Market efficiency.

A theoretical property of free markets that states the greatest cumulative social benefit occurs at the market-clearing price.

Free markets have some important properties.

• Prices act as a signal of the per-unit reward for performing a specific task.
• Prices settle on the values that clear the market.
• Assuming no externalities, the market clearing price is efficient.

Example: apply price theory to an oil field that has a large reserve just below the surface (i.e. low cost to extract).

• This theory suggests the price of this oil cannot deviate substantially from the prevailing low-risk interest rate in the economy. Why is that?
• How does this explain the relatively small price fluctuations we see in the price of gas throughout the year, despite large seasonality fluctuation in demand?

Auction mechanisms.

A type of market that directly solicits bid information from buyers and/or sellers to set the price and determine participation.

Auctions have many desirable properties.

• Use market information to promote efficiency.
• Most forms are "strategy proof" (though, some are susceptible to collusion).
• Can be used to explain a wide variety of economic behaviour.

Example: Campaigns are often considered to be a type of "all-pay" auction.

• What does bidding look like in political campaigns?
• Why makes all bids expensive in this environment?
• Objective: win the election. How would you advise a candidate to expend their resources optimally?

Theory of the firm.

A theory that suggests firms exist to minimize the transaction costs associated with free markets (Coase, 1937).

• This theory establishes the nature of costs a firm is likely to maintain, given the production technologies that are available.
• This approach also shapes our understanding of industry and supply-chain formation.

The combination of average and marginal costs explains a remarkable amount.

• Marginal costs inform on the ability to price in the market.
• Average costs inform on the ability to shrink/grow profitably.

Example: Half of the following restaurants are franchised -- McDonald's, Chipotle, Starbucks, Burger King, In-and-out Burger, Domino's Pizza.

• Can you guess which are not franchised?
• How do the cost structures of franchised and non-franchised restaurants change the marginal and average costs of production for the corporation?
• How can these cost structures help explain why the restaurants above have succeeded with their respective models?

Asymmetric information.

A market failure that results from one side of the market having less product/service-related information than the other.

This issue comes in two flavors.

• Adverse selection: a pre-contract issue caused by hidden information.
• Moral Hazard: a post-contract issue caused by hidden actions.

There are two ways to manage its problems.

• Signaling: a costly signal that proxies for the hidden information.
• Screening: a sorting mechanism that forces agents to reveal their actions/type.

Example: Imagine two people from different parts of London are thinking about buying insurance on their new e-bikes.

• What might motivate these two e-bike owners to have different WTP for insurance?
• Which problems are represented by adverse selection? Moral Hazard?
• How might the insurance company determine the source of WTP discrepancy?
• What are the consequences to the insurance company from not solving this problem?

Principal-agent problems.

A labor market failure that results from a mis-alignment of incentives between the owner of capital and the operator of said capital.

Optimal compensation schemes must have two properties.

1. Incentive compatibility: the contract must produce the necessary effort.
2. Selection compatibility: the contract must attract the right labor.

Example: Instacart operates within a relatively new principal-agent market.

• What is Instacart and what is the nature of their principal-agent problem?
• What can Instacart do to align the incentives between the shopper and the client?
• Are there potential issues with the client as well as the shopper?

Matching markets.

Markets that rely on a non-price mechanism to determine the allocation of resources.

These markets need three important properties.

1. Thickness: sufficient number of market participants on both sides.
2. Incentive compatibility: market participants have the incentive to reveal their true preferences.
3. Clearing time: the market is able to facilitate all trades.

Example: Netflix faces a massive matching problem between their content and their subscribers.

• How does Netflix currently address this matching problem?
• Does anyone remember Netflix's business model when they were still mailing DVDs?
• What changes might you suggest Netflix make to their current matching strategy?
• How does this problem inform their customer acquisition strategy? Their content offering?

Crowdfunding.

A means of financing a project that relies on many, disconnected backers, typically through pre-purchasing a product.

Several benefits to crowdfunding.

• Maintains equity at negative interest rates.
• First to market and free advertising.
• More inclusive source of funding (empirical result).

Attracts various backer types.

1. Friends and family & high WTP backers.
2. Goal-gradient backers.
3. Risk-averse backers.

Example: Indiegogo is a platform that specializes in crowdfunding innovative products that apply new technologies.

• What type of asymmetric information is Indiegogo responsible for managing?
• Which backer type do you think would have the greatest (positive) response to Indiegogo successfully addressing this market failure?
• How does Indiegogo addressing this market failure change the strategies among entrepreneurs?

Social norms.

Tacitly understood rules that are understood by a group and are capable of shaping behaviour.

We have discussed a few types of social norms.

• Distributional social preferences: how a resource is shared among a community shapes perceptions of value and satisfaction.
• Descriptive norms: the prevalence of a behaviour in a community.
• Injunctive norms: the tacitly understood preferences of the community on a behaviour.

Example: Patagonia has developed a reputation for being ardent environmental activists. "We're taxing ourselves 1% for the planet."

• How do social norms inform our understanding of why these activities enhance their brand?
• Do you believe this is a profit-maximizing strategy?

Reference-dependent preferences.

Tradeoffs are evaluated according to the comparisons that frame the individual's decision.

The reference-dependent model has some important properties.

• Reference point: a "baseline" consumption level that frames which outcomes are gains and which are losses.
• The individual's expectations on future outcomes typically serve as the reference point.
• Loss aversion: the subjective evaluation that losses hurt more than same-sized gains.

Example: the pandemic has forced many in the workforce to spend more time at home.

• How might working from home for two years shift an employee's framing on work-life balance?
• How could you explain the ongoing labor frictions using reference-dependent preferences?
• Does reference-dependent preferences predict things will eventually "go back to normal"?

Present bias.

A tendency to over-weight immediate gratification over one's own long-run interests.

Present bias breaks a few important economic properties of time-based tradeoffs.

• Dynamic consistency: rational agents make plans about their future and stick to them unless new information forces them to update.
• Rational agents apply a single discount factor to the present value of future streams of consumption.
• Present bias says neither of these are true.

Example: Peloton has developed a business model that capitalizes on several biases.

• How does present bias motivate someone to invest in expensive exercise equipment?
• How does loss aversion prevent people from canceling a $50/month subscription?