On Minimum Wages

The minimum wage was devised so as to assist the low-skilled and low-paid members of the workforce by guarantying that there is floor below which the market wage cannot fall. Although it's a well-intentioned policy, it has perverse effects and in fact, it does more damage than good to the people it aims at helping. However, when trying to illustrate the problems of such policies, one is often vilified and socially disparaged. Yet, I will still try to explain 3 issues that arise due to the imposition of minimum wages.

Let us start by considering the general labour market of Figure 1. In such a market the firms demand labour and the workers supply the labour. The demand curve slopes downward since the higher the wage the less workers the firms want to hire on average. Similarly, the higher the wage the more the workers are willing to work.

Figure 1: A general labour market

Suppose that at wage "W*" the number of workers the firm wants to hire equals the number workers that are willing to work and thus the market clears. In this equilibrium, we have "L*" workers hired with each receiving "W*", and most importantly, there is NO unemployment because "L*" workers are willing to work and exactly "L*" workers are working.

If, however, the wage rate "W*" is deemed to be too low,  the government may wish to increase it by imposing a minimum wage. This means that the wage rate must be placed ABOVE the equilibrium wage, otherwise such a policy is pointless. For example, the government may impose a minimum wage of "Wmin". However, at this rate "LS" workers want to work whereas the firms want employ only "LD".  Consequently, only "LD" workers are employed and the rest "Ls - LD"  are considered unemployed since they are willing and able to work but cannot find employment (the economic definition of unemployment).
Surely, the minimum wage benefits those "LD" workers who continue to be employed as they now receive higher wages. However, how about those "L*- LD" workers who lost their job? Will the workers that are still employed concur to transfer part of their wage to reimburse them? Although, total earnings for the workforce as whole could increase due to the minimum wage (if the percentage drop in employment is less in absolute terms than the percentage increase in the wage), the fact remains that now we have unemployed workers.

One may suggest, that the firm should not layoff its workers. However, suppose you are a firm owner and you have determined that a particular job is worth $400 to you and you currently have 1 employee. What would you do if a minimum wage was imposed which raised the wage rate to $500? In fact you have a couple of options; (i) you wait until your employee's contract expires and then you fire him or her (or fire him or her immediately), or, (ii) you continue to pay him or her $400 but now this payment will be "under the table". The first option results to unemployment and the second to underground economy. Both pretty terrible options.

Yet the emergence of unemployment is not the only unfortunate consequence of minimum wages. I find that Milton Friedman was correct to point out that employment is a dynamic game. A worker may start at a low-paying job in order to receive some training and skills which will help him or her in his or her future career path. That is, a low-paying job can help people who where unable to attend a university or a college to put their foot in the door and receive some training which could prove extremely valuable. As a matter of fact, Walmart's store managers are mostly workers who were initially hired for the lowest paid jobs at the company. By raising minimum wage less workers will be able to put their foot in the door. 

In concluding, the policy of minimum wages is counterproductive as it has numerous unintended consequences three of which where stated above; (1) unemployment, (2) underground economy and (3) deprivation of opportunity for training. Moreover, a solid and extremely valid case can be made that one must not meddle with market prices since they provide valuable information about the market.

Figure 2: Subsidizing employment

But, let's ignore this issue for the moment and suppose that we all agree that the wage must be increased to "Wmin". Instead of imposing a minimum wage which will result to unemployment, the government could instead subsidize employment by paying a sum of money to the firms for each worker they employ. This would shift the demand curve outwards in order to cross the supply curve at wage "Wmin" with "Ls" workers employed as seen in the figure on the left. Hence, under the subsidization scheme both wages and employment increase, whereas with the minimum wage only wages increase with employment falling. 

So, if you were the government, which policy would you choose?

About Voting

Elections are right around the corner again. And again we are told that we should not abstain. The reasons provided for this rhetoric are plentiful and familiar. They are also without substance. Some may even propose a return to the compulsory voting; that is, punishing those who abstain either by fines or even imprisonment. In fact, they argue that forcing people to vote will result to election results that more accurately reflect the people´s choice.

