SL354
Intermediate Microeconomics
Monday
Tuesday
Thursday
Friday
Week 1
Introduction
Varian, 1
Budget Constraints
Varian, 2
Preferences
Varian, 3
Utility
Varian, 4
Week 2
Optimal Choice
Varian, 5
Consumer Demand
Varian, 6 [7]
S. & I. Effects
Varian, 8
Cooperation, etc.
Thaler, 2 – 3
Buying & Selling
Varian, 9
Intertemporal Choice
Varian, 10
Endowment Effects
Thaler, 6 – 8
Surplus, Demand
Varian, 14 & 15
Demand, Equilibrium
Varian, 15 & 16
Equilibrium
Varian, 16
Asset Markets
Varian, 11
Uncertainty (Risk)
Varian, 12
Uncertainty (Risk)
Varian, 12
Diversification
Varian, 13
Behavioral Finance
Thaler, 9 – 10
Real Financial Markets
Thaler, 11 – 12, 14
Pure Exchange
Varian, 31
Pure Exchange
Varian, 31
Technology
Varian, 18
General Equilibrium
TBD
Welfare
Varian, 33
Welfare
Varian, 33
Auctions
Varian, 17
Auctions
Thaler, 5
No Class
Asymmetric Information
Varian, 37
Asymmetric Information
TBD
Week 3
Week 4
Week 5
Week 6
Week 7
Week 8
Week 9
Week 10
Exam 1
Consumer Surplus
Varian, 14
Exam 2
Risky Assets
Varian, 13
Exam 3
Production
Varian, 32
Exam 4
Externalities
Varian, 34
Exam 5
Externalities
Rural Neighbors and the Right to Farm
Before you build your dream house in the country, thoroughly investigate the surroundings.
During the last several decades, more and more city people have migrated to rural areas to pursue their
modern American dreams. They seek a peaceful place in the country, away from the noise and crime of
cities. Many choose homes in modest (or not so modest) subdivisions that press into formerly agricultural
lands.
This intrusion of urban life into rural life results in an inevitable conflict. How surprised some neighbors
are to wake up one spring morning to roaring machinery, buzzing flies, the stench of manure and a mist of
pesticides in the air. And how angry many become when they learn that they can't do anything about it.
The Legal 'Right to Farm'
States now give farmers a basic "right to farm" without the fear of lawsuits brought by offended neighbors.
As one judge remarked while dismissing a lawsuit against a hog farmer, "pork production generates odors
which cannot be prevented, and so long as the human race consumes pork, someone must tolerate the
smell.“
Before the right-to-farm laws were enacted (most of them in the 1980s), courts shut down many a farmer's
operation because it was a nuisance to the neighbors. For example, a group of annoyed neighbors, whose
homes had sprung up around a Massachusetts hog farm, sued and closed it in 1963.
Some judges tried to strike a middle ground and ended up applying restrictions that would let the farming
operation continue. A Florida court, for example, allowed a hog farm to stay in business but limited how
many hogs the farmer could have. The judge also issued instructions on how to store and feed the garbage
the hogs were accustomed to eating.
Pure Exchange and Externalities

B
·
X’
Good 2 (Externality)
·
X
·
A
·
Good 1 (Income)
Pure Exchange and Externalities : The Coase Theorem

B
·
X’
X
Good 2
·
A
·
·
Good 1
Production Externalities
P
S’ = S +MSC
S
[= Marginal Private Cost]
D
[= Marginal Private Benefit]
P’
P*
MSC
Q’ Q*
Optimal Output
-- Society’s View
[Marginal Social Cost]
Q
Optimal Output
-- Private Market’s View
The Coase Theorem Again
Coase, “The Problem of Social Cost” (1960)
“It is strange that a doctrine as faulty as that developed by Pigou
should have been so influential …”
“The traditional approach [to the externality problem, the
‘Pigovian’ approach] has tended to obscure the nature of the
choice that has to be made. The question is commonly thought of
as one in which A inflicts harm on B. But this is wrong. We are
dealing with a problem of a reciprocal nature. To avoid the harm to
B would be to inflict harm on A … The problem is to avoid the more
serious harm.”
Ronald Coase
1910 -
The Coase Theorem: In the absence of transaction costs, all government allocations of property rights are
equally efficient, because interested parties will bargain privately to correct any externality.
Implication: Any market plagued by externalities can be made efficient if property rights are clearly
defined and assigned, and if transaction (bargaining) costs are negligible.
Carbon Tax vs. Cap & Trade
Surplus Analysis
Carbon Tax
P
Cap & Trade
P
S’
= S + tax
S
P’
S’
S
P’
P*
P*
D
Q’
Q*
D
Q
Q’
Q*
Q
Markets with asymmetric information
Varian’s “market for plums and lemons”
P
S plums : P  44Q ps

2200  Pplums
1925  P̂plums
D plums : P  4400  44 Q pd
Slemons : P  1100  44Qls
1375  P̂lemons
Duncertainquality

1100  Plemons


 pr plums* D plums   prlemons* Dlemons 
Dlemons : P  3300  44Qld
Qˆ plums
||
43.75
Q plums
Qˆ lemons
||
||
56.25

Qlemons
Q
||
50
Adapted from Varian, Intermediate Microeconomics, 7th ed., 695 – 696. His example is itself an adaptation from a famous paper by George
Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics 84 (1970): 485 – 500.
Markets with asymmetric information
General categories of problems of asymmetric information:

Adverse Selection: A situation in which individuals possess hidden information,
leading to a market selection process that results in a pool of individuals with
economically undesirable characteristics.

