difficult to contract about with the building owner – for example, maintenance activity – and that may adversely affect the quality of the hotel service.

•

A third problem, discussed in the article, is that revenue growth for hotel chains now depends to a greater degree than previously on expansion in the number of hotels that they operate; hence, there is a greater need for hotel chains to be expanding the number of hotels that they operate.

Do you think any of the potential problems for an organisation in having an input supplied externally would be alleviated if: (i) It was known that the organisation would be seeking to have the input supplied externally in many future time periods; or (ii) The organisation used multiple external suppliers to provide the input?

Potential disadvantages of external supply of an input include that the external supplier may, for example, misuse key information, engage in hold-up behaviour or not provide the required quality of non-contractible elements of the input being supplied. i

The incentive of the external supplier to take these types of actions will be lower where the supplier is concerned about repeat business from the firm to which they are supplying the input. For example, the external supplier will have a greater incentive to provide a high quality input where they believe there is a possibility of being a supplier in the future, compared to where the current period is the only time period for which the external supplier will supply the input.

ii The incentive of the external supplier to take these types of actions will be lower where the supplier is concerned that the firm could use an alternative supplier for the inputs it requires.

Case 8.7 The ups and downs of supply in Australia’s iron ore industry Summary This case study uses the example if the iron ore industry in Australia to show how it is possible to construct a long-run market supply curve for a perfectly competitive market.

Suggested answers 1

Suppose all firms in the iron ore industry in Australia have costs that are described by the examples in Figure 8.7.2. The industry includes two firms with low costs the same as Rio Tinto, three firms with middle-ranked costs the same as Fortescue, and two firms with high costs the same as Mount Gibson. Draw the long-run market supply curve for the industry.

Long run market supply curve for iron ore P

P3

P2

P1

Q R 2q1

2

R F 2q2 +3q2

R

F

M

2q3 + 3q3 + 2q3

In his 2012 book Economics is Everywhere, Dan Hamermesh describes a recent development in the radiology industry and the dramatic effect on the cost structure of firms in the industry from that development. The main development has been electronic storage and transmission of X-ray images. This development has meant that radiology firms no longer need large storage spaces for old X-ray images or to hire couriers to carry the X-rays from their headquarters to doctors’ clinics. a

How are fixed costs and short run marginal costs of supplying radiology services likely to differ between production methods without (‘old method’) and with (‘new method’) computer storage and online transmission of X-ray images?

The new method will have a lower FC and a lower SRMC than the old method. The lower FC is because radiology businesses can ‘stop leasing the huge warehouse in which it stores old films’. The lower SRMC is because ‘there is no need for couriers to carry films from the radiologists’ headquarters to the offices of treating physicians (doctors)’. Hence the SR average cost for the new method will be below the SR average cost for the old method at all quantities.

$ SRACold

SRACnew

Q

b Assume that the market for radiology services is perfectly competitive. Suppose that the industry is initially in long-run equilibrium with all firms using the old method of production. Then the new method of production becomes available. i

Describe the process of adjustment in the industry from the initial long-run equilibrium to a new long-run equilibrium where firms are using the new method of production.

The firm and market begin in LR equilibrium. This is represented as point A in the graph below. The equilibrium market price and quantity traded, P1*and Q1*, are determined by market demand and SR market supply. At price P1* a firm chooses the profit-maximising quantity q1*. The firm earns zero profits because P1*= SRAC1(q1*).

Following the introduction of the new technology for any firm there is a decrease in SRMC (from SRMC1 to SRMC2) and a decrease in SRAC (from SRAC1 to SRAC2).

The decrease in SRMC will cause an increase in the SR market supply (from SRS 1 to SRS2). That increase in market supply will cause a decrease in the price to P2*. The profit-maximising quantity for the firm becomes q2*, and the market quantity traded becomes Q2*. The firm is making positive profits equal to: q2*(P2* – SRAC2(q2*)).

The outcomes in the market and for the firm are represented by point B in the graph below.

Because the firm is earning positive economic profits, new firms will be induced to enter the market. This will increase the SR market supply. New entry will continue until the firm again earns zero profits. This happens when SR market supply has increased to SRS3, where the equilibrium price is P3*. The firm maximises its profits by choosing a quantity q3*. It earns zero profits since P3*= SRAC2(q3*). The market quantity traded is Q3*. These outcomes for the firm and in the market are represented by point C. The outcomes again constitute a long-run equilibrium.

SRMC1

$

SRAC1

SRS2

SRMC2

A

A

SRAC2

●

P1* P2* P3*

SRS1

P

SRS3

●

P1*

●

ii

●

●

●

B

B

C

C

D q

How Q1*Q2*Q3* does the new long-run equilibrium differ from the initial long-run equilibrium?