This, however, need not be the case. Allowing people to freely choose whether to participate in the elections or not has its pros and cons. On the one hand, a major advantage is that among those who choose to participate in the process, we will have people who really care about the issues and are thus more informed. That is, we eliminate those who are rather indifferent and passive, and are thus more likely to vote randomly  or even worse vote what their peers suggested. In other words, the signal to noise ratio increases.

On the other hand, a major concern is that at the end more polarized than informed voters participate. This is a major concern because polarized voters choose based on emotion and not logic. In such a case introducing randomness (stemming from compulsory voting)  in the process may result to a better result. However, before positing such an argument we should evaluate the level of polarization among such voters. How rigid are they?

Moreover, it might as well be the case that introducing compulsory voting may amplify the polarization among voters and not reduce it. If someone is passive enough to the point where he or she would not otherwise vote, then it is highly likely that she will not get informed about the issues. Consequently, he or she might vote what her polarized peers favor.


As far as the reasons which are provided for why one must vote, I take issue with 3 particular talking points that are frequently invoked.

1) Civic Duty: Many will often simply suggest that it´s someone´s civic duty to participate in the elections by voting. I disagree. Just because you feel overwhelmed with "patriotism" and believe that this is your duty, it does not mean that everybody embraces the same mindset. Please do not project your views onto us. I believe that it´s my civic duty to protect everybody´s opinion and ability to choose freely what they will do. It is likely that everybody has a different interpretation of what their duties are.

Being a member of a society is not like being member of an inclusive club where you have to sign a statement which clearly indicates your duties and responsibilities. When I was born, nobody gave me anything which stated my duties to sign. Please refrain from using such an emotional rhetoric and stop trying to shame someone into voting.

2) Abstaining maintains the status-quo: Another common argument is that failing to vote during elections condones in effect the status-quo and legitimizes corruption of the politicians. So, if you politicians can recognize that you are corrupted, why don´t you just change your behavior?

3) Influence on election result: another point often raised is the fact that abstaining from voting suggests that you cannot influence the result. Let´s check this one out. Suppose we have 4 voters and 3 alternatives to choose from; candidate A, candidate B and neither (denoted by N).  Suppose 2 voters favor A, 1 favors B and the 1 is undecided and considers abstaining.

If the undecided voters abstains then candidate A gets 2/3 of the votes, whereas if the undecided voter does vote then we have 3 possible scenarios:

- Votes for B, in which case A and B get 2/4 of the votes. In this case, the undecided voter has a significant effect on the result.
- Votes for A, in which case  A gets 3/4 of the votes. In this case, the undecided voter simply amplifies the difference, but has no effect on the ordering of preferred candidates.
- Votes for Neither, in which case A gets 2/4 of the votes  and B gets 1/4 of the votes. Again, the undecided voter has no effect on the ordering of preferred candidates.

So, by abstaining the undecided voter affects the result only in the case where she would vote for candidate B if he or she was forced to vote.

Now further suppose that if forced to vote, the undecided voter is equally likely to vote for each alternative. Then forcing such a voter to vote leads to a standstill 1/3 of the time. But since the undecided voter is indifferent such an outcome is inefficient. Allowing her to abstain will improve efficiency in this society as in such case will have a definite winner and the result will more clearly represent the society´s preferences.


With that all  being said, I am going to vote, but I know why. I have a strong preference and I am familiar with the different candidates and their positions on issues that are important to me. I do acknowledge though that the issues that are important to me, could very well be of secondary importance to other voters. Moreover, on the issues that are important to those other voters, the candidates may vary very little in their positions, which may lead to a lot of voters being indifferent. Similarly, it could be the case that people do not want to or do not have the time to get informed about the issues. Quite frankly, I would prefer them abstaining rather than voting randomly.

