Justin Wu Econ 201 Final December 11, 2012

True/False/Uncertain
1. Uncertain. If the firm were producing high-end goods or goods catered towards the
upper-class, they could be increasing product quality by not catering to the infra-marginal
lower class. However, if we take product quality to be the average desirability across all
consumers, then failure to internalize the preferences of the infra-marginal would
decrease the product quality. Essentially, it depends on what type of good the firm is
producing.
2. True. Making prices more transparent to customers allows them to pick and choose the
one they believe is the most desirable. In the case of identical products, they will always
choose the firm with the lower price- thus driving prices down to cost and increasing
competition. In addition, concealing the prices from rival firms would hinder collusion,
because the cartel would have a much harder time determining which if any firms
were cheating or depressing prices to steal customers.
3. Uncertain. There are two counter-balancing effects going on here. First, price
discrimination could potentially increase welfare. Perfect degree price discrimination
always increases welfare, but imperfect price discrimination might hurt it. Without more
information, it is difficult to determine exactly how price discrimination affects aggregate
welfare. On the other hand, price discrimination could lead to inefficiency as companies
may over-invest in methods to price discriminate. Another possibility we discussed in
class, is that price discrimination amongst different markets (textbooks and drugs) may
increase consumer surplus if we were to prevent arbitrage. In addition, if companies
know that they will be able to extract profits from customers, they will have an incentive
to enter the market. With all these factors, it is difficult to tell whether or not public
policy should try to limit price discrimination in general.
4. False. When there is adverse selection, the marginal cost will be decreasing because the
most costly customers usually buy first. To alleviate the burden on each firm, there
should be a greater number of them, because each firm would have to bear less of a cost
for the bad customers. The stronger the adverse selection, the more likely the firm will
make a loss before profiting. If firms realize they will be losing money, there is less
incentive for them to provide the good. Thus, the larger number of firms, the better.
5. Uncertain. While this may be true, the larger the society, the larger the free-rider problem
will be. Some people may lie about their expected utility of the public good in order to
pay less. This is because they think that there is more of a chance that others will cover
their costs. However, in a smaller society, this would be more unlikely as their will be
more social pressure to get the public good funded. In addition, people will be aware of
the fact that their contributions are worth much more in a small society.
Short Answers
1. Democracies tend to be less regulated and decentralized than command economies
(Fascism, socialism, etc.). This might seem like a good thing, according to Smiths
Justin Wu Econ 201 Final December 11, 2012
invisible hand, however, there are some major weaknesses. First, if there is less
regulation, then there are more opportunities for skewed markets. Collusion and
Monopolies (or both) have a greater chance of going unnoticed/unpunished than say, a
command economy where the government has direct control over the market. In addition,
democracies in theory have greater wealth disparities because forms of redistribution
are rare. It is difficult to get taxes passed, and the government cannot seize property when
needed.
Democracies value equality in the sense of status. Social status does not prevent you from
seeking opportunities, while in serfdom, your social status defines your very being.
Democracies tend to be more effective in places where the citizens feel like a part of a
whole. What I mean, is that democracies are better when each person sees him/herself as
a member of the community. Recall the example in which countries with higher HHIs of
ethnicity had (generally) less income inequality. A representative government only works
if each citizen is willing to perform his/her duty to society. This is why the expertise +
voting solution to public goods/bads works well in a democracy. However, democracies
tend to fare worse when there is no sense of social cohesion. If people are willing to lie
on surveys or provide false information in order to maximize their individual welfare,
then democracies can break down very quickly. If each citizen has no idea of their
responsibilities they dont vote, they do not follow set rules, etc. then democracies
tend to look more like mob-rule or tyranny of the majority. This is one of the causes of
the free-rider problem. If people believe they can shirk from responsibilities, then
markets do not work.
Economic theory suggests that regulations are needed in order to make democracies
better. Of course, the regulations need to give enough room for people to innovate or feel
motivated to participate. However, laws such as those prohibiting collusion are vital if a
democracy is to succeed. Democracies should pass regulations promoting competition
instead of allowing a single entity, whether it is the government or an individual, to
dominate the market.

