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Unformatted text preview: Part V: Distortions of the Invisible Hand from Strategic Decisions In everything we have done so far, we have always assumed that individual decision makers whether consumers or workers or firms are sufficiently small relative to the market that they cannot influence market prices. As a result, we have referred to the behavior exhibited by such small decision makers as price taking behavior. Alternatively, we could call such behavior non-strategic because in a world where I am such a small agent, there is no way for me to strategically alter my behavior in order to change the general economic environment that is characterized by prices. This non-strategic or price-taking behavior was then fundamental to the first welfare theorem, a theorem that only holds in competitive (price-taking) settings (assuming no price distortions, externalities or asymmetric information). In Part V, we now turn to an analysis of strategic behavior that arises in economic settings where individuals are not small relative to their economic environment and where their actions can therefore alter that environment. This takes us beyond the model of competitive markets and then permits us to demonstrate how the first welfare theorem ceases to hold when some individuals gain market power . It also, however, requires us to introduce some new tools. Chapter 23 begins with an introduction to basic concepts in game theory . Game theory has emerged in economics and other social sciences as the primary tool for thinking about strategic behavior. It models economic situations in the form of games in which players face incentives similar to those that individuals with market power face in the real world. Within a game theory model, we can therefore investi- gate how strategic behavior impacts the equilibrium that emerges. The competitive model can be reframed as a game theory model in which individuals simply have no incentive to think strategically, but as the economic environment becomes less competitive, strategic considerations become increasingly important. One particular type of game, known as the prisoners dilemma , will become particularly important in some upcoming chapters. While we will be able to give economic examples within the context of our devel- opment of game theory in Chapter 23, we will investigate more well-defined problems in the remaining chapters of Part V. If we can think of perfectly competitive markets as one extreme, we can think of perfect monopoly (in which a single firm is the only one producing a particular good) as the opposite extreme. Chapter 24 begins with this opposite extreme and illustrates how such concentrated market power leads to inefficiency. Within this chapter, we will be able to investigate different strategies 681 682 that monopolists might employ as they use their market power for their own ad- vantage. In some instances, we will find that good economic reasons exist for the presence of a monopoly, such as in industries that have very high fixed costs. Inpresence of a monopoly, such as in industries that have very high fixed costs....
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- Fall '07