Finally,it´s wrong to suggest that just because someone abstained, then he or she has no right in criticizing the winner in the future. Just because a voter was indifferent when the election was taking place, this does not mean that this indifference cannot be broken in the future. Similarly, we are supposed to be a democracy and just because someone exercised his or her right to abstain, this does not mean that we should withhold his or her right to free speech until the next election. As a matter of fact, he or she might raise a good point that the rest of us failed to see.

On bitcoin

In the last month there has been a lot of discussion about cyber currency and specifically about the bitcoinm which has experienced a meteoric rise in value (relative to the dollar) over this winter season. This has prompted many to suggest that the bitcoin is the currency of the future. This may well be the case at some point.

However, it's important to curtail our expectations about the current possibilities that such a currency offers. In particular, some were quick to suggest that the bitcoin may offer an alternative to the euro for countries such as Cyprus. This is a provocative sound bite, but with no meaningful substance.

Proponents of such schemes may posit that even if not suitable for a whole a country to adopt, the bitcoin offers a way to earn a handsome profit because it is valued so highly. Such assertions neglect to mention that asset prices and currency rates reflect all publicly available information in that the market has already priced in all the publicly available information. In fact, since the internet fastened the speed of the distribution of news and expanded the market, adjustments in prices and rates is almost instantaneous. Hence, a small trader must outsmart the market in order to earn profit through such trades. A nearly impossible task.

But let me return to the claim that it is a good idea to switch your currency of exchange to the bitcoin for a second. Thanks to websites http://www.coindesk.com/price/ and http://epp.eurostat.ec.europa.eu/portal/page/portal/exchange_rates/data/main_tables I was able to find (close) rates of exchange for bitcoin and euro relative to US dollar (that is, how many US dollars a bitcoin and a euro buy at closing rates).

In Figure 1, we see the daily percentage change in value for bitcoin (blue line) and for euro (red line) for the period Aug 1 2013 - Dec 18 2013. The difference in variation is striking. The bitcoin varies greatly in value whereas the euro does not. Hence, holding all your assets in bitcoins might not be such a good idea as the value of your wealth would fluctuate enormously on daily basis. In contrast, the euro exhibited a certain stability which offers a certainty about the value of one's wealth.

Figure 1:

Yet the above comparison might not be fair as the euro has ECB backing it whereas the bitcoin does not. But, the proponents of the bitcoin suggest the absence of a central authority is a plus. Yet the data is clear that bitcoin is not the safest method of storing your wealth.

It could be of course that the bitcoin is fluctuating in such a manner due to the fact that it is new and people do not know much about it. In Figure 2, we see the daily percentage change in value for both the bitcoin (blue) and the euro (red) since their respective inception. It is immediately apparent the euro has never exhibited fluctuations of similar magnitude to those exhibited by the bitcoin.

Figure 2:

It is thus clear that for the time being, the bitcoin is not the safest storage of wealth. But more can be said. In particular, looking at the percentage change in value of the monthly average of each exchange rate we see a similar picture to the earlier. That is, the bitcoin (blue) displays wild fluctuations, while euro (red) does not. Therefore, the bitcoin may not be the safest storage even for longer horizons.

Figure 3:

Yet, in spite of the noted fluctuations in value, it might be possible that for an investor with mean-variance utility to use the bitcoin as part of a diversified portfolio. Specifically, if we look at the changes in daily value (note: traders gain by changes in value), since bitcoin's inception the mean change for bitcoin was .418 dollars with standard deviation 16.86, whereas for euro the mean change was .000279 with standard deviation .008. Hence, neither dominates the other. Moreover, as seen below the two changes seem uncorrelated.

 Figure 4:

 Hence, a portfolio divided between w percent bitcoin and 1-w percent euro would have variance

where DB is change in bitcoin value and DE is change in euro value. In fact, a portfolio which would have consisted a proportion 0<w<0.000000469069 of bitcoin would have had a smaller variance than a portfolio with just euros, and also would have had a higher expected return.