Specifically, what is the effect on the market equilibrium price, market quantity traded, and the quantity supplied per firm? q1* q3* q2*

The introduction of the new technology causes: •

a decrease in the equilibrium price (because the new technology lowers costs, and firms must earn zero profits in LR equilibrium)

•

an increase in the market quantity traded (because there has been an increase in market supply)

•

an increase in the quantity supplied by each firm (FC and SMRC are both decreased by the new technology. Hence SRAC is minimised at a higher quantity when the new technology is introduced. Therefore the firm’s output will be higher in the new LR equilibrium)

•

the number of firms increases.

Case 8.8 Can game theory make you a game show champion?

Summary This case study illustrates the concept of dominant strategies in strategic situations, using the example of players choosing strategies in the game show ‘Friend or Foe’.

Q

Suggested answers 1

The market for cigarettes in a country is dominated completely by two firms, Chokoe Ltd and Fumed Lungs Ltd. The market size is fixed at $8 billion. Each firm can choose whether to advertise or not. Advertising costs $1 billion for each firm that advertises. If one firm advertises and the other does not, then the firm advertising captures the whole market. If both firms advertise, they split the market 50:50 and pay for their respective advertising. If neither advertises, they split the market 50:50 but without the expense of advertising. a

Draw a game table to describe this game.

Game table: Fumed lungs Advertise Chokoe

Not advertise

Advertise

$3 billion, $3 billion $7 billion, $0

Not advertise

$0, $7 billion

$4 billion, $4 billion

b What strategy would you advise Fumed Lungs Ltd to follow?

Fumed Lungs has a strict dominant strategy to choose ‘Advertise’. c

What would you predict will be the strategy chosen by each firm?

Each firm has a strict dominant strategy to choose ‘Advertise’. d Is there an outcome that would make both firms better off? Why aren’t they able to achieve this outcome?

Both firms would be better off if they both chose ‘Not advertise’. However, it is not individually rational for either firm to choose this strategy. For example, if Chokoe really believed that Fumed Lungs was going to choose ‘Not advertise’, it can always do better by choosing ‘Advertise’.

2

Alan Accountant and Edwina Economist are advising their friend Ignatius from ICAC. The advice is about whether an individual whose behaviour ICAC is examining, Ned Kelly, might have acted corruptly by seeking to lobby a political party, TrueBlue. It is known that Ned Kelly would like a subsidy for his business to be approved. For the subsidy to be approved it is necessary for both TrueBlue, and the other major political party, SimplyRed, to support the subsidy. It is known that, in the absence of lobbying by Ned Kelly, the pay-offs to TrueBlue and SimplyRed are:

SimplyRed TrueBlue

Support

Not support

Support

40, 40

40, 20

Not support

50, 50

50, 40

It is also known that, if Ned Kelly lobbies TrueBlue, then it increases its pay-off from supporting the proposal by 20.

Alan Accountant says: ‘I do not think that Ned Kelly has tried to lobby TrueBlue.

This is because he didn’t need to. Even without lobbying there is dominant strategy for each political party to choose to support the subsidy.’ Edwina Economist disagrees: ‘I believe that Ned Kelly had an incentive to lobby TrueBlue. Without lobbying the subsidy would not be approved. But with the subsidy both political parties will support it.’ Who do you believe is correct, Edwina or Alan? Explain your answer.

Either with or without lobbying, SimplyRed does have a dominant strategy to ‘Support’. Therefore, whether the proposal is supported will depend on TrueBlue. In the absence of lobbying, True Blue does not have a dominant strategy to choose ‘Support’, and hence the proposal will not be supported. With lobbying, True Blue does have a dominant strategy to choose ‘Support’, and hence the proposal will be supported. Therefore there is an incentive for Ned Kelly to lobby. Hence Edwina is correct and Alan is incorrect.

3

Lygon Street is the restaurant capital of Melbourne. Tourists and locals flock there for the mix and quality of cuisine that is available. There is, however, one thing that visitors to Lygon Street don’t like: spruikers, those pesky salespeople who stand outside a restaurant trying to lure customers. An article in The Age (2010) described how, responding to public discontent about spruiking, the owners of eight restaurants on Lygon Street had met and agreed to ban spruiking. But the agreement did not last long. The article describes how only the day after the agreement had been made, one of the restaurants, Sale e Pepe, had put a spruiker back on the street.

