The Insurance Market

Those who decide to purchase insurance come across moral hazard, and the insurance companies deal with adverse selection. Moral hazard takes place because a person that has insruance against a loss has less motivation than a person that may be uninsured to avert a loss. In class, the example we were presented with was a person who has car theft insurance has less incentive to lock their car as opposed to a person who does not have car theft insurance.

Insurance companies have to figure our ways to work around the moral hazard and adverse selection issues, which can be done by separating the high-risk from the low-risk clients. For instance, they can lower premiums for low-risk clients and raise them for high-risk clients. A particular example of such a situation can be made of an auto insurance company that offers a "no-claim" bonus, in which the insurance company lowers payments for their client if that client does not make a clain within a particular amount of time. Other ways are by offerring different deductible rates. A lower deductible with a higher amount of monthly payments is offered to high risk clients and a higher deductible with a lower amount of monthly payments is offered for the low risk clients.

Game Theory

Invented in 1937 by John von Newmann and continues to be a major research topic in economics, the Game theory is a method that economists use evaluate behavior which acknowledges shared interdependence and with consideration of the expected behavior of others, also referred to as strategic behavior. It assists in the understanding many types of economic, political, biological, and social rivalries, including oligopoly.

Typically, a game consists of three features: rules, strategies, and playoffs.
An example to apply the game theory to is the “Prisoners’ dilemma.” The game is between two prisoners who are arrested for a crime but are suspected for a smaller crime without evidence.
There are four different strategies in this dilemma. One being that they both confess and each will receive 3 years of imprisonment, if they both deny then each will receive two years of imprisonment. If prisoner 1 confesses and prisoner 2 denies, then Prisoner 1 will receive 1 year of imprisonment and Prisoner two will receive ten years of imprisonment, and vice versa if the strategy is switched. The trick of the game is that neither of the prisoners will know what the other one will do.

Signaling Quality through Advertisement in a Monopolisitc Competition

Signaling occurs when an informed person of a firm takes some sort of action to send out a message to those who are less informed.

A firm that sells a consistently high quality product can run a costly campaign to advertise their product because it is likely that the consumers will continue to purchase that product since it is of high quality.

In contrast, it does not make sense for a firm that sells a low quality product to run a costly campaign to attempt to advertise their product because the amount of money spent by that company to advertise their product will exceed the revenue that is brought in by selling that product because it likely that most consumers will attempt to try that product once, and will not purchase it again if it is low quality.

It is more likely that consumers will believe an advertisement that is much more expensive and flashy looking because they feel that a firm will not go through all the trouble spending a great amount of money if their product is not good. The expensive flashy advertisement for the high quality product will send out a signal to the audience and consumers that the particular product is very good without having to say much about the product itself.

Barriers to Entry in a Monopoly

A barrier to entry is a restraint that shields a firm from the entry of a new competitor. There are three barriers to entry that exist in a monopoly: Natural, ownership, and legal.

A natural barrier to entry in a monopoly occrs when one firm can assemble the full market demand at a lower expense than two or more other firms are able to assemble. For instance a cable provider can provide its customer's cable for a price lower than other companies.

Ownership barrier to entry occurs when one firm holds control of all production and supply. For instance, DeBeers is a company that control the entire production of raw diamonds in the world.

Legal barrier to entry occurs when the governemnt restricts entry in to the market through issuing patents, licenses, public franchises and copyright to a firm. An example of this would be the United States Postal Service. They have the exclusive right to deliver first-class mail, they are a public franchise. A patent is an exclusive right issued to the inventor of a service or good. A license isseud by the government to a firm manages the entry into certain professions, occupations, industries. A copyright is an exclusive right that is issued to author or creator of a literary, musical, artistic, or dramatic piece.

Change in Demand in a Perfectly Competitive Market

In a competitive market the firms are are not making any economic profit and the entreprenuer makes normal profit. It is part of a long-run equilibrium. With that said, the demand increases which causes prices to rise and firms will have to increase proudction in order to be able to maintain the marginal cost equal to the price, and the firm will make economic profit. In this process, the market becomes part of short-run equilibrium.

The economic profit is what interests a firm to participate in a market. As the number of firms enter into a market, the market supply increases and the prices will start to decrease. With lower prices, firms' output decreases in order to maintain the marginal cost equal to the price.

There are two different types of equilibriums associated with this: Initial long-run competition and new long-run equilibrium. The difference between the two is the permanant increase in demand in the number of firms. Every firm produces the same amount of output in the new long-run equilibrium as at first and does not make any economic profit.

A decrease in demand causes a lower price, ecnomic loss, and exit from the market. The exit from the market will decrease the market supply, cause an increase in prices, and will eradicate economic loss.

Monopoly Price-Setting Strategies

Monopolies face tradeoffs between price and the quantity that is traded or sold. There are two price setting potentials that generate different tradeoffs, which are single price and price discrimination.