On the proposed first residence policy

Cyprus has been in the eye of the storm for a while now. An array of adverse shocks has hit the economy of the small island economy (a nice summary can be found in Zachariadis' analysis). Due to the severity and magnitude of both the liquidity shock and wealth effects, which ensued the "deposit-shares swap" (or as it has been wrongly dubbed "the haircut") and the resolution of Laiki took place, the government is worried about a surge in non-performing loans. What´s particular worrisome for the government is the possibility of home confiscations by banks as a response to mortgage defaults.

As a result, the government has put forward a policy that aims to address the problem of people ending up without a house. Specifically, if someone defaults on her mortgage (let`s call her the "defaulter"), then an can either buy or lease her mortgage contract/house from her bank (let`s call the owner of the contract, the "M.O."). The defaulter, however, has the right to live in the house (whose mortgage she defaulted on) as long as she is willing to pay a monthly rent to the M.O.. Moreover, the defaulter can, at a pre-decided point in the future, buy back her mortgage/house from the M.O. The buy-back price equals to the value of the mortgage (loan) when it was defaulted.

For example, suppose John had started off with a $100,000 mortgage and paid back 40% of it, but now decided to default. Then, an MO can buy his mortgage/house from John´s bank, but John can still live in his house as long as he pays rent. Moreover, at some point he can buy back his house so long he gives back the $60,000.

So, here is the key issue with the proposed policy that has also been a subject of some controversy among MPs; any amount John pays as rent is not intended to be used as mortgage repayment. In fact, a lot of people questioned the ability of the proposed policy to guarantee that no-one will end up homeless. At this point, I should also mention that the proposed policy plan is only concerned with the first home of each family. Hence, it does not protect homeowners from complete home confiscations of their second, or third etc., house.

In fact, this provision leads to some complexities that seems that have eluded most of our politicians. For instance, what defines a first home; if someone defaults on all his property, who decides which is one is his first home? And how is this decision being made?. These are some concerns that have not really received any attention, and unfortunately will not receive any here either.

My main focus is to address the concern about the payment of the rent mentioned above. Some have hinted at the immorality of making a house occupant pay rent for what used to be his house. Furthermore, people deem it unfair that the rent is not being used for mortgage repayment. Yet it is possible for the defaulters to benefit from this arrangement.

In order to illustrate this fact, let's introduce some notation so that we can do a bit of economics. Let "R" denote the monthly rent (assumed to be time invariant), while "Tmax" is the number of months an individual expects to live in a house, when she first moves in. It´s further assumed that an individual does not anticipate to ever move out, so Tmax essentially is the number of months an individual expects to live. "V0" is the value of the mortgage in period 0, and thus is the total amount that the individual has to pay back (for simplicity assume interest rate is 0). In such case, an individual who makes an average monthly payment of "P" towards her mortgage is expected to pay back the whole amount in "Y" years. That is, V0=P∙Y. Lastly, I assume no credit constraints in that an individual can borrow as much as she likes.

Given the above, in period 0 we cannot have Tmax∙R<P∙Y. To see this, suppose that we do. Then, an individual faces the following tradeoff. She could rent a house for all Tmax months, which will cost her Tmax∙R. Alternatively, she can buy a house worth V0 (assuming she borrow the whole value of the house). Then, she will have to pay back P∙Y. Clearly, the former dominates the latter, and hence no one would take up a mortgage. By a symmetric argument, it's obvious that we cannot have Tmax∙R>P∙Y, because if this was not the case, no one would be renting a house. So, if we want to derive an equilibrium in which we have both tenants and owner occupancy, we must have Tmax∙R=P∙Y.

If we solve for the average monthly mortgage instalment, we get

P = (R∙Tmax)/Y.

This formula enables the comparison between the average monthly mortgage payment (P) and rent (R). It's immediately apparent that P≥R when Tmax ≥Y. So, a natural question is whether Tmax ≥Y is a logical assumption to make. In fact, if we assume otherwise, then nobody would be a lender, because she would never receive her money back. This because Y represents the months it takes to repay the mortgage, while Tmax the maximum number of months an individual expects to live. Hence, lending money out would be mean that upon the death of the borrower, the lender would not have received all her money back. So, nobody would lend if Tmax <Y were not the case. Hence, we have Tmax ≥Y.

