Problem Set 1, Fall 1995-- Solutions
1. Describe a situation where value maximization does not imply efficiency.
This was not intended as a trick question, but ended up being one. I meant to ask "where efficiency can be obtained w/o value maximization." From page 36-37 in Milgrom and Roberts, value maximization always implies efficiency. If there exist wealth effects, there can be efficient allocations that are not value maximizing, because people's valuation of goods may change with their wealth. So value maximization always implies efficiency, regardless of whether there are wealth effects.
I apologize for any anguish I have caused.
2. Consider a situation where prices are determined via bargaining. What conditions must hold for the market to coordinate economic activity so that an efficient point is reached? Is government intervention justified on efficiency grounds in such a situation? On other grounds?
This is designed to get at the Coase Theorem. You need a) no wealth effects and b) zero bargaining costs. You might also put c) costlessly enforceable property rights, but this is contained in b. Government intervention is not justified on efficiency grounds, but may be justified if the allocation that results is for some reason undesirable.
3. What must hold for the price mechanism to guide economic activity so that an efficient point is reached?
Apply the first welfare theorem. There must be a competitive equilibrium, which means that all markets exist (in all possible states of the world), consumers maximize utility, producers maximize profits, and prices are such that supply equals demand.
4. Define opportunism. Are the freight-haulers in Alchian-Demsetz opportunistic? Provide an example of an economic arrangement or institution would not exist absent opportunism. Be precise in describing exactly why this is the case.
Opportunism is "self-interest" with guile. This implies that people are slightly shady -- ruthlessly pursuing their self interests even if it means they are doing things they promised not to do. The freight-haulers are opportunistic because they are supplying less effort than they promised. One example of an economic arrangement that would not exist w/o opportunism is monitoring -- if people kept their promises why would monitoring exist?
5. Is it reasonable to apply the Coase Theorem toward analyzing firms in bankruptcy? Why or why not?
No. Firms in bankruptcy are generally wealth-constrained, so the "no wealth effects" assumption will probably not hold. See M&R, p. 35-6.