Microeconomics is a branch of economics that
studies the behavior of individuals and small
impacting organizations in making decisions
on the allocation of limited resources.
Typically, it applies to markets where goods
or services are bought and sold.
Microeconomics examines how these decisions
and behaviors affect the supply and demand
for goods and services, which determines prices,
and how prices, in turn, determine the quantity
supplied and quantity demanded of goods and
services.
This is in contrast to macroeconomics, which
involves the "sum total of economic activity,
dealing with the issues of growth, inflation,
and unemployment."
Microeconomics also deals with the effects
of national economic policies on the aforementioned
aspects of the economy.
Particularly in the wake of the Lucas critique,
much of modern macroeconomic theory has been
built upon 'microfoundations'—i.e. based
upon basic assumptions about micro-level behavior.
One of the goals of microeconomics is to analyze
market mechanisms that establish relative
prices amongst goods and services and allocation
of limited resources amongst many alternative
uses.
Microeconomics analyzes market failure, where
markets fail to produce efficient results,
and describes the theoretical conditions needed
for perfect competition.
Significant fields of study in microeconomics
include general equilibrium, markets under
asymmetric information, choice under uncertainty
and economic applications of game theory.
Also considered is the elasticity of products
within the market system.
Assumptions and definitions
The fundamentals of Microeconomics lies in
the analysis of the preference relations.
Preference relations are defined simply to
be a set of different choices that an actor
can choose that actors can also compare between
any two bundles of choices In order to analyze
the problem further, the assumption of transitivity
is added to the mix.
These two assumptions of completeness and
transitivity that are imposed upon the preference
relations are what is termed rationality.
Microeconomic analysis are conducted mainly
through imposition of additional constraints
on the preference relations or even relaxation
of the above stated assumptions although such
relaxation makes the problem much harder to
analyze.
The theory of supply and demand usually assumes
that markets are perfectly competitive.
This implies that there are many buyers and
sellers in the market and none of them have
the capacity to significantly influence prices
of goods and services.
In many real-life transactions, the assumption
fails because some individual buyers or sellers
have the ability to influence prices.
Quite often, a sophisticated analysis is required
to understand the demand-supply equation of
a good model.
However, the theory works well in situations
meeting these assumptions.
Mainstream economics does not assume a priori
that markets are preferable to other forms
of social organization.
In fact, much analysis is devoted to cases
where so-called market failures lead to resource
allocation that is suboptimal by some standard.
In such cases, economists may attempt to find
policies that avoid waste, either directly
by government control, indirectly by regulation
that induces market participants to act in
a manner consistent with optimal welfare,
or by creating "missing markets" to enable
efficient trading where none had previously
existed.
This is studied in the field of collective
action and public choice theory.
"Optimal welfare" usually takes on a Paretian
norm, which in its mathematical application
of Kaldor–Hicks method.
This can diverge from the Utilitarian goal
of maximizing utility because it does not
consider the distribution of goods between
people.
Market failure in positive economics is limited
in implications without mixing the belief
of the economist and their theory.
The demand for various commodities by individuals
is generally thought of as the outcome of
a utility-maximizing process, with each individual
trying to maximize their own utility under
a budget constraint and a given consumption
set.
Microeconomic topics
The study of microeconomics involves several
"key" areas:
Demand, supply, and equilibrium
Supply and demand is an economic model of
price determination in a market.
It concludes that in a competitive market,
the unit price for a particular good will
vary until it settles at a point where the
quantity demanded by consumers will equal
the quantity supplied by producers resulting
in an economic equilibrium for price and quantity.
Measurement of elasticities
Elasticity is the measurement of how responsive
an economic variable is to a change in another
variable.
Elasticity can be quantified as the ratio
of the percentage change in one variable to
the percentage change in another variable,
when the latter variable has a causal influence
on the former.
It is a tool for measuring the responsiveness
of a variable, or of the function that determines
it, to changes in causative variables in a
unitless way.
Frequently used elasticities include price
elasticity of demand, price elasticity of
supply, income elasticity of demand, elasticity
of substitution between factors of production
and elasticity of intertemporal substitution.