Consequently, we must have that P≥R; namely, that monthly rent is at most equal to the average monthly mortgage repayment. Hence, a defaulter will in fact observe a reduction in his monthly housing costs once his house is seized. Of course a defaulter will lose ownership, and will most likely have to move at some point to a new place. This will impose further costs, which are ignored in this simple analysis. Furthermore, one could argue that instead of forcing rent upon defaulters is suboptimal to an extension of Y.

These arguments, however, do not negate the fact that a defaulter will experience a decrease in her monthly housing fee. Moreover, observe that maximum value of Y is Tmax, and that if Y=Tmax, then the borrower  will simply die right after she gets full ownership of the house. In such a case, renting and "owning" a house are ultimately equivalent. If, instead,Y is increased but maintained below Tmax, then an individual can earn house ownership before she dies. However, given the equilibrium condition stipulates P = (R∙Tmax)/Y and Tmax ≥Y, then R will still be lower than P, and thus for a sufficiently impatient individual (i.e., sufficiently small discount factor), renting will still be superior.

All in all, should it be left to the market forces, then we would expect that the government`s proposed policy will enable the defaulters to swap the combination (renting, low housing fee) for (ownership, high housing fee). However, it conceivable to anticipate that the determination of the rent will not be decided by market forces, but will be instead capped by the state. Of course a rent fee cap only make senses, from the point of view of the state, if the cap is placed below the equilibrium rent fee. In other words, it is quite conceivable to expect that the rent paid by the defaulters will be well below the equilibrium rent, which in turn is less than the mortgage payment, as established above. Hence, the government´s proposed policy can greatly benefit defaulters.

Is It Time To Have A Child?

During the last month I found myself entrapped in a series of discussions concerning the best time to have a child. While not my favourite topic in the world, deciding when to have a child is one of the biggest decisions a household has to make. This initiated my interest to examine this decision by using simple economic modelling. (Note: I omit the mathematical characterisation of the model in this post, but hopefully I will post it in the near future.)

Of course my simple analysis omits several factors that come into play in the decision making process, but I find that key features of such a decision are still illustrated. Before moving on to the results, I should identify my simplifying assumptions:

A1: Each household can only have one child.
A2: Each household has two "parents".
A3: Before a child is born, both parents earn wages and receive the same wage in each period.
A4: After the child is born, only the highest paid parent continues to work.
A5: Parents live for T years.
A6: Parents derive a constant pleasure each period from having a child and exert a constant effort each period by raising a child. But total effort increases the longer it takes to have a child (i.e., younger parents are more “efficient”).

The key assumptions are A2 & A4, which collectively boil down to the requirement that parents decrease their time at work in order to raise their child. So, A2 & A4 can be replaced by requiring parent(s) to shift some of their "working time" towards "raising time". Assumption A1 is taken so as to simplify the analysis, while A3 is made in order to generate a difference in income after a child is born. Finally, A5 can be considered as the life expectancy.

In essence, the problem of deciding when to have a child is an optimal stopping problem, where the household stops to be childless and switches to parenthood. So, given that households have finite lives A5 is our constraint.

In the simplest model, households cannot accumulate savings and yet the results seem intuitive. On the one hand, I find that the higher the wages the household has to forfeit from when it has a child, the longer it takes to have a child. Similarly, the longer the household expects to live, the longer it will postpone parenthood. On the other hand, the higher the pleasure the household derives from having a child, the sooner it will decide it have a child. Effort has exactly the same effect as pleasure. That is, the higher the per period effort that needs to be exerted, the sooner the child will come. It's also interesting to note that pleasure and effort have the most profound effect, followed by forfeited wages and life expectancy.

