Recently read a very intersting "cartoon" style book on Microeconomics, written by Grady Klein (a cartoonist) and Yoram Bauman PhD (an environmental economist). Here are some of the bits that particularly caught my attention.
The Big Question
A recurring theme in the book is that the "Big Question" in economics is "Under what circumstances does INDIVIDUAL optimisation lead to outcomes that are GOOD FOR THE GROUP AS A WHOLE?"
Asymmetric Information and Adverse Selection
Much Economic theory works on the basis that buyers have sufficient information to allow them to make the best choice betweeen different sellers. Situations where that is not the case are known as having "asymmetric information" with a good example being private used car sales.
In this case the sellers know whether the cars they are offering are lemons or genuinely good cars - but the buyers are often in the dark. This leads buyers to reduce how much they will pay for a car, which in turn leads to sellers with the best cars leaving the market as they cannot get the price their car is worth. So now the market has an even higher proportion of lemons, making it MORE likely that that is what the buyer will end up with.
This effect is known as "Adverse Selection" and won George Akerlof (and others) the Nobel Prize in 2001, for work looking at Adverse selection in the Individual Healthcare market. In this case, adverse selection occurs because Healthcare companies cannot tell the difference between insurance buyers who will get very ill and those who will stay healthy, so the Healthcare companies levy charges based on the average patient costs. This results in healthy people not buying insurance, and drives up the charges for other, relatively unhealthy, people.
Pareto Improvement
A Pareto Improvement is one that makes at least one person better off, and no-one worse off.
The book gives the example of a parent who has two children and gives them a quarter of a cake each, it is a "pareto improvement" because both children are better off and neither is worse off.
But it is not "pareto efficient" because there is a further improvement (giving each child another quarter of cake each) which makes the children better off, without making either worse off.
Unfortunately, another pareto efficient example would have been if the parent had given ALL the cake to only one child - as one child is better off, and the other is no worse off than having no cake. So, it can be seen that pareto efficiency does not address fairness!
Dominant Strategy and the Prisoners Dilemma
A "dominant strategy" is one that is the best option irrespective of what other people chose and is well illustrated in the famous "prisoners dilemma".
The problem is that, in the prisoners dilemma, the dominant strategy for each prisoner (snitch on the other) results in a pareto inefficient outcome for both of them (i.e. if they had both kept quiet), they would have got shorter sentences.
This is very relevant to many real world problems. The book gives the example of, in a city with buses but without bus lanes, the dominant strategy for commuter is to take the car as this will get them to their destination quicker than the bus if everyone else takes their car (as all will be stuck in traffid jams) and will DEFINITELY get them to their destination quicker than the bus if everyone else takes the bus (as the roads will be free of jams)
Similarly, climate change, overfishing and other "tragedy of the commons" problems are related to the prisoners dilemma.
On the plus side, if the two prisoners can negotiate, then there is a much better chance of them arriving at a pareto efficient outcome.
Taxes and Elasticity
The book explains how, while politics defines who directly pays taxes on goods, where the actual tax burden lies is defined by how "elastic" (sensitive to price) the supply and demand is.
If supply is more elastic(sensitive to price) than demand then the sellers will be more responsive to price changes (such as the imposition of taxes) than sellers, so sellers will be the ones who shoulder most of the tax burden. And vice versa
In short, the less elastic side bears more of the tax burden.
Important to note that the elasticity of supply or demand may change with differing prices and with time (as new production comes on stream for example).
Other Stuff
Perhaps the most interesting parts of the book are towards the end, when the authors talk about the world view of economists, describing how they play great store by the idea that competitive markets are great but recognise that markets in the real world are imperfect and need some basic rules to keep markets working well:
1) Understand the markets limitations (e.g. beware of markets that are pareto efficient but very unfair)
2) Protect competition (e.g. by regulating against cartels and monopolies)
3) Give the market second chances. (e.g. by implementing taxes or caps to combat market failures such as pollution)
When looking at unfair markets, economists often prefer to minmise intervention and maximise personal choice, so might favour giving starving people money instead of food (See Amartya Sen's work on famines where food was plentiful, but not affordable)
The authors also provide a short history of microeconomics, describing how it focussed on competitive markets in the 18th and 19th century then, in the mid 20th century, investigations into game theory showed that individual self interest often does not lead to good outcomes for the group as a whole, for example in cases of asymetric information. This made economists like Joseph Stiglitz nervous about economic theory.
