Introduction to the Class
and
States & Markets
International Political Economy
Prof. Tyson Roberts
1
Lecture 1 Goals
•
•
•
•
•
•
The value of models
Intro to decision theory & game theory
Time horizons, Pareto efficiency, externalities
Institutions & transaction costs
Syllabus & expectations for class
Questions, suggestions
2
The Value of Models
Source: Tetlock 2008: Expert Political Judgment
3
Commercial break
• If you want to learn more about models than
we’ll be doing in this class, I recommend this
online (free) course (starts Oct. 5, 2015):
https://www.coursera.org/course/modelthinking
• Khan Academy also has some online tutorials that
may be useful
https://www.khanacademy.org/economics-financedomain/microeconomics
4
Decision Theory
•
•
•
•
Single actor (decider)
Choices
Value (utility) of outcomes
Probability of each outcome, given each
decision
• Expected utility of each choice
• Choose the action with the highest (expected)
utility: rationality
5
Decision Theory Example
• Actor: You
• Choices:
– Don’t have diploma
– Take classes at UCI to get diploma
6
Decision Tree
No
diploma
What are the pros and cons
of each decision?
UCI
Decision Theory Example
• Don’t have diploma
– Costs:
•0
– Benefits:
• Work full time right away
8
Decision Theory Example
• Take classes at UCI to get diploma
– Costs:
• Lose 40 hours per week x 36 weeks per year x 4 years
• $$$$ Tuition
• Have to read some boring books, listen to boring
lectures
– Benefits:
• Earn more income with diploma
• Network of friends
• Smarter, healthier, happier
9
Decision Theory Example
• Assume utility of each choice=
– Don’t have diploma: +100 now
– Classes at UCI for diploma: -50 now, +250 later
• Which has the greatest utility?
10
11
Decision Tree with Numerical Utilities
No
diploma
100
UCI
- 50 + 250 = 200
Time Horizons
• Taking classes has a higher expected utility, but…
• The costs are upfront, the benefits are delayed
• If you value the present more than you value the
future, you might prefer not to wait
13
The Marshmallow Test
http://www.youtube.com/watch?v=QX_oy9614HQ
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Discount Factor
• Assume that
– the costs and earnings during first four years are
valued at full value
– the benefits after four years (includes bump in pay
& “happier, healthier, smarter”) are valued at half
value
• Recalculate utility for “No Classes” and “UCI”
15
Decision Tree with Calculated Utilities
No
diploma
100
UCI
– 50 + (1/2) 250 = 75
Decision Tree with Calculated Utilities &
Discount Factor = ½
No
diploma
100
UCI
75
Game Theory
•
•
•
•
Multiple actors
Choices
Value (utility) of outcomes
Value of each choice, given other actors’
choices
18
Game Theory: Trade
• Choices:
– Don’t trade
– Trade
• Utility of outcomes
– Utility if don’t trade vs. Utility if trade
19
Some Game Theory Terminology
• Pareto Improvement:
At least one player is better off
and no players are worse off
• Pareto Efficient/Optimal:
No Pareto Improvements available
• Pareto Inefficient/Sub-Optimal:
Pareto Improvements are available
Vilfredo Pareto
Trade enables Pareto Improvements for Pareto SubOptimal Situations
20
Market as freedom:
Trade enables Pareto improvements
Baker
Offer some bread
for some coffee
Barista
Eat only bread
Offer some coffee
for some bread
Barista:
4
Baker:
4
Barista:
2
Baker:
2
Drink only coffee
Barista:
2
Baker:
2
Barista:
2
Baker:
2
“The possibility of coordination through voluntary co-operation rests on the
elementary -- yet frequently denied -- proposition that both parties to an economic
transaction benefit from it, provided the transaction is bi-laterally voluntary and
informed.” (M. Friedman 1962)
21
Market as freedom:
Trade enables Pareto improvements
Baker
Offer some bread
for some coffee
Barista
Eat only bread
Offer some coffee
for some bread
Barista:
4
Baker:
4
Barista:
2
Baker:
2
Drink only coffee
Barista:
2
Baker:
2
Barista:
2
Baker:
2
Which outcome is Pareto Efficient?
22
Market as freedom:
Trade enables Pareto improvements
Baker
Offer some bread
for some coffee
Barista
Eat only bread
Offer some coffee
for some bread
Barista:
4
Baker:
4
Barista:
2
Baker:
2
Drink only coffee
Barista:
2
Baker:
2
Barista:
2
Baker:
2
Which outcome is Pareto Efficient?
Answer: Offer, Offer (at least one is better off, none are worse off)
23
So, should all assets be tradable?
24
So, should all assets be tradable?
What about college diplomas?
Why? Why not?
25
Externalities/Spillovers
Externality: a cost (negative externality) or
benefit (positive externality) that is not
transmitted through prices and is incurred by a
party who was not involved as either a buyer,
seller, or producer of the goods or services
causing the cost or benefit.
26
What are some possible positive externalities
(for society) of college education?