Consumer demand theory
Consumer demand theory relates preferences
for the consumption of both goods and services
to the consumption expenditures; ultimately,
this relationship between preferences and
consumption expenditures is used to relate
preferences to consumer demand curves.
The link between personal preferences, consumption
and the demand curve is one of the most closely
studied relations in economics.
It is a way of analyzing how consumers may
achieve equilibrium between preferences and
expenditures by maximizing utility subject
to consumer budget constraints.
Theory of production
Production theory is the study of production,
or the economic process of converting inputs
into outputs.
Production uses resources to create a good
or service that is suitable for use, gift-giving
in a gift economy, or exchange in a market
economy.
This can include manufacturing, storing, shipping,
and packaging.
Some economists define production broadly
as all economic activity other than consumption.
They see every commercial activity other than
the final purchase as some form of production.
Costs of production
The cost-of-production theory of value is
the price of an object or condition is determined
by the sum of the cost of the resources that
went into making it.
The cost can comprise any of the factors of
production: labour, capital, land.
Technology can be viewed either as a form
of fixed capital or circulating capital.
Perfect competition
Perfect competition describes markets such
that no participants are large enough to have
the market power to set the price of a homogeneous
product.
An example is Ebay.
Perfect monopoly
A monopoly + polein πωλεῖν) exists
when a single company is the only supplier
of a particular commodity.
Oligopoly
An oligopoly is a market form in which a market
or industry is dominated by a small number
of sellers.
Oligopolies can result from various forms
of collusion which reduce competition and
lead to higher costs for consumers.
Market structure
The market structure can have severL types
of interacting market systems.
Different forms of markets is a feature of
capitalism and advocates of socialism often
criticize markets and aim to substitute markets
with economic planning to varying degrees.
Competition is the regulatory mechanism of
the market system.
Monopolistic competition, also called competitive
market, where there is a large number of firms,
each having a small proportion of the market
share and slightly differentiated products.
Oligopoly, in which a market is run by a small
number of firms that together control the
majority of the market share.
Duopoly, a special case of an oligopoly with
two firms.
Monopsony, when there is only one buyer in
a market.
Oligopsony, a market where many sellers can
be present but meet only a few buyers.
Monopoly, where there is only one provider
of a product or service.
Natural monopoly, a monopoly in which economies
of scale cause efficiency to increase continuously
with the size of the firm.
A firm is a natural monopoly if it is able
to serve the entire market demand at a lower
cost than any combination of two or more smaller,
more specialized firms.
Perfect competition, a theoretical market
structure that features no barriers to entry,
an unlimited number of producers and consumers,
and a perfectly elastic demand curve.
Examples of markets include but are not limited
to: commodity markets, insurance markets,
bond markets, energy markets, flea markets,
debt markets, stock markets, online auctions,
media exchange markets, real estate market.
Game theory
Game theory is a major method used in mathematical
economics and business for modeling competing
behaviors of interacting agents.
Applications include a wide array of economic
phenomena and approaches, such as auctions,
bargaining, mergers & acquisitions pricing,
fair division, duopolies, oligopolies, social
network formation, agent-based computational
economics, general equilibrium, mechanism
design,and voting systems, and across such
broad areas as experimental economics, behavioral
economics, information economics, industrial
organization, and political economy.
Labour economics
Labour economics seeks to understand the functioning
and dynamics of the markets for wage labour.
Labour markets function through the interaction
of workers and employers.
Labour economics looks at the suppliers of
labour services, the demands of labour services,
and attempts to understand the resulting pattern
of wages, employment, and income.
In economics, labour is a measure of the work
done by human beings.
It is conventionally contrasted with such
other factors of production as land and capital.
There are theories which have developed a
concept called human capital, although there
are also counter posing macro-economic system
theories that think human capital is a contradiction
in terms.
Welfare economics
Welfare economics is a branch of economics
that uses microeconomic techniques to evaluate
well-being from allocation of productive factors
as to desirability and economic efficiency
within an economy, often relative to competitive
general equilibrium.
It analyzes social welfare, however measured,
in terms of economic activities of the individuals
that compose the theoretical society considered.
Accordingly, individuals, with associated
economic activities, are the basic units for
aggregating to social welfare, whether of
a group, a community, or a society, and there
is no "social welfare" apart from the "welfare"
associated with its individual units.