At the end of the 20th century microeconomists started wondering under what circumstances people even acted like optimising individuals. (see work by Daniel Kahnman)
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| "The Cartoon Introduction to Economics" Vol1 Microeconomics by Grady Klein and Yoram Bauman |
The Big Question
A recurring theme in the book is that the "Big Question" in economics is "Under what circumstances does INDIVIDUAL optimisation lead to outcomes that are GOOD FOR THE GROUP AS A WHOLE?"
Asymmetric Information and Adverse Selection
Much Economic theory works on the basis that buyers have sufficient information to allow them to make the best choice betweeen different sellers. Situations where that is not the case are known as having "asymmetric information" with a good example being private used car sales.
In this case the sellers know whether the cars they are offering are lemons or genuinely good cars - but the buyers are often in the dark. This leads buyers to reduce how much they will pay for a car, which in turn leads to sellers with the best cars leaving the market as they cannot get the price their car is worth. So now the market has an even higher proportion of lemons, making it MORE likely that that is what the buyer will end up with.
This effect is known as "Adverse Selection" and won George Akerlof (and others) the Nobel Prize in 2001, for work looking at Adverse selection in the Individual Healthcare market. In this case, adverse selection occurs because Healthcare companies cannot tell the difference between insurance buyers who will get very ill and those who will stay healthy, so the Healthcare companies levy charges based on the average patient costs. This results in healthy people not buying insurance, and drives up the charges for other, relatively unhealthy, people.
Pareto Improvement
A Pareto Improvement is one that makes at least one person better off, and no-one worse off.
The book gives the example of a parent who has two children and gives them a quarter of a cake each, it is a "pareto improvement" because both children are better off and neither is worse off.
But it is not "pareto efficient" because there is a further improvement (giving each child another quarter of cake each) which makes the children better off, without making either worse off.
Unfortunately, another pareto efficient example would have been if the parent had given ALL the cake to only one child - as one child is better off, and the other is no worse off than having no cake. So, it can be seen that pareto efficiency does not address fairness!
Dominant Strategy and the Prisoners Dilemma
A "dominant strategy" is one that is the best option irrespective of what other people chose and is well illustrated in the famous "prisoners dilemma".
The problem is that, in the prisoners dilemma, the dominant strategy for each prisoner (snitch on the other) results in a pareto inefficient outcome for both of them (i.e. if they had both kept quiet), they would have got shorter sentences.
This is very relevant to many real world problems. The book gives the example of, in a city with buses but without bus lanes, the dominant strategy for commuter is to take the car as this will get them to their destination quicker than the bus if everyone else takes their car (as all will be stuck in traffid jams) and will DEFINITELY get them to their destination quicker than the bus if everyone else takes the bus (as the roads will be free of jams)
Similarly, climate change, overfishing and other "tragedy of the commons" problems are related to the prisoners dilemma.
On the plus side, if the two prisoners can negotiate, then there is a much better chance of them arriving at a pareto efficient outcome.
Taxes and Elasticity
The book explains how, while politics defines who directly pays taxes on goods, where the actual tax burden lies is defined by how "elastic" (sensitive to price) the supply and demand is.
If supply is more elastic(sensitive to price) than demand then the sellers will be more responsive to price changes (such as the imposition of taxes) than sellers, so sellers will be the ones who shoulder most of the tax burden. And vice versa
In short, the less elastic side bears more of the tax burden.
Important to note that the elasticity of supply or demand may change with differing prices and with time (as new production comes on stream for example).
Other Stuff
Perhaps the most interesting parts of the book are towards the end, when the authors talk about the world view of economists, describing how they play great store by the idea that competitive markets are great but recognise that markets in the real world are imperfect and need some basic rules to keep markets working well:
1) Understand the markets limitations (e.g. beware of markets that are pareto efficient but very unfair)
2) Protect competition (e.g. by regulating against cartels and monopolies)
3) Give the market second chances. (e.g. by implementing taxes or caps to combat market failures such as pollution)
When looking at unfair markets, economists often prefer to minmise intervention and maximise personal choice, so might favour giving starving people money instead of food (See Amartya Sen's work on famines where food was plentiful, but not affordable)
The authors also provide a short history of microeconomics, describing how it focussed on competitive markets in the 18th and 19th century then, in the mid 20th century, investigations into game theory showed that individual self interest often does not lead to good outcomes for the group as a whole, for example in cases of asymetric information. This made economists like Joseph Stiglitz nervous about economic theory.
At the end of the 20th century microeconomists started wondering under what circumstances people even acted like optimising individuals. (see work by Daniel Kahnman)