Then I proceed to extend the model in order to allow for savings, child and general costs (note: costs are the same each period). Moreover, I impose the requirement that in equilibrium the household must either spend or leave as bequest all of its earned income. This is a neat condition as it gives us the optimal time to have a child (since it must hold in equilibrium).

In the extended model, the opportunity cost of having a child comprises of lost wages and child costs. The effect of the latter is ambiguous, while the effect of lost wages is clear-cut. In particular, the higher the wage (that has to be given up) the sooner the household will choose to have a child. This might seem counterintuitive at first as it contradicts the results of the simple model above. However, recall that this wage is earned prior to the child birth, so the higher it is, the faster the household will accumulate sufficient savings in order to have a child.

This channel allows the wage earned after the child is born to also affect the optimal time to have a child. As in the case of forfeited wages, I derive a negative association. That is, the higher the wages after the child is born are, the sooner the child will come. In this case, the higher wage will enable the household to avoid depleting their savings too early, and thus will be able to support its child. Finally, as in the simple model, I find that effort and pleasure decrease the optimal time to have a child.

In conclusion, despite the model's simplicity it's interesting to find the varying effects wages can have. My initial hunch was that of a positive relationship, which was confirmed in the simplest model. However, it was intriguing to unravel the effects of savings and how they can reverse the effects of wages.

Capping the price of frappe

I had been at the university for a couple of weeks and, while it´s fall, the weather still called for a frappe. I did not want to walk the 200 meters to go to the fancy cafe, however I needed an iced coffee desperately, so I decided to go to the canteen that I had only recently found out about.

So, I went in and ordered a frappe. The cashier, in turn, asked for €1.10. Really, that cheap? This canteen is in prime location (right in the middle of the university, which is full of frappe-thirsty students!!!), packed with young students, whose willingness to pay for a frappe is unreasonably high (as any visit to the fancy cafe clusterings would attest), and, with no real competitors around.1

This canteen is practically a local monopoly and it appears to be violating one of the basic economic principles. That is, that a profit-maximizing monopolist equalizes her marginal revenue (the change in her revenue from the sale of an additional unit) to her marginal cost (the change in her cost due to the production of an additional unit), so that the profit-maximizing number of frappes is determined. Then, the demand function will give the profit-maximizing price.

However, this canteen's behavior seems to be going against this principle. Even though, the quantity of frappes may well be at the profit-maximizing level of a monopolist, the price certainly is not. To see the intuition behind this claim, suppose for simplicity that the demand side of the market can be described by a representative agent with a linear inverse demand function of the form p=a/b - d/b, where d is the quantity demanded, b>0 measures the price sensitiveness of the consumer, while a>0 is the maximum number of frappes the consumer can have.

I postulate the assumptions that a=4, and b=0.5, without maintaining that these values fully describe the market, but I do argue that they are reasonable and help to get the main point through.  As claimed before, the willingness of a student to pay for cup of iced coffee is pretty high. Moreover, frappe is the "traditional" iced coffee to the point where most people order it without even checking the price first. Although, this might be because, in most places, frappe is the cheapest coffee, the crucial point is that Cypriot consumers are pretty insensitive to frappe's price. (Also, a=4 and b=0.5, suggest that at price of €8, quantity demanded is 0, and given that people were willing to pay €7.50 for frappe then I am pretty confident about the parameter values.)

We proceed by defining

 and, thus,

Equipped with the necessary tools from the demand side, we now move to the supply side, where we will examine the cost function of the canteen.
So, how much does a frappe cost? To answer this, we need to break down its ingredients. A frappe includes a couple of tablespoons of coffee and sugar, a bit of milk and a lot of tap water. Obviously, the cost of making an extra frappe is approximately zero, and indeed the equilibrium price will be lower, the lower the marginal cost (i.e., a higher marginal cost will only magnify the problem discussed below); consequently, for simplicity let's set the marginal cost equal to zero. 2

Hence, in equilibrium "Marginal Revenue=0". A bit of algebra would reveal that, in this simple model, the quantity a representative agent consumes is "d=a/2=2" (since a=4), while the profit-maximizing price is "p=a/b - d/b=8 - 4= €4".