•
•
•
•
Economic productivity
Public health
Democratic quality
Other quality of life enhancements such as
art, environmental quality, etc.
27
States with more college graduates
tend to be more productive
28
A farmer considers whether to drill a deeper well into the aquifer
in order to grow more pistachios during the drought
Should he? What is the “rational” thing to do?
29
Economic decision from market forces:
supply and demand
• Demand: High – nuts increasingly popular
• Supply: Low – drought reduces ability to
growth pistachios
30
High demand + Low Supply => High Prices
Rational decision is to drill more during drought!
Price
S
D
5
3
1
1
2
3
Quantity
Are there any externalities from increased
drilling during a drought?
32
Thousands of farmers tap into the same aquifer
If everyone drills “rationally” the aquifer may eventually dry up:
Tragedy of the Commons
33
How does the “time horizon” concept play
a role in this tragedy of the commons?
• Short term best choice (drill) leads to disaster
in long term
34
• “Fundamentally, there are only two ways of
coordinating the economic activities of
millions. One is central direction involving the
use of coercion--the technique of the army
and of the modern totalitarian state. The
other is voluntary co-operation of individuals-the technique of the market place.” (M.
Friedman 1962)
35
• “(a government official) is directed and
controlled through a system of commands
while (a business entrepreneur) is directed
and controlled by a system of inducements.”
(Lindblom 1982)
36
• “Economic arrangements play a dual role in
the promotion of a free society. On the one
hand, freedom in economic arrangements is
itself a component of freedom broadly
understood, so economic freedom is an end in
itself. In the second place, economic freedom
is also an indispensable means toward the
achievement of political freedom.” (M.
Friedman 1962)
37
• “Policy is imprisoned in market oriented
systems… No democratic nation state has ever
arisen anywhere in the world except in
conjunction with a market system… But… no
market society can achieve a fully developed
democracy because the market imprisons the
policy-making process.” (Lindblom 1982)
38
Market as prison:
Trade ONLY allows Pareto improvements
Diploma salesman
(assume diploma sales are legal)
Offer to take
payment to stop
selling
College graduates
Sell diplomas
Offer to pay
diploma salesman
to stop selling
Grads:
Salesman:
Grads:
Salesman:
-4
4
-5
2
Leave diploma
salesman to sell
Grads:
Salesman:
Grads:
Salesman:
-5
2
-5
2
Which outcome is Pareto Efficient?
39
Market as prison:
Trade ONLY allows Pareto improvements
Diploma salesman
(assume diploma sales are legal)
Offer to take
payment to stop
selling
College graduates
Sell diplomas
Offer to pay
diploma salesman
to stop selling
Grads:
Salesman:
Grads:
Salesman:
-4
4
-5
2
Leave diploma
salesman to sell
Grads:
Salesman:
Grads:
Salesman:
-5
2
-5
2
Which outcome is Pareto Efficient?
Answer: Offer, Offer (at least one player is better off, none are worse off)
40
Market as prison:
Trade ONLY allows Pareto improvements
Diploma salesman
(assume diploma sales are legal)
Offer to take
payment to stop
selling
College graduates
Sell diplomas
Offer to pay
diploma salesman
to stop selling
Grads:
Salesman:
Grads:
Salesman:
-4
4
-5
2
Leave diploma
salesman to sell
Grads:
Salesman:
Grads:
Salesman:
-5
2
-5
2
“policy is imprisoned not in the sense that it cannot break out of its confinement but
in the sense that to release it we must pay ransom” (Lindblom)
41
What are three possible outcomes from drought
and farmers digging wells?
(According to podcast)
1. Mad Max (no restraint)
2. Government Regulation (imposed restraint)
3. Cooperation (negotiated restraint)
42
Which is the most promising way to avoid the
Tragedy of the Commons for the aquifer? Why?
• Government regulation
• Because there are thousands of farmers.
• Negotiated agreements, when the “rational”
choice is to “cheat,” are very difficult when
there are many actors
– More on that in coming weeks!
43
“Bottom of the Well”
Thousands of other farmers
Stop drilling wells
Farmer 1:
Farmer 1
Stop drilling wells
0
Farmer 1:
Drill
10
Drill
Other
Farmers:
0
Farmer 1:
Other
Farmers:
0
Farmer 1:
-40
-40
Other
Farmers:
-40
Other
Farmers:
-40
NOTE: Payoffs assume short term individual benefit = 10 if drill, long term social cost =
-100 x discount factor ½ = -50 if (almost) everyone drills.
Which outcome is Pareto Efficient?
44
“Bottom of the Well”
Thousands of other farmers
Stop drilling wells
Farmer 1:
Farmer 1
Stop drilling wells
0
Farmer 1:
Drill
10
Drill
Other
Farmers::
0
Farmer 1:
Other
Farmers:
0
Farmer 1:
-40
-40
Other
Farmers:
-40
Other
Farmers:
-40
NOTE: Payoffs assume short term individual benefit = 10 if drill, long term social cost =
-100 x discount factor ½ = -50 if (almost) everyone drills.