Single price monopoly is a firm that has to sell each unit of its output for the same price to all of its customers. Price discriminating monopoly is when a firm that vends different units for different prices that are not related to cost differences. Airlines, for instance have different prices for the same flights. If a firm price discriminates it makes the impression that it is doing so in the favor of their customer(s) when in fact it is charging each group of customers the greatest price they can get them to pay in order to increase their profit.

Market Types

There are four market types: Perfect competition, monopoly, monopolistic competition, and oligopoly.

Perfect competition exists when: many firms sell the same product to a number of buyers, there are no barriers to entry or exit from the market, established firms do not have any advantage over new firms, and sellers and buyers are informed of the prices. These circumstances occur at the time that the market demand for the particular product is large relative to the productivity of a single producer.
Monopoly is a market for a good or service which has no close replacements and in which there is one provider that is protected from competition by an obstacle preventing the entry of new firms. The phone, gas, electricity and water supplies are considered as local monopolies in some places.

Monopolistic competition is a market in which a great number of firms compete against each other by creating similar but faintly different products. For instance, different companies such as Nike, Asics and other brands that sell running shoes all compete with each other but they have a monopoly on their particular show brand.

Oligopoly is markets in which there are a small number of firms which are interdependent that compete with each other. Oligopolies may produce nearly identical products such as batteries or differentiated products such as soda products.

Maximizing Total Utility

The consumer’s objective is to allocate the available budget in a manner that will maximize total utility. In order to achieve this goal, the consumer must choose the most reasonably priced combination of goods at which the total of the utilities acquired from all goods consumed is as big as feasible. In order to be able to find the best budget allocation for the consumer, we can use the utility maximizing rule, which consists of two things; allocating the full amount of the accessible budget and making the marginal utility per dollar equivalent for all of the goods.

To allocate the full amount of the available budget you have to come up with combinations that reach the entire available budget. You want to maximize total utility because you want to get the most for your dollar when you are facing scarcity. You do not have to literally use your entire amount of money on purchases, allocating a budget can involve saving money as well. You can decide the amount of money you want to save, and spend the rest on goods. Equalizing the marginal utility per dollar can be achieved by creating a combination that formulates the marginal utility per dollar equivalent for both of the goods. Marginal utility per dollar is the marginal utility from a good matched to the cost of the good. You are able to calculate the marginal utility per dollar by dividing the marginal utility of a good by the price of that good. In order to be able to find the utility maximizing choice, you calculate the marginal utility per dollar for only the most reasonable priced combinations that deplete your entire budget.

Excludable and Rival Goods

An Excludable good or service is the possibility of preventing a person from enjoying its advantages if they have not paid for it. Examples of excludable goods are Brinks Security, any sort of concert that you have to pay in order to be able to see. Non excludable gods or services are those that are made to be extremely difficult to avert someone from enjoying it, for instance the police department of a city, or the fisheries. Anyone has access to fisheries or to the help of a police officer.

A good or service is considered to be rival it its utility by a person decreases the available amount for another person. For instance a security company such as Brinks may work for more than just one Bank, but the truck they use to transport money to the banks at the same time. Non rival goods or services are those whose use by a person doesn’t reduce or diminish the amount available for others. For instance, the services a police department and a concert on television are non rival.

Private goods excludable as well as rival because they can be consumed only by one person at a time that has purchased it or owns it. Public goods are nonrival and excludable because they can be consumed by any person at anytime and nobody can be barred from using it. Common resources are rival and no excludable because one part of it can be used on one time, but nobody can be barred from using it. Natural monopolies are nonrival and excludable because they are able to produce at a lower expense than two or more other firms are able to.

Negative Production and Consumption Externalities

An externality is a cost or subsidy which comes from production and falls on anyone but the producer. It can also be a cost or subsidy that comes from consumption and falls on someone apart from the consumer. A negative externality is one that inflicts external cost.

Negative production externalities are when someone other than the producer of that occurrence is being affected. For instance, clearing forests destroys the wildlife habitat and reduces the amount of carbon dioxide that plants naturally release into the atmosphere, which creates an enduring affect on temperature. Another example could be talking during a lecture in class. While someone may be having a conversation during a lecture, those who surround that person may become distracted from the lecture and experience a hard time comprehending or even listening to their professor. Examples of negative consumption externalities include smoking in restricted areas. Smoking affects people’s health and may be unpleasant to a person who is sensitive to the fumes. Certain restaurants, bars/clubs, and airlines ban smoking in an attempt to prevent negative consumption externalities, but on the other hand, this creates a negative consumption externality on those who prefer to smoke or take pleasure in while they are eating, drinking or partying, or flying.

