Lecture Notes: Nov. 6

Econ. 103, Fall 2002, Prof. Nancy Folbre

Next Monday is Veteran's Day. Live it up.

Plan for the day: Review of payoff matrices and Chapter 10, start into Chapter 11, view McLibel video.

Here's another payoff matrix relevant to the airline industry:

As before, first cover the rightmost column and ask what the row player would choose from the leftmost column. United would choose "don't raise ad spending." Then cover the leftmost column and ask what the row player would choose from the right most column. United would choose raise ad spending. This means that United does NOT have a dominant strategy. It's best choice depends on what TWA does.

Now, consider TWA, the column player. What is its best choice if United chooses to raise ad spending (confining your attention to the top row)? Raise ad spending. What if United chooses not to raise ad spending (confining your attention to the bottom row). TWA's best strategy is to raise ad spending. In other words, TWA DOES have a dominant strategy.

The equilibrium outcome here is that TWA will raise ad spending and United will not (the cell in the lower left corner). Once in that cell, neither player has an incentive to change their strategy.

Here's an example more related to current events. Keep in mind that these payoff possibilities are hypothetical, as is the structure of the game. Most payoff matrices describe simultaneous moves, in which the sequence doesn't matter. But in the real world game the sequence (who moves first) often matters a great deal. I do not think that the game below offers an accurate picture of the strategic situation. But it does offer a nice illustration of the Prisoner's Dilemma. In this case, the Warrior's Dilemma.

Both players are better off if neither attacks. But the fear that the other will attack creates a situation in which the dominant strategy for each player is to attack, an outcome that leads to the greatest overall losses.

One more example of a payoff matrix, that provides an insight into a concept the textbook develops in Chapter 11, the "positional externality." This arises from a competitive situation in which individual players have an incentive to incur something harmful to themselves or others in order to win. But if they both do it, incurring the harm gives neither a strategic advantage. As in the Prisoner's Dilemma, they are worse off pursuing their individual self interest than they would be if figured out a way to coordinate their actions and follow an enforceable rule.

Foray into Chapter 11

It's important for you to be able to define externalities, give examples of them, graphically illustrate their effect on the relationship between individual and social efficiency, understand the Coase theorem, and tragedy of the commons.

Externalities are a cost that falls on people other than those who pursue the activity, or make the individual choice in question.

A memorable example of a negative externality is a fart (when other people are nearby).

Most forms of pollution are negative externalities.

A beekeeper in a crowded area in which bees are likely to sting people is creating a negative externality.

A memorable example of a positive externality is a good joke, especially if it is overheard by or gets passed onto a lot of people who weren't a part of the original audience which may have paid for it.

I would like to think that a smile also creates a positive externality.

Trust, kindness, and reciprocity create positive externalities, as do rules that prevent individuals from getting stuck in coordination problems such as those represented by prisoner dilemma type situations.

A beekeeper living next to an apple orchard is creating a positive externality--the pollination of the trees.

Negative externalities create a divergence between private and social cost. They imply that social cost is higher than private cost. This can be graphically represented by a social cost curve that is above and to the left of the private cost curve. The intersection of this social cost curve with demand will be to the left of the intersection of private cost and demand. That is, the socially efficient point will be to the left of the point that utility maximizing individuals would choose.

In this situation, private choices lead to too much of something....

like, too many cars (relative to bikes), and as a result too much air pollution.

Positive externalities create a divergence between private and social benefit. They imply that social benefits are greater than private benefits. This can be graphically represented by a demand curve that is above and to the right of the private demand curve. The intersection of social demand and private cost will be to the right of the intersection of private demand and private cost. That is, the socially efficient point will be to the right of the point that utility maximizing individuals would choose. In this situation private choices will lead to an insufficient amount of something...like, not enough bikes (relative to cars) and as a result, not enough good health, gnarly calves and smiling faces.

See Figure 11.1, which is reproduced in slide 11-4. This is the most important figure of the chapter.

The Coase Theorem, named after a guy named Coase (pronounced cose, rhymes with hose) claims that individuals should be able to figure out ways of making private and social costs and benefits coincide through negotiation or lawsuits. For instance, an individual who is adversely affected by pollution should be able to threaten to sue the polluter. The threat of paying the cost should motivate the polluter to cut back to the efficient level.

Sometimes this works. But sometimes it doesn't, for obvious reasons. It is often hard to prove cause and effect. Lawsuits are expensive, etc.

The 60 Minutes clip McLibel offers an interesting example of a lawsuit that was brought against a British environmental group for passing out leaflets criticizing McDonald's practices.

To find out more about this issue, if you missed the video, you can go to the following website:

www.mcspotlight.org