Economics of information
Information economics or the economics of
information is a branch of microeconomic theory
that studies how information and information
systems affect an economy and economic decisions.
Information has special characteristics.
It is easy to create but hard to trust.
It is easy to spread but hard to control.
It influences many decisions.
These special characteristics complicate many
standard economic theories.
Opportunity cost
Opportunity cost of an activity is equal to
the best next alternative uses/foregone.
Although opportunity cost can be hard to quantify,
the effect of opportunity cost is universal
and very real on the individual level.
In fact, this principle applies to all decisions,
not just economic ones.
Opportunity cost is one way to measure the
cost of something.
Rather than merely identifying and adding
the costs of a project, one may also identify
the next best alternative way to spend the
same amount of money.
The forgone profit of this next best alternative
is the opportunity cost of the original choice.
A common example is a farmer that chooses
to farm their land rather than rent it to
neighbors, wherein the opportunity cost is
the forgone profit from renting.
In this case, the farmer may expect to generate
more profit alone.
This kind of reasoning is a very important
part of the calculation of discount rates
in discounted cash flow investment valuation
methodologies.
Similarly, the opportunity cost of attending
university is the lost wages a student could
have earned in the workforce, rather than
the cost of tuition, books, and other requisite
items.
Note that opportunity cost is not the sum
of the available alternatives, but rather
the benefit of the single, best alternative.
Possible opportunity costs of a city's decision
to build a hospital on its vacant land are
the loss of the land for a sporting center,
or the inability to use the land for a parking
lot, or the money that could have been made
from selling the land, or the loss of any
of the various other possible uses — but
not all of these in aggregate.
The true opportunity cost would be the forgone
profit of the most lucrative of those listed.
One question that arises here is how to determine
a money value for each alternative to facilitate
comparison and assess opportunity cost, which
may be more or less difficult depending on
the things we are trying to compare.
For example, many decisions involve environmental
impacts whose monetary value is difficult
to assess because of scientific uncertainty.
Valuing a human life or the economic impact
of an Arctic oil spill involves making subjective
choices with ethical implications.
It is imperative to understand that no decision
on allocating time is free.
No matter what one chooses to do, they are
always giving something up in return.
An example of opportunity cost is deciding
between going to a concert and doing homework.
If one decides to go the concert, then they
are giving up valuable time to study, but
if they choose to do homework then the cost
is giving up the concert.
Any decision in allocating capital is likewise:
there is an opportunity cost of capital, or
a hurdle rate, defined as the expected rate
one could get by investing in similar projects
on the open market.
Opportunity cost is vital in understanding
microeconomics and decisions that are made.
Applied microeconomics
Applied microeconomics includes a range of
specialized areas of study, many of which
draw on methods from other fields.
Industrial organization examines topics such
as the entry and exit of firms, innovation,
and the role of trademarks.
Labor economics examines wages, employment,
and labor market dynamics.
Financial economics examines topics such as
the structure of optimal portfolios, the rate
of return to capital, econometric analysis
of security returns, and corporate financial
behavior.
Public economics examines the design of government
tax and expenditure policies and economic
effects of these policies.
Political economy examines the role of political
institutions in determining policy outcomes.
Health economics examines the organization
of health care systems, including the role
of the health care workforce and health insurance
programs.
Urban economics, which examines the challenges
faced by cities, such as sprawl, air and water
pollution, traffic congestion, and poverty,
draws on the fields of urban geography and
sociology.
Law and economics applies microeconomic principles
to the selection and enforcement of competing
legal regimes and their relative efficiencies.
Economic history examines the evolution of
the economy and economic institutions, using
methods and techniques from the fields of
economics, history, geography, sociology,
psychology, and political science.
Development
Traditional marginalism
The modern field of microeconomics arose as
an effort of neoclassical economics school
of thought to put economic ideas into mathematical
mode.
An early attempt was made by Antoine Augustine
Cournot in Researches on the Mathematical
Principles of the Theory of Wealth in describing
a spring water duopoly that now bears his
name.
Later, William Stanley Jevons's Theory of
Political Economy, Carl Menger's Principles
of Economics, and Léon Walras's Elements
of Pure Economics: Or the theory of social
wealth gave way to what was called the Marginal
Revolution.
