Question from Past Microeconomics Qualifying Exam[]

Fall 2004 - Section II, Question two, George Mason University

"Market failures" like monopoly, externalities, and imperfect information are usually thought to reduce market efficiency. Discuss two exceptions, carefully explaining your underlying assumptions.


A firm operating in a monopolistic market will only be able to extract increased profits at the expense of consumers from the market if there is no threat of entry of other firms into the market. With the threat of competitors entering the market a monopolist will have to behave like a competitive firm selling its product at P=MC, otherwise it would be profitable for competitors to enter the market.

The efficiency implications of imperfect information are uncertain. Symetric and asymetric imperfect information can lead to efficient outcomes. However, asymetric imperfect information can have efficiency implications through moral hazard and adverse selection. Given for example the market for used cars. The value of used cars X is uniformly distributed on the interval [0,100]. There is asymetric information: Buyers only know average values of used cars, while sellers know the true value of their car. Buyer value cars at bX their true value.

  • If b<1 there is no surplus to be realized in this market.
  • If b>1, total potential surplus is equal to an average of 50(b-1) per car. The average car is worth 50 to the current owner. If b=1.07, this indicates that the buyer values it at 7% more, implying surplus of 3.5.
  • However, if 1<b<2, 0% of this potential surplus is realized. A bid of x implies that the average sold car was worth x/2 to the initial owner. The value to the buyer is according (x/2)*b, which is less than x for 1<b<2.
  • If b³2, however, the value to the seller of bidding x is greater than or equal to x. This means that 100% of the market surplus will be realized.

Bryan Caplan on the efficiency implications of symmetric imperfect Information: Many textbooks state that market outcomes are inefficient if there is "imperfect information." This is a gross over-statement. Market efficiency and imperfect information are often compatible.

This is particularly clear where there is symmetric imperfect information, where everyone is equally in the dark.

Suppose for example that I don't know how much I will enjoy my consumption bundle, so U(x,y)=xay1-a + e, where e~N(0,s2). My optimal decision is still to spend a*I on x and (1-a)*I on y.

Similarly, suppose I don't know my relative tastes for x and y, so U(x,y)=xay1-a, where a=.5 with p=.6, and a=.9 with p=4. Then I simply maximize U(x,y)=.6[x.5y.5]+.4[x.9y.1].

General point: Just because you are ignorant does not mean you are stupid. If you are uncertain, you adopt more "general purpose" strategies that take account of all of the possible outcomes.

This micro-stub needs improving.

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