Game theory v. price theory

1
Game theory v. price theory
2
Game theory

• Focus strategic interactions between
  individuals.
• Tools Game trees, payoff matrices, etc.
• Outcomes In many cases the predicted outcomes
  are Pareto inefficient.
• But remember the Coase Theorem!

3
Price theory

• Focus market interactions between many
  individuals.
• Tools supply and demand curves
• Outcomes In many cases the predicted outcomes
  are Pareto efficient. (This is the working of the
  invisible hand.)
• But remember the underlying assumptions and what
  can go wrong

4
Assumptions of price theory

• Each buyer and seller is small relative to the
  size of the market as a whole, and so each buyer
  and seller is a price-taker who takes the market
  price as given.
• Complete markets there are markets for all goods
  (and therefore no externalities).
• Complete information Buyers and sellers have no
  private information.

5
Price-taking assumption

• Each buyer and seller is small relative to the
  size of the market as a whole, and so each buyer
  and seller is a price-taker who takes the market
  price as given.
• If this assumption is not met, some buyers and/or
  sellers have market power, e.g., monopoly,
  monopsony, duopoly, etc.
• Resulting inefficiencies?

6
Complete markets assumption

• Complete markets there are markets for all goods
  (and therefore no externalities).
• If this assumption is not met, there are
  externalities, either positive or negative.
• Resulting inefficiencies?

7
Complete information assumption

• Complete information Buyers and sellers have no
  private information.
• If this assumption is not met, there can be
  asymmetric information.
• Resulting inefficiencies?
• Example the market for lemons (from Akerlofs
  Nobel Prize-winning paper)

8
The market for lemons

• Consider a used car market in which sellers know
  the quality of their car, but buyers cannot tell
  if a given car is a peach or a lemon.
• What is the effect of this asymmetric information
  on the market?
• Until Akerlofs paper, economists thought that
  there was no major effect.

9
A numerical example

• Imagine that sellers cars are equally divided
  among 4 values 4800 (the peaches), 2300,
  1500, and 1000 (the lemons).
• Buyers cannot distinguish between them, so
  theyre only willing to pay the average value
  (i.e., expected value) for a used car.
• What is the expected value if all 4 types of cars
  are sold?

10
Expected value if 1000/1500/ 2300/4800 cars
are all sold?

• 1500
• 2000
• 2400
• 2800
• 3300
• 4200

11
A numerical example

• Sellers cars are equally divided among 4 values
  4800 (the peaches), 2300, 1500, and 1000 (the
  lemons).
• If all 4 types of cars are sold, buyers are only
  willing to pay the average value (i.e., expected
  value) for a used car 2400.
• But sellers of 4800 cars (the peaches) wont
  sell for this amount!

12
A numerical example

• We cant have a market where all 4 types of cars
  are sold, but maybe we can have a market where 3
  types are sold 2300, 1500, and 1000 (the
  lemons).
• Again, buyers are only willing to pay the average
  value (i.e., expected value). What is that value
  if cars are equally divided between these 3 types?

13
Expected value if 1000/1500/ 2300 cars are all
sold?

• 1000
• 1200
• 1400
• 1600
• 1800
• 2000

14
A numerical example

• We cant have a market where even 3 types of cars
  are sold, but maybe we can have a market where 2
  types are sold 1500, and 1000 (the lemons).
• Again, buyers are only willing to pay the average
  value (i.e., expected value). What is that value
  if cars are equally divided between these 2 types?

15
Expected value if 1000/1500/ cars are all sold?

• 1100
• 1250
• 1400

16
The market for lemons

• In the numerical example, we have complete
  unraveling and only the worst-quality cars (the
  lemons) are sold. This is called adverse
  selection because the cars that are sold appear
  to be selected adversely.
• A more important example of adverse selection
  health insurance.

17
A numerical example

• Imagine that consumers likely health care
  expenditures are equally divided among 4 values
  200, 2700, 3500, and 4000.
• Insurance companies cannot distinguish between
  them, so in order to avoid losing money they have
  to charge at least the average cost for health
  insurance.
• Who are the peaches and who are the lemons?

18
Who are the peaches and who are the lemons?

• Peaches are 200, lemons are 4000.
• Peaches are 4000, lemons are 200.

19
A numerical example

• Consumers likely health care expenditures are
  equally divided among 4 values 200, 2700,
  3500, and 4000.
• If all 4 types of consumers buy health insurance,
  companies have to charge at least the average
  cost, ¼(200)¼(2700) ¼(3500)¼(4000) 2600.
• But the peaches wont pay that much!

20
A numerical example

• So maybe we can have a market where 3 types buy
  insurance 2700, 3500, and 4000.
• Again, insurance companies have to charge at
  least the average cost, which is
  1/3(2700)1/3(3500)1/3(4000)3400.
• Again, the low cost buyers will choose to
  self-insure.

21
A numerical example

• We cant have a market where even 3 types of
  consumers buy insurance, but maybe we can have a
  market with 2 types are sold 3500 and 4000
  (the lemons).
• But insurance companies must charge at least the
  average cost (3750) and at this price the
  lower-cost consumers will self-insure, leaving
  only the lemons.

22
Assumptions of price theory

• Each buyer and seller is small relative to the
  size of the market as a whole, and so each buyer
  and seller is a price-taker who takes the market
  price as given.
• Complete markets there are markets for all goods
  (and therefore no externalities).
• Complete information Buyers and sellers have no
  private information.