Suppose that there are two restaurants in Lygon Street. On each day they operate they must make a choice between ‘Spruik’ or ‘Not spruik’. Neither restaurant observes the choice made by the other restaurant prior to making its own choice. a

Draw a game table showing this game, including pay-offs, so that it is a strict dominant strategy for each restaurant to choose ‘Spruik’.

Restaurant 2 Restaurant 1

Spruik

Not spruik

Spruik

5, 5

10, 0

Not spruik

0, 10

8, 8

(Note: The game table should have two players, each making a choice between ‘Spruik’ and ‘Not spruik’. Obviously it is then OK to have any pay-offs – as long as they are chosen so that it is a strict dominant strategy to choose ‘Spruik’.) b Could this game be described as an example of a prisoners’ dilemma?

Yes, this is an example of the prisoners’ dilemma. There is an outcome that would be mutually beneficial for both restaurants and which maximises the total pay-off – This is where both restaurants choose to ‘Not spruik’. However, we would not predict that this outcome will occur because both restaurants have a strict dominant strategy to choose to ‘Spruik’. When both restaurants choose to ‘Spruik’ then the pay-off to both is less than if they had been able to commit to choose to ‘Not spruik’.

4

In the 2012 US Presidential election it is estimated that $7.4 billion was spent on TV and radio advertising. All this spending, however, may have had little effect on the outcome of the election. As The Economist (2012) noted: ‘Vast sums have been spent on TV advertising, mostly cancelling each other out.’ An expert commentator, Lynn Vavreck from UCLA, describes the election spending as a ‘stalemate’; arguing that the Presidential candidates were mainly spending in order to neutralise the effects of their opponent’s advertising. a

How could you represent as a simultaneous game the choices made by Presidential candidates about the amounts of advertising to support their campaigns?

In the game table below the two Presidential candidates have been represented as each making a choice between a ‘Low’ and a ‘High’ level of advertising. Pay-offs in the game table are the shares of votes won by each candidate.

Obama

Romney

Low budget advertising

High budget advertising

Low budget advertising

50, 50

0, 100

High budget advertising

100, 0

50, 50

b How would you describe the pay-offs from alternative amounts of advertising so that the predicted outcome is for both candidates to spend large amounts on advertising?

The pay-offs have been chosen so that it is a strict dominant strategy for each candidate to choose a ‘High’ level of advertising. This is despite the fact that the payoffs are also consistent with the statement made that when both candidates spend large amounts on advertising they will cancel out each other. c

Can this strategic situation where Presidential candidates make choices of amounts of advertising be described as a prisoners’ dilemma game?

Yes, this situation can be described as a prisoners’ dilemma. When each candidate adopts the high-budget advertising strategy they each obtain 50 per cent of the votes and must pay for the advertising. But they could each obtain exactly the same share of the votes, and pay a much smaller amount of money, if they were to adopt the lowbudget advertising strategy. In other words, the candidates would be better off if they could agree to both choose the low advertising budget. The dilemma is that they can never make this commitment in a credible way. As soon as one candidate believes that the other candidate will choose the low-advertising-budget strategy, then the other candidate can make himself better off by choosing the high-advertising-budget strategy, which will mean he wins 100 per cent of the vote. This strategic situation has the same structure as the prisoners’ dilemma. The dominant strategy equilibrium gives an outcome that is inferior for both participants to an alternative outcome – but as long as the participants are rational they will never be able to coordinate on that strategy.

Case 8.9 Beauty or computer skills: Which will most increase your pay?

Summary This case study discusses why labour market earnings differ between individual workers, with a particular focus on the effects of physical beauty and computer skills.

Suggested answers 1

Use a demand/supply model to represent a perfectly competitive labour market for engineers. a

Under what circumstances would changes in labour demand have no effect on equilibrium wages for engineers? What does this imply about entry to and exit from this occupation?

Changes to labour demand will have no effect on equilibrium wages where labour supply is perfectly elastic with respect to wages (see figure below). Labour supply of engineers will be perfectly elastic where: i

there is potentially a limitless group of workers who can take up the occupation of being an engineer

ii entry to and exit from the occupation is costless, and does not affect the opportunity cost of being an engineer.

W

LS LD1

LD2 L

Figure 1

b Suppose that there is an increase in the number of years of education required to qualify as an engineer. How would you represent this in the demand/supply model? What will be the effect on equilibrium wages for engineers?

An increase in the years of education required to qualify as an engineer will raise the opportunity cost of becoming an engineer. The minimum wage at which individuals are willing to work as engineers will therefore increase by this amount, and there will be an upward shift of the labour supply curve by that same amount. Hence (see figure below) there will be an increase in the equilibrium wage equal to the increase in opportunity cost.