Which outcome is Pareto Efficient? One farmer only drills
45
“Bottom of the Well”
Thousands of other farmers
Stop drilling wells
Farmer 1:
Farmer 1
Stop drilling wells
0
Farmer 1:
Drill
10
Drill
Other
Farmers:
0
Farmer 1:
Other
Farmers:
0
Farmer 1:
-40
-40
Other
Farmers:
-40
Other
Farmers:
-40
But if EVERY farmer chooses to drill => Tragedy of the Commons
46
Now assume transaction costs:
Going to market costs 2 units
Baker
Barista
Offer some coffee
for some bread
Drink only coffee
Offer some bread
for some coffee
Eat only bread
4 – 2, 4 – 2 =
2 – 2, 2 =
2, 2
0, 2
2, 2 – 2 =
2, 0
2, 2
Which outcome is Pareto Efficient?
47
Now assume transaction costs:
Going to market costs 2 unit
Baker
Barista
Offer some bread
for some coffee
Eat only bread
2, 2
0, 2
2, 0
2, 2
Offer some coffee
for some bread
Drink only coffee
Which outcome is Pareto Efficient?
Answers: Offer, Offer AND Drink only coffee, Eat only bread
48
What if cost of going to market = 3
Baker
Barista
Offer some coffee
for some bread
Drink only coffee
Offer some bread
for some coffee
Eat only bread
4 – 3, 4 – 3 =
2 – 3, 2 =
1, 1
-1, 2
2, 2 – 3 =
2, -1
2, 2
Which outcome is Pareto Efficient?
49
What if cost of going to market = 3
Baker
Barista
Offer some coffee
for some bread
Drink only coffee
Offer some bread
for some coffee
Eat only bread
4 – 3, 4 – 3 =
2 – 3, 2 =
1, 1
-1, 2
2, 2 – 3 =
2, -1
2, 2
Which outcome is Pareto Efficient?
ANSWER: Drink only coffee, Eat only bread
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Institutions
• “Institutions are the rules of the game in
society or, more formally, are the humanly
devised constraints that shape human
interaction.” (North, 1990)
• “Institutions – at least those that support
markets – are social arrangements designed to
reduce such transaction costs.” (Rodrik)
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Some institutions that reduce
transaction costs
• Law & order (police, courts, etc.)
• Regulation (food safety, water usage, car
emissions, etc.)
• Monetary system (stable currency, etc.)
• Tax collection & administration (road
construction, etc.)
52
Market exchange is an institution to change the
distribution of assets
What institution might be used to enable honest
students to prevent salesmen from selling
diplomas without resorting to payment?
53
Markets & states as complements
(Rodrik)
• States rely on markets for lending, taxes, etc.
• Markets rely on states to create and enforce
rules, and to preserve the legitimacy of
markets by protecting people from risks and
insecurities of markets
54
Review of concepts
•
•
•
•
•
•
•
Utility
Time discounting/present value
Pareto efficiency/optimality
Externalities
Transaction costs
Institutions
Market as freedom vs. market as prison
55
Takeaways from College Diploma
Example
• People with short time horizons often make
choices that are not optimal in the long run
• Because of externalities, society is sometimes
better off if it puts restrictions on free trade by
encouraging or discouraging certain types of
transactions
• For individuals with weak impulse control,
societal restrictions (institutions) may motivate
choices that are better for that individual (as well
as society) in the long run
56
Takeaways from Rodrik Chapter 1
• Markets & states are substitutes: alternative
institutions for allocation & re-allocation of
resources
• Markets & states are complements:
– States (and interstate arrangements) enable
markets to function, and
– Markets efficiently facilitate economic exchange
for states
57
“If men were angels, no government would be
necessary.” – James Madison
“If students were angels, no graded work or
deadlines would be necessary.” – Tyson Roberts
58
Syllabus
• The syllabus is designed to encourage you to
make choices that will be good for you in the
long run!
– Read, work, attend lecture every week
– Actively engage with material
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Topics
• Lectures 1-2: Introduction to basic concepts
• Lectures 3-10: Economics & politics of trade,
development, & the global economy
• In-class midterm
• Lectures 11-17: Multinational corporations,
financial globalization, and crises
• Lecture 18: Globalization, Inequality, and the
Environment
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Lecture activities (4 hours/week)
•
•
•
•
•
Lectures
Videos
Discussions, small group and plenary
Practice exercises
Midterm and final exam
61
At home learning (~12 hours/week)
• Readings (1 required textbooks, the rest
online)
• Podcasts
• Videos
• Problem sets (3)
• Research exercises (3)
• Studying for exams
• Extra credit: Reading responses
62
Evaluation
• Reading quizzes (10%) (3 dropped)
• Problem Sets (10%)
• Research exercises (10%) (1 PS or RE
dropped)
• Midterm exam (30%)
• Final exam (40%)
• Extra credit:
– Reading responses (+ 1-2%)
• No late work accepted
63
• Questions?
• Suggestions?
64
Thank you
65