How do these results compare to real life? The quantity demanded of two frappes seems about right; most students drink a frappe in the morning right before (or even during) classes, and one near noon.

The price, though, differs significantly from the price of €1.10 that is actually charged. This is €2.90 difference per frappe, and although the exact price deviation is not important, what is important is that the price differs from a monopoly price, and it differs greatly. What's also important is that the particular canteen has been operating under the current management for a while now, which reveals that it's, at least, covering its average cost (note: a (near) zero marginal cost does not imply a zero average cost).

As the price of most its products are also capped, one may wonder how is the canteen covering its costs, which are labour, rent and input costs.
The labour costs are pretty standard, and are determined by the labour market for coffee-house workers, and the same goes for the input costs (of course, the canteen management could choose to use expired raw materials, but she still has to buy the products).
This leaves us with the rent, which is the one the canteen can (partially) influence. Suppose, for  a moment, that the university when deciding to lease the space, it realizes that the canteen will be a local monopoly, and thus, the rent that will be charged should correspond to a local monopolist. Further, suppose that the university decides that the prices should be capped. As the rest of the (main) costs are beyond the control of the candidate canteen operator, then it's clear that no operator would be signing up the lease. Therefore, since prices are capped, it must be that the university is charging less than the monopolist rent.

In other words, the university is not getting the appropriate returns for its asset, and it is losing surplus. However, the said surplus is not a deadweight loss as it is transferred to the consumers (i.e., primarily the students) in the form of consumer surplus.This constitutes a transfer of welfare from the university towards the university community.

Since frappe is only one of the many products whose price is capped, we conclude that the transfer of welfare arising from the university's price capping policy is significantly more than argued above.
Indeed, this type of welfare transfer should struck as a problem to anyone, as it is an inefficient allocation of university funds. While the value in euros of the lost university surplus may not amount to the hundreds of thousands, it could still be a significant amount. An that could be used to aid the need-based funds, or the excellence-awards funds, or could be used in another way so that everybody is better off.

All in all, economists across the globe, more often than not, object to price caps, because the price as determined in the free-market provides vital information. In most occasions (and this one could not but be one of them), the free-market is able to aggregate economy-wide information and reflect all one needs to know in the price. Capping that creates market frictions in terms of information. However, it also creates another type of friction as the present passage argues. That is, there is an indirect transfer of welfare from the university towards (mainly) the students. This is indeed a friction as it is (weakly) dominated by a direct transfer of welfare by the university, which could be achieved by transferring either money to the students or improving its services towards the student population. Such an arrangement would benefit everybody.


Footnotes:

1. The only competitors being (i) the aforementioned fancy coffee house, and (ii) the canteen-type cafe in the senate house, which both, in fact, serve different types of markets --- i.e., provide different products, and, in the case of the senate canteen, serve mostly senate employees. 

2. Another reason for assuming a zero marginal cost is apparent when we consider the time period to be a day. In this case, the materials needed to make a frappe are already bought, and thus they are a fixed cost. As a result, the marginal cost in this case is 0.

Reciprocity in corruptio regionem

Imagine you are a resident of corruptio regionem.

You have always been an obedient citizen; prompt to your duties, paying your taxes and voting for representatives, who you know that were not reciprocating your righteousness. In particular, you always suspected that they were corrupted and taking side-payments, but only recently scandals broke out highlighting the extent of corruption.

In addition, your politicians exerted minimum effort governing the country and its economy which has led the country to the brink of economic collapse. (This is not to say that they were the only at fault for the state of current economic affairs, but let's take the assumption that the biggest share of the blame is attributed to them.)

Assuming there is still some margin for saving the country, how would you react to this crisis? Would you (as part of the people) sigh "bygones are bygones" and make your best to save the economy? Or, would you be bitter about the inability of those in charge, which would lead you to act in a way such that the collapse is unavoidable?

