BFHMicro_draft_2017.06.17.pdf - SAMUEL BOWLES DUNCAN FOLEY S I M O N H A L L I D AY MICROECONOMICS COMPETITION CONFLICT C O O R D I N AT I O N 4 B OW L

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Unformatted text preview: SAMUEL BOWLES, DUNCAN FOLEY & S I M O N H A L L I D AY MICROECONOMICS: COMPETITION, CONFLICT & C O O R D I N AT I O N 4 B OW L E S , F O L E Y & H A L L I DAY - D R A F T This text is provisional and under active revision. Please do not quote without permission. Figure 1: (Left to Right: Simon Halliday, Samuel Bowles and Duncan Foley outside the Santa Fe Institute, Santa Fe, New Mexico, Summer 2015. Samuel Bowles (PhD, Economics, Harvard University) heads the Behavioral Sciences Program at the Santa Fe Institute. He has taught microeconomic theory to undergraduates and PhD candidates at Harvard, the University of Massachusetts, and the University of Siena. He is the author of Notes and Problems in Microeconomic Theory (1980), Understanding Capitalism: Competition, Command and Change (2004) and Microeconomics: Behavior, Institutions and Evolution (2005) Duncan K. Foley (PhD, Economics, Yale University) is the Leo Model Professor of Economics at the New School for Social Research and an External Professor of the Santa Fe Institute. He has taught microeconomic theory to undergraduates and graduate students at MIT, Stanford, Barnard College of Columbia University, and the New School for Social Research. He is author of Understanding Capital: Marx’s Economic Theory (1986), Growth and Distribution (with Thomas R. Michl) (1999), Unholy Trinity: Labor, Capital and Land in the New Economy (2003), and Adam’s Fallacy: A Guide to Economic Theology (2006). Simon Halliday (PhD, Economics, University of Siena, Italy) is assistant professor of economics at Smith College and an affiliate of the Southern Africa Labour and Development Research Unit of the University of Cape Town and LabSi experimental economics lab at the University of Siena. He has taught microeconomics, game theory and industrial organization to graduate and undergraduate students at the University of Cape Town, South Africa, Royal Holloway, University of London, UK and Smith College, MA, USA. He does research in African development, experimental economics, and behavioral economics. Contents Preface 11 I People, Economy and Society 19 1 Society: Coordination Problems & Economic Institutions 23 2 3 1.1 Social Coordination Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 1.2 Games and institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 1.3 The fishermen’s dilemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 1.4 The fishermen’s dilemma as a game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 1.5 Pareto-comparisons and Pareto-efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 1.6 Social coordination failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 1.7 How institutions can address Coordination Problems . . . . . . . . . . . . . . . . . . . . . . . 51 1.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 People & Preferences 59 2.1 Preferences, beliefs and constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 2.2 Experiments on economic behavior. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 2.3 The Ultimatum Game: Reciprocity and Retribution . . . . . . . . . . . . . . . . . . . . . . . . . 67 2.4 Lessons from Ultimatum Game experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 2.5 The Public Goods Game . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 2.6 Further experimental results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 2.7 Empirically-based social preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 2.8 The lab and the street 2.9 Policy: A Fine is a Price 2.10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Constrained Optimization: Doing the best you can 93 3.1 Utility: preference and indifference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 3.2 Tradeoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 3.3 Social Preferences, coordination failures and iso-value curves 107 3.4 The feasible set of actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 3.5 Doing the best you can . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 3.6 Price lines and the offer curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 3.7 Policy application: environmental trade-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 3.8 Conclusion: scarcity and diversification 125 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 B OW L E S , F O L E Y 4 A Risky & Unequal World 5 6 & H A L L I DAY - D R A F T 129 4.1 Choosing a job and other risky decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 4.2 Avoiding worst case outcomes: Risk-dominance . . . . . . . . . . . . . . . . . . . . . . . . . . 136 4.3 Risk Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 4.4 Doing the best you can in a risky world . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 4.5 Investment: Risk aversion and wealth differences . . . . . . . . . . . . . . . . . . . . . . . . . 150 4.6 Insurance, risk exposure and risk taking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 4.7 Choosing justice behind a "veil of ignorance" . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 4.8 Measuring economic inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 4.9 Policy and philosophy application: Ordinal and cardinal utility . . . . . . . . . . . . . . . . . . . 163 4.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 Property & Exchange: Mutual Gains & Conflicts 173 5.1 Mutual gains from trade: conflict and coordination . . . . . . . . . . . . . . . . . . . . . . . . . 174 5.2 The Edgeworth Box and the Social Planner . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 5.3 Personal Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 5.4 History, property and power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 5.5 Impersonal exchange: Pareto-efficient allocations among strangers who trade . . . . . . . . . . 