The Ability-to-Pay Principle

The ability-to-pay principle is the proposal that people ought to pay taxes in accordance to how easily they are able to tolerate the tax. This principle entails comparing and evaluating people along two components, which are horizontally and vertically.

Horizontal equity is the obligation that taxpayers with the equal ability to pay taxes should pay the exact same taxes. It is easy to consent to in principle, but it is tough to apply and practice it. It is not difficult to apply horizontal equity to those who are the same in every matter,. The greatest obstacle is when you have to evaluate the disparity in the aptitude to pay that comes from the condition of a person’s wellbeing and from their domestic responsibilities.

Vertical equity is the obligation that taxpayers with a greater aptitude to tolerate a greater portion of taxes. This proposal is easily interpreted that those with higher income ought to pay higher taxes, at the same time; it is difficult to conclude the point of how much taxes should rise when income rises. The U.S tax code utilizes progressive income taxes, which is the standard tax rate that rise with income. They are thought to be reasonable and fair on the foundation of the vertical equity notion, but their utilization to attain vertical equity creates an issue for achievement of horizontal equity. A good example of this issue is the tax code for single and married people.

Barriers to Efficiency

There are barriers that cause underproduction and over production when it comes to efficiency. These barriers include price and quantity policies, taxes and subsidies, externalities, public goods and common resources, monopoly and high transaction costs.

Price policies can deter price changes that set equilibrium for quantity demanded and quantity supplied. Take for example rent prices for apartments. There is a limit on the maximum amount that landlords can charge their renters. Quantity policies are able to set a maximum value on the amount of goods that can be produced which can lead to underproduction. The government can set up a limit on the amount of crop farmers can produce, which can result in underproduction.

Taxes raise the prices paid by consumers or buyers and decrease the prices obtained by sellers. This leads to a decrease in the quantity produced and results in underproduction. Subsidies are imbursements to producers given by the government. This decreases prices paid by consumers or buyers and increases the prices obtained by sellers.

An externality is a cost or gain that affects another person, but not the seller of that buyer of a good or service. It can result in overproduction if there is external cost, for instance burning coal to produce electricity causes acid rain and can spoil crop. The plant that is producing air pollution by burning coal does not consider the cost of the pollution, and creates overproduction. An external benefit can occur if an apartment owner chose to install a smoke detector, this would beneficial to her neighbor as well. But she does not consider her neighbor’s benefit, and chooses to not install a smoke detector. This leads to underproduction.

Public goods are benefits that everyone experiences and nobody can be rejected from these benefits. Public goods can lead to underproduction. Uncongested non-toll roads are an example of public goods. Common resources are not owned by anyone and are used by everyone. For instance, air is a common resource; everyone is able to breathe air and cannot be excluded from using it.

A monopoly is a company or business that is the only supplier or a good or service. Cable television is supplied by companies that are monopolies. Maximization of profit is the self-interest of a monopoly. Since monopolies don’t have competitions, they are able to set their own price. Monopolies can lead to underproduction because they don’t produce enough and charge a high price.

High transaction costs is the opportunity costs of creating or performing trades in a market. The stores in a shopping mall are markets that utilize large quantities of limited labor and capital supply. The opportunity cost must be worth tolerating for founding or launching a market. If transaction costs are too high, than it may lead to underproduction in the market.

What influences price elasticity of demand?

There are two things that have an influence on price elasticity of demand; Accessibility of substitutes and the quantity of income that is spent.

If a substitute is easy to find, than the demand of a good or product is elastic. In other words, if something such as an ingredient can be replaced by another ingredient, then the good that is produced with either of those ingredients it elastic. If a substitute is difficult to find, than the demand of that product is inelastic. For instance, oil has inelastic demand because it has insufficient substitutes. It is needed to operate transportation devices such as cars, buses, boats, etc. There are three factors that contribute an influence on the aptitude to obtain a substitute from a good or product. These factors are whether the good is a luxury or a requirement, how scarcely defined it is, and the time it takes to find its substitute. Necessities are inelastic because they don’t have good substitutes, and luxuries have an elastic demand because they are not a requirement. The demand for a scarcely defined good is elastic. For instance, there are many different types of coffee drinks, such as cappuccinos, Starbucks and Indigo Coffee both makes cappuccinos. Coffee itself is inelastic, because there is no substitute that is like it. Tea, for instance is not the same as coffee it does not consist of the same ingredients. The more time that has passed since the change in price of a good occurred, the greater the elasticity becomes of demand for a good. When gas prices went up recently, the demand for gas did not change, instead people switched to more fuel efficient cars, and that is what caused the amount of fuel demanded to decrease-in which the demand became more elastic.

People are not able to purchase the same amount of goods and services as they once did when prices rise and income decreases. The greater the amount of income is spent on a good, the greater the influence of a rise in price on the amount of that good or service that people are able to meet the expense of purchasing, which results in a more elastic demand.