privatevalue auction

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Review of Previous Section (1)
Concepts we introduced
private-value auction common-value auction oral
auction sealed-bid auction English auction
Dutch auction first-price auction second-price
auction
Vickrey auction consumer surplus producer
surplus profits revenue costs winner's curse
market failure
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Review of Previous Section (2)
  Why is it always in the interests of potential
buyers to bid "honestly" in a Vickrey auction,
but not in other types of auctions?   How do we
calculate consumer surplus and producer surplus
from information about bids made and seller costs
in a Vickrey auction?   How does a Vickrey
auction maximize the sum of consumer surplus and
producer surplus?   Why may a Vickrey auction
not maximize the sum of consumer surplus and
producer surplus, if people do not accurately
know the value of the good they are bidding
for?   In what way are Vickrey auction like
posted-offer markets?
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Chapter 2 Three Principles

• Economics is about happiness
•  Incentives matter
• The indifference principle

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3.1 Economics is About Happiness
As economists we start from the assumption that
whatever we observe people doing, they must be
doing it because any other behavior will make
them less happy.
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Feltovich, Nick, Rick Harbaugh, and Ted To
(2002) Too cool for school? signaling and
countersignaling. RAND Journal of Economics,
33(4)630-649.
Why do so many of the smartest students, drop out
of college?
? Three types of people dumb (lots of them),
mediocre and smart. ? Employers are willing to
pay higher wages for ability, but they have
difficulty identifying a potential employees
ability. ? Through interviews, they can
distinuish smart from dumb. But they cannot
identify the mediocre.
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Smart people go to college to distinguish
themselves from the mediocre.
? Mediocre go to college to distinguish
themselves from the dumb, and to get confused
with the smart.
? Dumb would like to go to college to get
confused with the mediocre, but they would fail
out if they did.
D M or S M or
S
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? Smart drop out of college
D M
S
Why dont the mediocre drop out of college? What
have we assumed makes people happy?
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Once one understands the reason why different
people would behave in this way in this
particular context, it opens the door to
understanding similar behavior in quite different
contexts.
The nouveau riche flaunt their wealth the old
rich scorn such displays.
Mediocre students answer the teachers easy
question, while the best students cant be
bothered.
Minor officials prove their status by being
petty, while the truly powerful show their
strength by being helpful.
A person of middling reputation angrily refutes
accusations against his character, while a
highly-respected person does not dignify the
accusations with a response.
Inadequate but wealthy men drive a Porsche, while
the more confident rich guys drive a Honda.
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Modeling Happiness with Utility Functions
We think about happiness in terms of utility, and
we imagine we can measure individual utility with
a unit of measurement that we will call a util.
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Marielas Utility from Soda and Water
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Soda and water are 1 per bottle and Mariela has
10 to spend. What combination of soda and water
maximizes her utility?
Soda and water are 1 per bottle and Mariela has
15 to spend. What combination of soda and water
maximizes her utility?
Soda is 0.50, water is 1 per bottle and Mariela
has 10 to spend. What combination of soda and
water maximizes her utility?
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Soda and water are 1 per bottle and Mariela has
10 to spend. What combination of soda and water
maximizes her utility?
Diminishing marginal utility. The greater the
number of soda or water bottles Mariela is
already consuming, the smaller is the marginal
utility of consuming an extra bottle. Similarly,
the marginal utility of water is smaller the
greater the number she is already consuming.
This property of utility functions is known as
the law of diminishing marginal utility, and
economists believe it is an extremely common, if
not universal, feature of peoples preferences.
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Why we have diminishing marginal utility.
You tend to get sick of consuming the same thing.
Your satisfaction from your first bottle of soda
is greater than the satisfaction from a bottle of
soda consumed after you have already drunk four
bottles.
In other cases the items you are consuming differ
from each other in some way. Consider the case of
CDs. If you have enough money to buy just one,
you will buy your favorite. If you have enough
money to buy two, you will also buy your second
favorite. As your second favorite CD does not
give you as much satisfaction as your first, the
marginal utility of the first CD is greater than
the marginal utility of the second CD.
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Opportunity cost the true cost of consuming
If Mariela increases her consumption of water by
one bottle, it costs her 1.
But there is another way to describe the cost. In
order to increase spending on water by 1,
Mariela must give up some soda.
If soda is 1 per bottle, then the cost of an
extra bottle of water is equal to one bottle of
soda. If soda is 0.50 per bottle, the cost is
two bottles of soda.
The opportunity cost of something is what you
must give up to get it.
When the price of soda falls, the opportunity
cost of water increases.
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Marginal Utility of Income
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3.2 Incentives Matter
Seat belts are dangerous
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The unemployed respond to incentives
People are most likely to find a job just when
their unemployment insurance runs out
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Predicting responses to incentives with utility
functions
Mariela 10 income, soda at 1 and water at 1
Mariela consumes 4 sodas and 6 waters
Surgeon general raises price of soda to 2 by
adding a 1 tax. What is Marielas response?
Mariela consumes 0 sodas and 10 waters
What is the smallest tax that induces Mariela to
consume 3 sodas instead of 4?
One cent.
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3.3 Incentives Matter
You are indifferent between studying and hanging
out with friends
If not, you would reduce the amount you study.
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The Astounding Miami International Airport
Escalator Problem
Escalators and stairs are right next to each
other. Why do some people take the stairs and
others take the escalator?
Assumptions people like getting to the second
floor quickly, but they dont like expending
effort.
The indifference principle if otherwise
identical people are doing different things, they
must be indifferent between them.
Prediction of theory (1) people who take the
stairs get to the top faster than those who use
the escalator.
Prediction of theory (2) fast escalators will
tend to be more crowded.
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Reading Landsburg, Steven E. (1994b) The
indifference principle. In The Armchair
Economist, New York The Free Press, ch. 4.
Each year, the Places Rated Almanac and The Book
of American City Rankings issue their reports on
the best places to live in America. San Francisco
gets credit for its cosmopolitan charms and
Lincoln gets credit for the allure of its housing
market. Weighing the importance of education,
climate, highways, bus systems, safety and
recreation, researchers rank cities in order of
overall desirability. The implicit assumption is
that researchers have identified features that
most people care about, and that we all pretty
much agree about their relative importance. If
that assumption is correct, and if your tastes
are not atypical, you can save yourself the
expense of purchasing the manuals. When all
factors are accounted for, all inhabited cities
must be equally attractive. If they werent,
nobody would live in any but the best. Landsburg
(p. 31)
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Indifference Curves
Marielas indifference map
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Marielas indifference map and budget constraint
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The effect of a reduction in the price of soda
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The effect of an increase in Marielas income.
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The effect of changes in the price of housing
when you already own a house.
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The escalator problem getting inventive with
indifference curves
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A Review of the three principles

• Economics is about happiness
•  Incentives matter
• The indifference principle