204 5.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 Coordination Failures & Institutional Responses 213 6.1 The common property resource problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 6.2 Best responses and Nash equilibria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218 6.3 Pareto efficiency and Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 6.4 Pareto-efficient effort levels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 6.5 Preventing the Fishermen’s Tragedy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 6.6 Communities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 6.7 Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 6.8 Private ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237 6.9 Government Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 6.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241 II Markets 249 7 Specialization, Exchange & Market Demand 255 7.1 Diversification, specialization and exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 7.2 Doing the best you can . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 7.3 Income, Prices and the Offer Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 7.4 Varieties of utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274 7.5 Price changes: income and substitution effects . . . . . . . . . . . . . . . . . . . . . . . . . . 284 7.6 Market demand and elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289 7.7 Consumer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 7.8 Conclusion: The Puzzle of Individual and Market Demand 297 . . . . . . . . . . . . . . . . . . . . MICROECONOMICS 8 9 - DRAFT Production: Technologies, Costs & Supply 301 8.1 Production 8.2 Production as a Function of Many Inputs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305 8.3 The cost-minimizing firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312 8.4 Characterizing technologies and technical change . . . . . . . . . . . . . . . . . . . . . . . . . 312 8.5 Cost minimization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 8.6 Cost functions with many inputs: Total, average, and marginal cost curves . . . . . . . . . . . . 318 8.7 Profit maximization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321 8.8 Price-taking at the equilibrium of a competitive market . . . . . . . . . . . . . . . . . . . . . . . 327 8.9 Technical change and innovation rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 8.10 Application: Evidence about costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 8.11 Conclusion: The puzzle of economies of scale and competition . . . . . . . . . . . . . . . . . . 335 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302 Competition, Rent-seeking & Market Equilibrium 339 9.1 The Cournot model of competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 9.2 Competition and social well-being . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 9.3 Price discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 9.4 Price-taking, rent-seeking, supply and demand . . . . . . . . . . . . . . . . . . . . . . . . . . 361 9.5 The Long Run with free entry and exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369 9.6 Application: Paradoxes of a segregated housing market 371 9.7 The perfect competitor and the paradox of perfect competition . . . . . . . . . . . . . . . . . . 375 9.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377 . . . . . . . . . . . . . . . . . . . . . 10 Information: Contracts, Norms & Power 381 10.1 Facilitating exchange: contracts, norms, and power . . . . . . . . . . . . . . . . . . . . . . . . 383 10.2 Principals, agents, and asymmetric information . . . . . . . . . . . . . . . . . . . . . . . . . . 387 10.3 Hidden attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389 10.4 Hidden actions: a contingent renewal contract for quality . . . . . . . . . . . . . . . . . . . . . 393 10.5 A comparison with complete contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405 10.6 Characteristics of the Contingent Renewal Equilibrium 407 10.7 An even simpler model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409 10.8 Short-side power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412 10.9 Contracts, norms and behavior in markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414 10.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 . . . . . . . . . . . . . . . . . . . . . . 11 Jobs, Unemployment & Wages 11.1 7 423 A thought experiment: Employers and workers in an ideal world of self employment or complete contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425 11.2 The labor discipline model: the real world of incomplete contracts for effort . . . . . . . . . . . . 430 11.3 The employee’s best response and the cost of losing a job . . . . . . . . . . . . . . . . . . . . 431 11.4 The firm’s wage offer and the cost of a unit of effort . . . . . . . . . . . . . . . . . . . . . . . . 437 11.5 Nash equilibrium wages and effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439 11.6 How many hours of effort should the employer hire? . . . . . . . . . . . . . . . . . . . . . . . . 441 11.7 Characteristics of the Nash Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 11.8 Macroeconomic application: labor discipline & the wage curve . . . . . . . . . . . . . . . . . . 448 8 B OW L E S , F O L E Y & H A L L I DAY - D R A F T 11.9 Labor discipline & incentives: Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453 11.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458 12 Interest, Credit & Wealth Constraints An Ideal (and Unreal) World of Complete Credit Contracts 12.2 The Real World of Incomplete Credit Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 470 12.3 Why Wealth Matters: Equity and Collateral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477 12.4 Competitive Markets, Wealth Constraints and Credit Market Exclusion . . . . . . . . . . . . . . 