Some common ideas behind those works were
models or arguments characterized by rational
economic agents maximizing utility under a
budget constrain.
This arose as a necessity of arguing against
the labour theory of value associated with
classical economists such as Adam Smith, David
Ricardo and Karl Marx.
Walras also went as far as developing the
concept of general equilibrium of an economy.
Alfred Marshall's textbook, Principles of
Economics was published in 1890 and became
the dominant textbook in England for a generation.
His main point was that Jevons went too far
in emphasizing utility as an attempt to explain
prices over costs of production.
In the book he writes:
"There are few writers of modern times who
have approached as near to the brilliant originality
of Ricardo as Jevons has done.
But he appears to have judged both Ricardo
and Mill harshly, and to have attributed to
them doctrines narrower and less scientific
than those they really held.
Also, his desire to emphasize an aspect of
value to which they had given insufficient
prominence, was probably in some measure accountable
for his saying, "Repeated reflection and inquiry
have led me to the somewhat novel opinion
that value depends entirely upon utility."
This statement seems to be no less one-sided
and fragmentary, and much more misleading,
than that into which Ricardo often glided
with careless brevity, as to the dependence
of value on cost of production; but which
he never regarded as more than a part of a
larger doctrine, the rest of which he had
tried to explain.
"
In the same appendix he further states:
"Perhaps Jevons' antagonism to Ricardo and
Mill would have been less if he had not himself
fallen into the habit of speaking of relations
which really exist only between demand price
and value as though they held between utility
and value; and if he had emphasized as Cournot
had done, and as the use of mathematical forms
might have been expected to lead him to do,
that fundamental symmetry of the general relations
in which demand and supply stand to value,
which coexists with striking differences in
the details of those relations.
We must not indeed forget that, at the time
at which he wrote, the demand side of the
theory of value had been much neglected; and
that he did excellent service by calling attention
to it and developing it.
There are few thinkers whose claims on our
gratitude are as high and as various as those
of Jevons: but that must not lead us to accept
hastily his criticisms on his great predecessors."
Marshall's idea of solving the controversy
was that the demand curve could be derived
by aggregating individual consumer demand
curves, which were themselves based on the
consumer problem of maximizing utility.
The supply curve could be derived by superimposing
a representative firm supply curves for the
factors of production and then market equilibrium
would be given by the intersection of demand
and supply curves.
He also introduced the notion of different
market periods: mainly short run and long
run.
This set of ideas gave way to what economists
call perfect competition, now found in the
standard microeconomics texts, even though
Marshall himself had stated:
"The process of substitution, of which we
have been discussing the tendencies, is one
form of competition; and it may be well to
insist again that we do not assume that competition
is perfect.
Perfect competition requires a perfect knowledge
of the state of the market; and though no
great departure from the actual facts of life
is involved in assuming this knowledge on
the part of dealers when we are considering
the course of business in Lombard Street,
the Stock Exchange, or in a wholesale Produce
Market; it would be an altogether unreasonable
assumption to make when we are examining the
causes that govern the supply of labour in
any of the lower grades of industry.
For if a man had sufficient ability to know
everything about the market for his labour,
he would have too much to remain long in a
low grade.
The older economists, in constant contact
as they were with the actual facts of business
life, must have known this well enough; but
partly for brevity and simplicity, partly
because the term "free competition" had become
almost a catchword, partly because they had
not sufficiently classified and conditioned
their doctrines, they often seemed to imply
that they did assume this perfect knowledge.
"
An early formulation of the concept of production
functions is due to Johann Heinrich von Thünen,
which presented an exponential version of
it.
The standard Cobb–Douglas production function
found in microeconomics textbooks refers to
a collaborative paper between Charles Cobb
and Paul Douglas published in 1928 in which
they analyzed U.S. manufacturing data using
this function as the basis of a regression
analysis for estimating the relationship between
inputs and output: this discussion takes place
through the concept of marginal productivity.
The mathematical form of the Cobb–Douglas
function can be found in the prior work of
Wicksell, Thünen, and Turgot.
