Econ 522 – Lecture 14 (Oct 23 2008)Logistics- midterm Tuesday- Chao OH Monday 11-12- My OH Monday 2:30-3:30 (also 1:30-2:30 if needed)- Next Thursday: lecture will most likely be canceled, you should all go to Menzie Chinn’s talk about the crisis (I’ll send out an email about it once I hear back from the organizers of the talk)- Don’t forget to vote!- I’ll give out solutions to HW2 at end of lectureone of the home work problems – Friedman: “A physician comes upon an auto accident, stops, and treats an unconscious and badly bleeding victim. A week later the victim receives a bill for services rendered. Must he pay it?”Consider the following alternatives:(i) The victim need not pay anything(ii) The victim must pay only the value of whatever materials were used up in treating him (bandages, etc.)(iii) The victim must pay the going market rate for comparable medical services(iv) The victim must pay whatever the doctor demandsWhich of these do you expect to lead to the most efficient outcomes? Why?The key: once the accident, and the treatment, have already happened, any transfers between victim and doctor do not impact efficiency. (No value being created or destroyed when the victim pays the doctor.) So the only way to answer the question is to look at how each rule would change behavior – the incentives for the doctor to stop and help, incentives to drive too much and too fast, and so on. (Examples.)Last new topic: Repeated GamesNearly everything we’ve done so far has assumed a one-shot interaction- that is, we’ve been assuming that the parties to a contract are only interested in maximizing their gain from that one particular contract,- and are not concerned with any future interactions with the same partner.Of course, in many cases, this is not true- Example. There’s a coffee shop near my house, and I go there several times a week. - One day, I forget my wallet, and ask if I can pay them back the next day for a cup of coffee and a muffin.- They say yes, and I show up the next day with the money. Why?Economists would say:- The reason I pay them back is that I want to keep transacting with them in the future, and the value I expect to get from those future transactions is worth more to me than the $3 I could save by breaking my promise now- And the reason they trusted me is that they expected this would be the case.- From a theoretical point of view, repeated games can be very hard to analyze, because a lot of different things can happen- But one of the things that can happen is that we can cooperate in a repeated game,even if we could not cooperate in the same one-shot game.Let’s go back to the original agency game we did a couple weeks ago.- You choose whether to trust me with $100, which I can double by investing it; and then I decide whether to keep the $200 or return $150 to you and keep $50 formyself- But now, suppose there is the possibility of playing the game more than once.- In particular, suppose that each time we play the game, there is a 10% chance it’s the last time we play, and a 90% chance that we get to play again.Think about my incentives to repay your money or keep it for myself. If I keep it for myself, I get a payoff of $200; but then you’ll never trust me again, so that’s all I’ll ever get. On the other hand, if I give you back your $150, you’ll probably trust me again the next time, and the time after that, and the time after that (provided I keep returning it). So the value I expect to get out of the relationship is50 + .9 X 50 + .9^2 X 50 + .9^3 X 50 + … = 50 / (1 - .9) = 500 > 200So I’m much better off returning your money, since I’ll make more money in the long-runif you keep trusting me.The same thing can happen with a repeated version of the prisoner’s dilemma.- Recall that in the one-shot prisoner’s dilemma, the only equilibrium was for both of us to rat on each other and go to jail for several years- However, if we expect to play the prisoner’s dilemma over and over, it turns out to be an equilibrium to both keep quiet- Actually, what turns out to be an equilibrium is for both of us to do the following:o Keep quiet the first time we playo As long as neither of us has ever ratted on the other, keep quieto Once either of us has ever ratted, I rat every time we play forever- This is called a “grim trigger” strategy – we play a good (cooperative) strategy, but if either of us every rats, this triggers a “punishment phase” where we are unable to cooperate- The threat of moving to this punishment phase keeps us both quiet, even though either of us would gain in the short-term by ratting each other out.- So in the prisoner’s dilemma, or the agency game, if the game will be played overand over, it’s possible to get cooperation.- Similarly, in situations where contracts cannot be enforced, repeated interactions with the same parties can lead to voluntary cooperation.- Even when you won’t always be transacting with the same person, transacting within a small community, where people are aware of your reputation, leads to a similar incentive.The Friedman book mentions an article by Lisa Bernstein on diamond dealers in New York. To quote:Buying and selling diamonds is a business in which people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting,weighing, and testing each one.The New York diamond industry was at one time dominated by orthodox Jews, forbidden by their religious beliefs from suing each other – making it a trust-intensive industry conducted almost entirely by people who could not use the legal system to enforce their agreements. While the industry had become more diverse by the time Bernstein studied it, dealers continue to rely almost entirely on private mechanisms to enforce contracts – in part for religious reasons, in part to maintain privacy, in part, perhaps, because those mechanisms functioned better than the courts.At the center of the system is the New York Diamond Dealers’ Club, which arranges private arbitration of disputes among diamond merchants. Parties to a contract agree in advance to arbitration; if, when a dispute arises, one of them refuses to accept thearbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted. Similar arrangements exist elsewhere in the world and exchange information with each other. Presumably the
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