481 12.5 Policy Application: Why Redistributing Wealth To The Poor May Enhance Efficiency . . . . . . . 485 12.6 Macroeconomic Application: How Monetary Policy Can Stimulate Investment and Raise Wages and Employment III 463 12.1 . . . . . . . . . . . . . . . . . . . . 464 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487 12.7 Economic History Application: Why Cotton Became King Following the End of Slavery . . . . . . 490 12.8 Wealth Constraints and Credit Market Exclusion: Evidence . . . . . . . . . . . . . . . . . . . . 491 12.9 Summing up: Why and How Wealth Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . 494 12.10 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496 Economic systems: ideal and imperfect 503 13 Perfect Competition & the Invisible Hand 507 13.1 A perfectly competitive equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509 13.2 Perfectly competitive market equilibrium and efficiency . . . . . . . . . . . . . . . . . . . . . . 512 13.3 Perfectly competitive markets and inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . 514 13.4 Efficiency and neutrality: Why the theorems are important . . . . . . . . . . . . . . . . . . . . . 518 13.5 Fundamental problems: Market failures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519 13.6 Policy application: Theory of the Second Best . . . . . . . . . . . . . . . . . . . . . . . . . . . 523 13.7 Fundamental problems: Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525 13.8 Bargaining, rent-seeking, and efficient exchange . . . . . . . . . . . . . . . . . . . . . . . . . 527 13.9 Bargaining to reach an efficient outcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533 13.10 The perfect competitor’s revenge: inefficiency under ideal exchange conditions . . . . . . . . . . 541 13.11 History of economics application: Planning vs the market . . . . . . . . . . . . . . . . . . . . . 544 13.12 Conclusion: Ideal systems in an imperfect world . . . . . . . . . . . . . . . . . . . . . . . . . . 546 14 Capitalism: Innovation & Inequality 553 14.1 Capitalism’s Success: The Hockey Stick of History . . . . . . . . . . . . . . . . . . . . . . . . 553 14.2 The Economics of Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 555 14.3 The “natural selection” of efficient institutions? . . . . . . . . . . . . . . . . . . . . . . . . . . . 561 14.4 Application: Why optimal contracts for team production fail . . . . . . . . . . . . . . . . . . . . 567 14.5 Why capital hires labor (rather than the other way around) . . . . . . . . . . . . . . . . . . . . . 569 14.6 Capitalist Firms: Sharing Risks & Promoting Innovation . . . . . . . . . . . . . . . . . . . . . . 572 14.7 Disparities in wealth and power: principals and agents 14.8 Unequal rewards: the profit curve, wages, and employment 14.9 Income inequality in the economy as a whole . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 14.10 Application: Public policy and employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 592 14.11 Application: Trade unions, income distribution, and economic performance . . . . . . . . . . . . 595 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 579 583 MICROECONOMICS 14.12 Glossary - DRAFT Conclusion: 21st century Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 597 605 Preface Most of the people in the world are poor, so if we knew the economics of being poor, we would know much of the economics that really matters . . . People who are rich find it hard to understand the behaviour of poor people. Economists are no exception, for they too find it difficult to comprehend the preferences and scarcity constraints that determine the choices that poor people make. T. W. Schultz, 1979, "Nobel Address: The Economics of Being Poor." p. 1 Economics and capitalism were born at the same time, in the 18th century. Economics, a scholarly discipline that was then called political economy, sought to understand how and why society was being transformed as a result of capitalism, a novel way of organizing how people produce, exchange and distribute the things we live on. Capitalism continues to change the world and the task of economics is to understand this process, and how capitalism and our economies might be made to work better for people today and in the future. To its 18th and early 19th century contributors, the subject of political economy was the wealth of nations and people. This was no less true of Karl Marx, the most famous critic of capitalism, than it was of Adam Smith’s whose The Wealth of Nations is considered the most powerful defence of the then emerging capitalist economic system. The wealth of nations and people In the 14th century, Ibn Battuta, one of the leading geographers and explorers of his age, traveled widely in Asia, Africa, the Middle East, Russia, and Spain. In 1347, he visited the land we now call Bangladesh. “This is a ... country... abounding in rice,” he wrote. He described traveling along its waterways passing “between villages and orchards, just as if we were going through a bazaar.” Six and a half centuries later, a third of the people of Bangladesh are undernourished, and the country is among the world’s poorest. At the time of Ibn Battuta’s visit to Bangladesh, Europe was reeling under the impact of the bubonic plague, which took the lives of a quarter or more Figure 2: A painting of Ibn Battuta by Léon Benett for Jules Verne (1878) Les Grands voyages et les grands voyageurs. Découverte de la Terre. Public Domain. 12 B OW L E S , F O L E Y & H A L L I DAY - D R A F T Figure 3: London Craftsmen’s Real Wages, with 1850 as the base year, from 1264 to 2001, Source: Robert Allen, 2001 London Craftsmen's Real Wages 600 400 200 1264 1300 1350 1400 1450 150...
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