2. Taxes are lower than the optimal level our simple models suggest mainly because there
would be public outcry against it. Seeing as the rich have more influence in the
government than the middle-class and lower-class, it would make no sense for them to
have higher tax rates for themselves. I believe this is the primary reason, but there are
also several important reasons why this is the case. Tax rates are not as high as they
should be, because of both nominal and positive reasons. For example, our simple version
of the model does not take into account the distortion on behavior if we were to raise
taxes. It is hard to calculate exactly how individuals would vary their behavior based on
different tax rates. Ideally, we would want to set the tax rate to a point where revenue is
maximized, but the distortion on behavior is minimal. For example, the rich might be rich
because they have a desire for money. You take away that incentive, then they might go
Justin Wu Econ 201 Final December 11, 2012
into a different profession or even stop working entirely. If they are providing some sort
of socially beneficial good, you do not want them to stop. That is a nominal reason. The
first reason I gave public backlash would be a positive reason. Supporting higher tax
rates as a politician could be akin to political suicide in some cases. Politicians generally
do not want to alienate their supporters and financial backers. Attempting to do
something like pass a bill for highly progressive taxation is a sure way to lose yourself
the re-election.


Qualitative problems
a. The market definition and industry concentration approach to merger analysis works
better when the products are undifferentiated. Upward pricing pressure works better when
the products are slightly differentiated. This is because, if products were undifferentiated,
the increase in price would be attributed to more market power. If a firm has a significant
amount of market power over the others, it reduces competition which is bad for
efficiency. When a single firm has enough power to influence prices, there is deadweight
loss which is undesirable. However, if the products are differentiated, then they are
fulfilling different niches in the industry. Thus, if two differentiated companies merged,
the increase in price would occur because of the increase in opportunity cost for that one
firm. This is perfectly acceptable because it is mediated through the market, and thus
does not creative a real externality.

b. One example of a public bad is smoking cigarettes. Cigarettes are addictive, bad for ones
health, and second-hand smoke is very dangerous. All-in-all cigarettes do more harm than
good for society. The coercive institution used to deal with this is taxation. The
government imposes a Pigouvian tax in order to force the smokers to internalize the
negative externality.
Another example is the merging of two companies to gain significant market power. This
is a public bad because it is non-rival and non-excludable. It is non-rival because one
person being hurt by the price increase does not preclude another from being harmed in
the same way. In addition, there is no way to exclude someone from the loss of welfare
generated by the monopoly. The coercive institution used to deal with this is the FTC and
DOJ. They regulate mergers and have the power to shut down any less-than-ideal
merging or acquisition.

c. The first is video games. The groups involved are the game developers and players.
People who play videogames generate value for other gamers because games are
generally more fun when there are more people playing. Having a large scene means
Justin Wu Econ 201 Final December 11, 2012
there will be metagame developments and competition to enjoy. In addition, the more
people that play, the more popular the developing company will be. The more popular
and prosperous they are, the more able they will be to release better content.
The second example is social networking sites such as facebook. The groups of users
consist of consumers, advertisers, and programmers. The users generate revenue for the
developers by clicking on ads. The advertisers give the programmers money in order to
advertise. And the programmers keep the site well-maintained for the users.
A third example would be information sharing websites such as course-reviews for
professors. These sites generate value to both the students and professors. For students,
they are able to prevent each other from taking courses from undesirable professors. For
professors, they are able to read the evaluations and adjust the course based on
recommendations/criticisms. This is a two-way market because both parties respond to
changes in price which in this case is the amount of criticism/compliments given in an
evaluation.

d. Harmful: Monopolies generate deadweight loss which is not optimal for society. This
point is obvious because they charge the price at the point where MC=MR instead of
where the demand curve intersects the cost curve. It raises the price while depresses the
quantity. An example is the diamond industry depressing quantity in order to keep its
prices high. A second reason might be that monopolies prevent entry. Even if someone
came up with a more efficient way to implement something, or a better way, they would
be unable to put it into action because of the monopoly. For example, Apple having a
monopoly because of IP stops potential innovation in the sector.
Beneficial: If there are barriers to entry or very large economies of scale, it might be
more efficient just to let one firm produce everything. Natural monopolies are examples
of this. Water lines, power cables, and infrastructure are costly. Too many competing
firms would lead to inefficiency and potentially low-quality goods because they are
trying to lower the price by as much as possible. Another benefit a monopoly brings is
the quantity limitation on bads. The drug market is an example of this. If the market for
cocaine were perfectly competitive, there would be too much of it going around. Since
cocaine is a bad, the higher the quantity, the worse off society is. However, with a
monopoly, they can raise prices to reduce demand and keep quantity low. Thus, the
monopoly is acting in favor of society.

e. Examples
i. redistribution
ii. Intellectual property or authenticity rents
iii. Price discrimination. More specifically, 3
rd
degree price discrimination because
you are sorting for elastic/inelastic buyers.
iv. Bertrand Edgeworth model