In other words, would you forget about the poor effort of those in charge and do your best? Or would you feel that you (as a citizen) were  treated unfairly and try to reciprocate "the love".

Let's simplify the analysis (by making it more complex). We have the following stage game, which is a modified Prisoner's Dilemma.

The row player is the Government, which can either exert "High" or "Low effort". The column player is the Citizen, who can "Cooperate" (for example pay his taxes), or "Don't cooperate" (for example cease filling his tax form, having dealings in the underground economy, and etc.).

It's immediately obvious that Low effort and Cooperate are dominant strategies for the Government and the Citizen respectively. So, the "best prediction" about the outcome a game theorist can make is that the Government will put minimum effort in, but the citizens will still cooperate. This is the unique Nash equilibrium of this simple game, where the Government has a payoff of 4X and the Citizen 2X. Indeed this a rational outcome, in the sense that a player should always be self-interested, and choose rationally the strategy that maximizes his payoff. 

The only problem with this prediction is that it exemplifies the omission from "traditional" non-cooperative game theory, the fact that in real-world people are not cold-blooded players who act without regard to the other's actions and how they deem those actions. Allow me to be more specific, all of us have emotions to which we act upon. For example, as Matthew Rabin (1993) argues if we deem the action of the other player as unfair and unkind then we might want to reciprocate with an action that is unfair and unkind, so that we will fell that social justice has been implemented. 

Such an implementation of social justice can bring about outcomes that are ex ante Pareto dominated by others (strictly speaking about the bi-matrix payoffs). Indeed in the simple game above, the outcome "Low effort, Don't" is a fairness equilibrium as per Rabin (1993). Although, ex ante the Nash equilibrium "Low effort, Cooperate" seems to Pareto dominate the "Low effort, Don't", it's possible that citizens feel that their politicians were unkind to them, and as a retaliation they responded with ceasing to cooperate.

Specifically, as with the Nash equilibrium, examination of Rabin's fairness equilibrium is concerned (only) with the strategies that occur with positive probability in equilibrium. More importantly though, in Rabin's world players are concerned with reciprocity. 

In particular, if a player perceives a behaviour as kind, then she might want to reward it by being kind as well, whereas an unkind behaviour might be punished. An unkind behaviour towards player i would of course lower i's material payoff. Retaliating unkindness often entails actions that lower i's material payoffs even more. Yet the satisfaction of "revenge" is possible to compensate i such that she finds it worthwhile to punish the unkind opponent.  With some (heavy) abuse of notation, the payoff function of player i is

where the first term represents the material payoffs (see table), the term outside the squared brackets is the perception of j's kindness by i (if it's positive then j is perceived as kind, if it's negative as unkind and if it's 0 then j is neither). Finally, the term is inside the brackets is i's kindness.

In this framework it can be shown if the citizens expect their politicians to exert low effort, and the politicians expect the citizens to not cooperate, then  "Low effort, Don't" is a fairness equilibrium.

This is far from thorough analysis of the above game, but merely a novel description. However, the main message is that behavioural game theory can help explain what traditional game theory cannot. This (extremely) simple game was devised with the "refuse" of Greeks to silently and blindly accept the idiom "bygones are bygones" to cooperate with their politicians and Troika to get out of the crisis in mind. Had they initially cooperated and avoided some costly strikes then the situation might have been better. Hence, to an outside observer not cooperating is a dominated strategy, and it seems inconceivable that the people refuse to count their losses and move on. However, as argued above behavioural game theory makes sharp predictions that it may well be that we get an equilibrium where the people just don't want to cooperate, because they want to punish the politicians; granted they do punish themselves as well, but they do punish the politicians as well.

All in all, even though the above passage by no means suggests that the simple game describes the real world, it says that there exists at least one fairness equilibrium which to my eyes seems to be pretty close to reality. 

References:

Matthew Rabin. Incorporating fairness into game theory and economics. American Economic Review, 83(5):1281–1302, December 1993.