Topics

1.    Information and Markets

a .     Markets as economizing on information

b.    Role of information for functioning of markets

c .     Definitions

d.    Analysis of markets with Model of Supply and Demand

2.    Information and Individual Decision-Making

a .    Optimal decision-making with perfect information

b.    Expected values

c .     Firms maximizing expected profits

d.    Consumers making decisions to maximize expected utility

e.    Certainty equivalent and risk premium

f.     Assessing preferences towards risk!

3.    Strategies to Deal with Uncertainty

a .    Acquiring information and the value of information to the firm

b.    Consumers purchasing insurance to hedge against bad outcomes

4.    Asymmetric Information

a .    Adverse Selection – definition and solutions!

b.    Moral Hazard – definition and solutions!

c .    Applications to the insurance markets and used car markets

d.    Our model for the market for health ins urance

Market Analysis

1.   Consider a perfectly competitive market for re-issue vinyl records, where market demand is given by QD (P) = 350 − 6P and market supply is given by QS (P) = 150 + 4P.

a.    What is the equilibrium price for records?

b.    Depict this market graphically. Fully label your graph, including the y-intercept and the equilibrium price and quantity.

c.    What would happen to the market if consumers’ incomes increased? Illustrate the effect on the market graphically, and discuss how you would expect equilibrium quantity and price to change.

d.   What would happen if, due to a recent resurgence in consumers’ interest in vinyl,       entrepreneurs open up more record pressing facilities to compete with the existing    producers? Illustrate the effect on the market graphically, and discuss how you would expect equilibrium quantity and price to change.

 e.    What would happen if the price of turntables (used to play vinyl records) falls? Illustrate graphically, and discuss how you would expect equilibrium quantity and price to change.

Firm Decision-Making Under Uncertainty

2.   Calculate the profit-maximizing level of output for a perfectly competitive firm in each of the following circumstances:

cost function is given by C (Q) = 1 Q, and the price =

3.   Your perfectly competitive firm’s marginal cost function is given by MC(q) =  q. Answer the following questions:

a.    If market demand is given by Q = 150 − 2P and market supply is given by Q = 10 + 5P, what would be the equilibrium price?

b.   At that price, find the profit-maximizing level of output for the firm and calculate their profits .

c.    You need to decide how much to produce today, but due to uncertainty regarding the price for  your key input you are now unsure about your cost function. With probability 1/4 the marginal  cost function will remain at MC(q) =  q, otherwise it will increase to be MC(q) = q . Given      this uncertainty, what is the profit-maximizing level of output for your firm today? What are the expected profits?

Consumer Decision-Making Under Uncertainty

4.    Ike has two options next year, Job A and Job B. The earnings in the two jobs differ and are               random. In Job A, earnings will be $16 with probability 1/3, $49 with probability 1/3, or $100 with probability 1/3. In Job B, earnings will be $36 with probability 1/2 or $64 with probability 1/2.

a.    If Ike has preferences over earnings given by u(e) = √e, where e denotes actual earnings, which job should he take and why?

b.    Calculate the Certainty Equivalent for Job A and the Risk Premium for Job B. Is Jack risk averse? How do you know?

Value of Information

5.   Consider the problem of a perfectly competitive firm with a cost function of MC(q) = 2q. The       firm faces uncertainty in the market price it will receive for it’s product. The price will be $10, $30, or $40, each with equal probabilities.

a.    Find the optimal level of output for the firm given the uncertainty.

b.    If the firm can pay for a perfect forecast of the future price, how much would they be willing to pay?

6.   You are the manager of a local band that has developed a following around the country. You are   planning the band’s next tour. Some of the band members want to keep the tour to a US tour as   you’ve done in the past, while others want to take the tour international (which you’ve never       done before). Because of past experience, you know that if you go on the US tour you will profit   $50,000. However, if you go international, you are unsure about the size of the crowd so you are  uncertain about your profits: with probability one half you yield high profits of $100,000, yet with equal probabilities you get either middling profits of $40,000 or profits of $0 because a very low   turnout means you just barely break even.

a.    If all that you care about is the expected profits from the tour, what advice to you give the band and why? Should they take the tour international?

b.   Suppose now that you have the option of paying a market research company for a perfect forecast of the profitability of an international tour prior to deciding upon which type of tour to undertake. How much would you be willing to pay for such a forecast, i.e. what is the value of that additional  information? A good way to start is with a decision tree!