Jacob Viner presented an early procedure for
constructing cost curves in his “Cost Curves
and Supply Curves”, the paper was an attempt
to reconcile two streams of thought when dealing
with this issue at the time: the idea that
supplies of factors of production were given
and independent of rate of remuneration or
dependent on rate of remuneration.
Viner argued that, “The differences between
the two schools would not affect qualitatively
the character of the findings,” more specifically,
“...that this concern is not of sufficient
importance to bring about any change in the
prices of the factors as a result of a change
in its output.”
In Viner's terminology—now considered standard—the
short run is a period long enough to permit
any desired output change that is technologically
possible without altering the scale of the
plant—but is not long enough to adjust the
scale of the plant.
He arbitrarily assumes that all factors can,
for the short run, be classified in two groups:
those necessarily fixed in amount, and those
freely variable.
Scale of plant is the size of the group of
factors that are fixed in amount in the short-run,
and each scale is quantitatively indicated
by the amount of output that can be produced
at the lowest average cost possible at that
scale.
Costs associated with the fixed factors are
fixed costs.
Those associated with the variable factors
are direct costs.
Note that fixed costs are fixed only in their
aggregate amounts, and vary with output in
their amount per unit, while direct costs
vary in their aggregate amount as output varies,
as well as in their amount per unit.
The spreading of overhead is therefore a short-run
phenomenon and not to be confused with the
long-run.
He explains that if the law of diminishing
returns holds that output per unit of variable
factor falls as total output rises, and that
if the prices of the factors remain constant—then
average direct costs increase with output.
Also, if atomistic competition prevails—that
is, the individual firm output won't affect
product prices—then the individual firm
short-run supply curve equals the short run
marginal cost curve.
In the long run, the supply curve for industry
can be constructed by summing individual marginal
cost curves abscissas.
He also explains that:
Internal economies of scale are primarily
a long-run phenomenon and are due either to
reductions in the technical coefficients of
production or to discounts resulting from
larger size.
Internal diseconomies of scale can be avoided
by increasing industry output by increasing
the number of plants without increasing the
scale of the plant.
External economies of scale are also either
technical or pecunary, but in this case are
due to the aggregate behavior of the industry,
and refer to the size of output of the industry
as a whole.
External diseconomies of scale may occur if
as industry output rises the unit price of
factors and materials rises as well due to
increasing competition for inputs with other
industries.
It should be made clear that these long-run
results only hold if producer are rational
actors, that is able to optimize their production
so as to have an optimal scale of plant.
Imperfect competition and game theory
In 1929 Harold Hotelling published "Stability
in Competition" addressing the problem of
instability in the classic Cournout model:
Bertrand criticized it for lacking equilibrium
for prices as independent variables and Edgeworth
constructed a dual monopoly model with correlated
demand with also lacked stability.
Hotteling proposed that demand typically varied
continuously for relative prices, not discontinuously
as suggested by the later authors.
Following Sraffa he argued for "the existence
with reference to each seller of groups who
will deal with him instead of his competitors
in spite of difference in price", he also
noticed that traditional models that presumed
the uniqueness of price in the market only
made sense if the commodity was standardized
and the market was a point: akin to a temperature
model in physics, discontinuity in heat transfer
inside a body would lead to instability.
To show the point he built a model of market
located over a line with two sellers in each
extreme of the line, in this case maximizing
profit for both sellers leads to a stable
equilibrium.
From this model also follows that if a seller
is to choose the location of his store so
as to maximize his profit, he will place his
store the closest to his competitor: "the
sharper competition with his rival is offset
by the greater number of buyers he has an
advantage".
He also argues that clustering of stores is
wasteful from the point of view of transportation
costs and that public interest would dictate
more spatial dispersion.
A new impetus was given to the field when
around 1933 Joan Robinson and Edward H. Chamberlin,
published respectively, The Economics of Imperfect
Competition and The Theory of Monopolistic
Competition, introducing models of imperfect
competition.
Although the monopoly case was already exposed
in Marshall's Principles of Economics and
Cournot had already constructed models of
duopoly and monopoly in 1838, a whole new
set of models grew out of this new literature.
In particular the monopolistic competition
model results in a non efficient equilibrium.
Chamberlin defined monopolistic competition
as, "...challenge to traditional viewpoint
of economics that competition and monopoly
are alternatives and that individual prices
are to be explained in terms of one or the
other."