Moral Hazard: A situation in which one party to a contact takes a hidden action that
creates benefits at the expense of another party to the contract.
Social institutions that help solve these market inefficiencies:
Private agent responses to problems of asymmetric information:

Signaling – the party possessing private information takes action to generate a
credible signal.

Screening – the party with imperfect information takes action to induce a
advantageous sorting of the market.
Public / Private sector responses to problems of asymmetric information:

Compulsory purchase plans (insurance markets)

Licensing and certification (note that this may also be done by private agents).

Market regulation, including “truth” laws and “insider trading” laws.
Agency costs
What is the “agency problem” and what are agency costs?
 Efficiency costs which arise when there is a divergence of
interests between parties to a transaction.
 When one party to a transaction cannot observe the effort of
another party, upon whose effort the value of the transaction
depends, we say there is a principal-agent problem. Examples:
• Shareholders (principal) cannot perfectly monitor the efforts
of a CEO (agent)
• CEO (principal) cannot perfectly monitor the efforts of
managers (agent)
 In such cases, the principal cannot determine whether a bad
outcome was the result of the agent’s low effort or due to bad
luck.
Agency costs and Governance of Economic Transactions
What is the “agency problem” and what are agency costs?
“In the absence of agency problems, all individuals associated
with an organization can be instructed to maximize profit or net
market value or to minimize costs. Individuals will be prepared to
carry out their instructions since they do not care per se about the
outcome of the organization’s activities. Effort and other types of
costs can be reimbursed directly and so incentives are not required
to motivate people. Also no governance structure is require to
resolve disagreements, since there are none.”
Oliver Hart, “Corporate Governance: Some Theory and Implications.” The Economic Journal 105 (May 1995): 678 – 689..
Basic Principal-Agent Model
Principal’s Share
Uncertainty
Observable Outcome
Payoffs
Agent’s Share
Agent’s Actions
Contract
The Agency Challenge. To structure a contract that specifies division of payoffs in
such a way that the agent’s actions will maximize those payoffs, given two
complicating factors:
 Uncertainty
 Unobservability of effort
The “Canonical” Agency Model
Assumptions
1.
An interdependent relationship between a principal and an agent in which there is goal
conflict. In terms of behavior motives, the utility of the principal is contingent upon a
strategic choice by the agent.
2.
The principal is risk neutral, i.e. his utility function is linear with respect to his source of
income (profits), which are influenced by the effort of the agent and subject to uncertainty.
V  x  is the market value of output, x

 x  f e, , where e is the effort level of the agent,  is uncertainty
U P  x, w  V  x   w, where 

w is the wage payment (variable cost)
3.
The agent is risk averse, i.e. his utility function is convex with respect to his source of income
(wages), and he experiences disutility from effort.

dU
d 2U

U A w, e   U w  e, where  U w is the utility deriving from wages, w, dw  0, dw 2  0

e is the agent' s effort level
4.
The agent has an outside opportunity (reservation wage), U A .
The “Canonical” Agency Model
Illustrative Example
1.
V x   10,30, e  0,1
2.
 ~ e  0  23 , 13 ; e  1 13 , 23 
 pr ( x)  23 ,V x   10
If e  0
EV x   16.67
1
 pr ( x)  3 ,V x   30
 pr ( x)  13 ,V x   10 
If e  1
EV x   23.33
2


pr
(
x
)

,
V
x

30
3


3.
U A w, e   w  e, and U A  1
4a. Scenario 1: Agent’s effort is directly observable by the principal. The principal establishes w at the minimum
level required to induce e = 1 (A level that will generate utility for the agent equal to their reservation utility).
Select w s.t. U A 
w 1  1  w  4
The utility-generating properties of this outcome (“First Best”):
U P  23.33  4  19.33; U A  4  1  1;
U  20.33
P, A
The “Canonical” Agency Model
Illustrative Example (continued)
4b. Scenario 2: Agent’s effort is not directly observable by the principle. Principal makes w contingent upon V x  ;
agent chooses e based on expected utility, E U A w, e . Define outcome-contingent wage rates as w30 if V x   30


and w10 if V x   10 . To induce e = 1, the principal’s offer must satisfy two constraints:
(1) Incentive compatibility constraint.
2
3

E U A w, e  1  E U A w, e  0
 
w30  1  13
 
w10  1 
1
3
 
w30 
2
3
w10

w30  9  w10
 The wage associated with high effort must “sufficiently” exceed the wage from low effort.
(2) Individual participation constraint.
2
3

E U A w, e  1  U A
 
w30  1  13

w10  1  1
4 w30  w10  36
The expected wage must exceed the agent’s reservation wage.
The optimal contract from the principal’s perspective is w30  9; w10  0. The utility-generating properties of this
outcome (“Second Best”):
E U P   E V x   w  23 30  9  13 10  0  17.33
E U A e  1 
  9  1  
2
3
1
3
 EU   18.33
P, A

0 1  1
The “Canonical” Agency Model
Summary
 Inability to observe effort entails efficiency costs (in terms
of lower utility or surplus generated from the transaction.
 The difference in utility outcomes may be interpreted as the
cost of inducing a risk-averse agent to accept some risk
 There is an implicit tradeoff between efficient risk bearing
and creation of incentive effects.