W

Increased opportunity cost due to extra years of education required W2

LS2

W1

LS1 LD

L Figure 2

c

Suppose that changes to the location of mining activities mean that engineers now work in locations that are less remote. How would you represent this in the demand/supply model? What will be the effect on equilibrium wages for engineers?

Moving to less remote locations should reduce the disamenity associated with being an engineer, and hence lower the opportunity cost of working as an engineer. The minimum wage at which individuals are willing to work as engineers will therefore decrease by this amount, and there will be an downward shift of the labour supply curve by that same amount. Hence (see figure below) there will be a decrease in the equilibrium wage equal to the increase in opportunity cost.

W

Decrease in opportunity cost due to moving to less remote locations W1

LS1

W2

LS2 LD

L Figure 3

2

Can you think of other factors – similar to using a pencil at work or sitting at a desk at work – that would have a statistical relation to a worker’s earnings, but are not actually characteristics that make the worker more productive?

Another example might be wearing a suit and/or tie at work. This will be correlated with being in a white-collar occupation, which tend to be higher paid than blue-collar occupations. However, it is difficult to think that wearing a suit makes a worker more productive; rather, it is being in a white-collar occupation that means a worker is likely to be required to wear a suit.

3

Economists think that workers’ earnings will be related to their productivity or human capital. You are going to undertake a statistical study to test this hypothesis. Ideally, what information about workers would you like to be able to include to represent their human capital?

There are generally regarded as being three main sources of human capital: genetic ability schooling and on-the-job training. Hence, ideally, it might be possible to obtain measures of all these components; for example, on aspects of schooling such as years of schooling, highest qualification obtained and field of main qualification.

Case 8.10 Superstars and the growing incomes of the very rich Summary This case study describes ‘superstar’ markets where earnings and market share are disproportionately concentrated on the most talented performers, and evaluates why superstars’ earnings seem to have grown so rapidly in recent times.

Suggested answers 1

It has been suggested that improvements in communications technology will soon enable a surgeon to advise on an operation that is being performed in another location in real time. How do you expect that this will affect the distribution of earnings among the world’s most talented surgeons?

Improvements in ICT of this type will expand the size of market available to top surgeons, and hence would be likely to make the distribution of earnings more concentrated among top surgeons.

2

In recent years, buying power in some markets, such as for commercial trial lawyers, is argued to have become more concentrated with a small number of large corporations that place a very high value on the services of those lawyers. How do you think this has affected the distribution of earnings among trial lawyers?

Where demand for services of trial lawyers becomes more concentrated among a group of buyers who have a relatively strong preference for high quality lawyers, this would be expected to increase the market share and earnings of those high quality trial lawyers.

3

MOOCs (massive open online courses) provide the scope for a university lecturer to teach to much greater numbers of students. What effect do you think the introduction of MOOCs will have on the market for university lecturers – and especially on the distribution of pay between lecturers?

The scope for an individual university lecturer to teach a larger number of students might cause an increase in demand for the services of lecturers who are regarded as the most effective or of the highest quality, and a decrease in demand for services of other lecturers. The proportion of students taught (face to face or online) by the most effective lecturers would increase, and by other lecturers would decrease. Hence the pay of the most effective lecturers would be expected to increase, and the pay and amount of employment of other lecturers would decrease.

4

In many sporting contests, such as tennis and golf tournaments, the difference in prize money from one finishing position to another decreases as you go down the placings. For example, the gap in prize money between first prize and second prize in most professional golf tournaments is larger than between the second prize and third prize. How might this pattern of increasing gaps in prize money be designed to provide appropriate incentives for effort by participants in the contests? How could this type of payment scheme give rise to a superstar-type market?

This prize structure could be argued to provide incentives for contestants to continue to exert effort as they proceed through a tournament. If a player enters a first-round match in a tournament and wins, the ‘prize’ includes getting to the second round, plus the possibility of moving through all the subsequent rounds. But by the time a player reaches a semi-final, the ‘prize’ will just be the value of getting to the next round, the final. Hence, if the prize money for winning each extra round in a tournament is equal, the financial incentive to win each round diminishes as a player moves from the first round through to the semi-final. One way to preserve the same incentive to win rounds throughout the whole tournament is to increase the size of gap in prize money for winning rounds. (See Sherwin Rosen, 1986, ‘Prizes and incentives in elimination tournaments’, American Economic Review, 76, 701–15.) Having a distribution of prize money where higher-placed contestants receive a disproportionate share of prize money could be another way in which superstar-type labour markets occur in professional sport.