He continues, "By contrast it is held that
most economic situations are composite of
both competition and monopoly, and that, wherever
this is the case, a false view is given by
neglecting either one of the two forces and
regarding the situation as made up entirely
of the other."
Later, some market models were built using
game theory, particularly regarding oligopolies.
A good example of how microeconomics started
to incorporate game theory, is the Stackelberg
competition model published in 1934, which
can be characterized as a dynamic game with
a leader and a follower, and then be solved
to find a Nash Equilibrium.
William Baumol provided in his 1977 paper
the current formal definition of a natural
monopoly where “an industry in which multiform
production is more costly than production
by a monopoly”: mathematically this equivalent
to subadditivity of the cost function.
He then sets out to prove 12 propositions
related to strict economies of scale, ray
average costs, ray concavity and transray
convexity: in particular strictly declining
ray average cost implies strict declining
ray subadditivity, global economies of scale
are sufficient but not necessary for strict
ray subadditivity.
In 1982 paper Baumol defined a contestable
market as a market where "entry is absolutely
free and exit absolutely costless", freedom
of entry in Stigler sense: the incumbent has
no cost discrimination against entrants.
He states that a contestable market will never
have an economic profit greater than zero
when in equilibrium and the equilibrium will
also be efficient.
According to Baumol this equilibrium emerges
endogenously due to the nature of contestable
markets, that is the only industry structure
that survives in the long run is the one which
minimizes total costs.
This is in contrast to the older theory of
industry structure since not only industry
structure is not exogenously given, but equilibrium
is reached without add hoc hypothesis on the
behavior of firms, say using reaction functions
in a duopoly.
He concludes the paper commenting that regulators
that seek to impede entry and/or exit of firms
would do better to not interfere if the market
in question resembles a contestable market.
Externalities and market failure
In 1937, “The Nature of the Firm” was
published by Coase introducing the notion
of transaction costs, which explained why
firms have an advantage over a group of independent
contractors working with each other.
The idea was that there were transaction costs
in the use of the market: search and information
costs, bargaining costs, etc., which give
an advantage to a firm that can internalize
the production process required to deliver
a certain good to the market.
A related result was published by Coase in
his “The Problem of Social Cost”, which
analyses solutions of the problem of externalities
through bargaining, in which he first describes
a cattle herd invading a farmer's crop and
then discusses four legal cases: Sturges v
Bridgman, Cooke v Forbes, Bryant v Lejever,
and Bass v Gregory.
He then states:
"In earlier sections, when dealing with the
problem of rearrangement of legal rights through
the market, it was argued that such a rearrangement
would be made through the market whenever
this would lead to an increase in the value
of production.
But this assumed costless market transactions.
Once the costs of carrying out market transactions
are taken into account it is clear that such
rearrangement of rights will only be undertaken
when the increase in the value of production
consequent upon the rearrangement is greater
than the costs which would be involved in
bringing it about.
When it is less, the granting of an injunction
or the liability to pay damages may result
in an activity being discontinued which would
be undertaken if market transactions were
costless.
In these conditions the initial delimitation
of legal rights does have an effect on the
efficiency with which the economic system
operates.
One arrangement of rights may bring about
a greater value of production than any other.
But unless this is the arrangement of rights
established by the legal system, the costs
of reaching the same result by altering and
combining rights through the market may be
so great that this optimal arrangement of
rights, and the greater value of production
which it would bring, may never be achieved."
This then becomes relevant in context of regulations.
He argues against the Pigovian tradition:
"...The problem which we face in dealing with
actions which have harmful effects is not
simply one of restraining those responsible
for them.
What has to be decided is whether the gain
from preventing the harm is greater than the
loss which would be suffered elsewhere as
a result of stopping the action which produces
the harm.
In a world in which there are costs of rearranging
the rights established by the legal system,
the courts, in cases relating to nuisance,
are, in effect, making a decision on the economic
problem and determining how resources are
to be employed.
It was argued that the courts are conscious
of this and that they often make, although
not always in a very explicit fashion, a comparison
between what would be gained and what lost
by preventing actions which have harmful effects.
But the delimitation of rights is also the
result of statutory enactments.
