Econ 170 Fall 2017 You should work on the problems below as you study for the se

Question

Econ 170 Fall 2017 You should work on the problems below as you study for the second midterm. Keep in mind though, this is not a study guide! You should also refer to your notes of all material covered since eh first midterm. I will also discuss the upcoming exam in class on Tuesday 10/31/17. I'll post suggested solutions to these problems Tuesday evening. 1. Contestable markets: a. What do we mean by contestable markets? In other words, what conditions must be satisfied for a market to be perfectly contestable? See relevant Viscusi reading posted on SacCT b. If a market is perfectly contestable, will it be efficient? Does efficiency depend on the number of firms actually in the market? Explain. Yes. See relevant Visucssi reading for further explanation. 2. Differentiate between adverse selection and moral hazard. Give two examples of each. Adverse selection occurs before the transaction and is demonstrated by the lemons problem, moral hazard comes after. We have discussed many examples in class, though you should thinik of additional ones on your own. 3. Note thát this question refers to Figure 7.3 on page 211 of the assigned Viscusi reading

Explanation / Answer

A market is perfectly contestable if entry and exit are costless and unimpeded. It will be efficient because the constant threat of the possible entry by new firms forces even the largest existing firm to behave well—to produce efficiently and never overcharge. Otherwise the firm will be threatened with replacement by an entrant that offers to serve customers more cheaply and efficiently.

There is a direct inverse relationship between the number of firms and the efficiency of the market, the fewer the firms, the less efficient the market will be. When the number of firms are less, the market becomes less contestable and firms enjoy monopoly power which brings down efficiency. Thus higher the number of firms, more efficient the market will be.

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