Here we also find evidence of an appreciation
of the reciprocal nature of the problem.
While statutory enactments add to the list
of nuisances, action is also taken to legalize
what would otherwise be nuisances under the
common law.
The kind of situation which economists are
prone to consider as requiring Government
action is, in fact, often the result of Government
action.
Such action is not necessarily unwise.
But there is a real danger that extensive
Government intervention in the economic system
may lead to the protection of those responsible
for harmful being carried too far."
This period also marks the beginning of mathematical
modeling of public goods with Samuelson's
“The Pure Theory of Public Expenditure”,
in it he gives a set of equations for efficient
provision of public goods, now know as the
Samuelson condition.
He then gives a description of what is know
called the free rider problem:
"However no decentralized pricing system can
serve to determine optimally these levels
of collective consumption.
Other kinds of "voting" or "signaling" would
have to be tried.
But, and this is the point sensed by Wicksell
but perhaps not fully appreciated by Lindahl,
now it is in the selfish interest of each
person to give false signals, to pretend to
have less interest in a given collective consumption
activity than he has, etc."
Around the 1970s the study of market failures
again came into focus with the study of information
asymmetry.
In particular three authors emerged from this
period: Akerlof, Spence, and Stiglitz.
Akerlof considered the problem of bad quality
cars driving good quality cars out of the
market in his classic “The Market for Lemons”
because of the presence of asymmetrical information
between buyers and sellers.
Spence explained that signaling was fundamental
in the labour market, because since employers
can't know beforehand which candidate is the
most productive, a college degree becomes
a signaling device that a firm uses to select
new personnel.
A synthesizing paper of this era is “Externalities
in Economies with Imperfect Information and
Incomplete Markets” by Stiglitz and Greenwald:
the basic model consists of households that
maximize a utility function, firms that maximize
profit—and a government that produces nothing,
collects taxes, and distributes the proceeds.
An initial equilibrium with no taxes is assumed
to exist, a vector x of household consumption
and vector z of other variables that affect
household utilities are defined, a vector
π of profits is defined along with a vector
E of households expenditures.
Since the envelope theorem holds, if the initial
non taxed equilibrium is Pareto optimal then
it follows that the dot products Π and B
must equal each other.
They state:
"Except in the special case where Π and B
exactly cancel each other out, the existence
of these externalities will make the initial
equilibrium inefficient and guarantee the
existence of welfare-improving tax measures."
One application of this result is to the already
mentioned Market for Lemons, which deals with
adverse selection: households buy from a pool
of goods with heterogeneous quality considering
only average quality, since in general the
equilibrium is not efficient, any tax that
raises average quality is beneficial.
Other applications were considered by the
authors, such as tax distortions, signaling,
screening, moral hazard, incomplete markets,
queue rationing, unemployment and rationing
equilibrium.
Behavioral economics
Kahneman and Tversky published a paper in
1979 criticizing the very idea of the rational
economic agent.
The main point is that there is an asymmetry
in the psychology of the economic agent that
gives a much higher value to losses than to
gains.
This article is usually regarded as the beginning
of behavioral economics and has consequences
particularly regarding the world of finance.
The authors summed the idea in the abstract
as follows:
"...In particular, people underweight outcomes
that are merely probable in comparison with
outcomes that are obtained with certainty.
This tendency, called certainty effect, contributes
to risk aversion in choices involving sure
gains and to risk seeking in choices involving
sure losses.
In addition, people generally discard components
that are shared by all prospects under consideration.
This tendency, called the isolation effect,
leads to inconsistent preferences when the
same choice is presented in different forms."
Great Recession and executive compensation
More recently, the Great Recession and the
ongoing controversy on executive compensation
brought the principal–agent problem again
to the center of debate, in particular regarding
corporate governance and problems with incentive
structures .
References
Further reading
External links
Open Source Introduction to Microeconomics
by R. Preston McAfee – California Institute
of Technology
Amosweb.com homepage – online economics
dictionary
X-Lab: A Collaborative Micro-Economics and
Social Sciences Research Laboratory
Micro Economics – the role of microeconomics
in supporting the social fabric of macro economies
Simulations in Microeconomics
http:media.lanecc.edumartinezpMicroHistory.html
– a brief history of microeconomics
