1.10 Externalities and Asymmetric Information.

Question 1

What are the effects of externalities?

Answer 1

Positive benefits others

Can make perfectly competitive market inefficient:
Negative - firms and consumers do not pay for harms
Positive - producers not compensated for benefits - underproduced

Question 2

How is negative externality ilustrated

Answer 2

(page 25)

Question 3

How are externalities privately

Answer 3

Private responses:
- Mergers and bargaining

Mergers:
- If a firm’s externality is damaging another’s profits, if they merge they could achieve an outcome that benefits both
- Also would work for positive externalities e.g. Research and development cooperation

Bargaining:
- If property rights clearly assigned, the firms could also bargain to achievee and efficiently optimal outcome

(See table on page 26)

If they bargain they can both profit but depends on property rights

Question 4

What is the Coase Theorem?

Answer 4

If ownership rights can be clearly assigned, affected parties can bargain and externalities don’t create efficiency problems

Unfortunately does not solve most problems - cost of bargaining high, hard to identify source of problems, often asymmetric information

Question 5

How do governments intervene with externalities?

Answer 5

• Quantity restrictions
• Taxes
• Creating markets

Taxes/restricting externalities can internalise the externality and shift it to social optimum

Question 6

What are issues with public intervention?

Answer 6

in general hard to set correct standard or tax, lack the perfect information about costs and benefits
- Which activities produce the externalities
- What is the value of the damage done

Tax usually hardest to maximise welfare - taxes and restrictions yield different results

Question 7

What are other ways governments control externalities

Answer 7

Market for pollution:
- Polluting firms get permits, create property rights allowing firms to bargain and trade permits with eachother. The statesets an overall pollution level and firms find the best way to achieve the level by trading permits

Over time the government reduces the permit, incentivising firms to sell their permits and reduce pollution

Question 8

What are the 2 properties of public goods

Answer 8

Non rival: more than one can consume the good

Non excludable: cannot prevent people from consuming the good

Question 9

What is open access common property

Answer 9

A good that is non exclusive but rival

An example is an ocean fisheries - all fishers have access but over time reduces number of fish creating a negative externality

Question 10

What are club goods?

Answer 10

Goods that are non rival but subject to exclusion

e.g. television, streaming services

Market intervention is difficult - often initial investmnet required so no entry if p = MC = 0

The market provision is inefficient - MC of providing an additional unit is 0. Charging positive price means p>MC, leading to welfare losses.

Question 11

What are club goods?

Answer 11

Goods that are non rival but subject to exclusion

e.g. television, streaming services

Market intervention is difficult - often initial investmnet required so no entry if p = MC = 0

The market provision is inefficient - MC of providing an additional unit is 0. Charging positive price means p>MC, leading to welfare losses.

Question 12

What are public goods

Answer 12

Non rival and non excludable

• Marginal cost of additional person using the good is 0 - anyone consumes once paid for
• Non exclusive - no one excluded from consumption

e.g. lighthouse, street lamp, national defence

Question 13

What is the socially optimal provision of public goods, how is it achieved?

Answer 13

e.g. security in a shopping centre

Hire until MCs = MBs
- Assume cost 10/hour - social MC = 10/h
- Private = Social MC
- Social MB = sum of indiviudla benefits (non rival)
- Individual demand curves reflect private marginal valuation

Total marginal benefit = vertical sum of demand curves

(Look at graph on page 26)

If shops hire seperately:
Shop 1 hires 2 guards (d1=MC)
Shop 2 hires no guards (d2<MC everywhere)

Optimal provision is where MSB = MSC: 5 guards

Market fails:
- Non rival implies public goods special type of positive externality
- Shop 1 not rewarded, benefits shop 2
- Non exclusivity means shop 2 free rides

Sometimes solved through social initiatives:
- Social pressure: convince each firm to voluntary tribute
- Mergers - if shops merge, joint valuation

In most cases though government intervention is needed:
- Private solutions onl work for small gruops,
- Public good provision involves many group members
-Government can coerce people into participation (tax)

Question 14

What are the 2 types of asymmetric information:

Answer 14

Hidden Characteristic: fact known to one party unknown to others - car quality buyers may not know

Hidden actions: one party cant observe action taken by other e.g. firm manager using company jet for personal use

Question 15

What is adverse selection:

Answer 15

Asymmetric information about hidden characteristic causes low quality products to be over represented
- Common in second hand
- market failure - reduces size of market or eliminates it
- Problem in insurance markets - life and health insurance

Question 16

What is a moral hazard?

Answer 16

Informed person taking advantage of a less informed person through unobserved actions
- Leads to misalignment of private and social incentives and creates market failures
- Adverse selection and moral hazards arise together e.g. in insurance

Question 17

What is an example of adverse selection

Answer 17

Second hand cars:
-People likely to offload worse quality cars than high quality

Uninfomred buyers only pay low price because likely to end up with a lemon

Can crowd out high quality cars altogether, leading to partial collapse of the market

Question 18

Perfect information in car market

Answer 18

Look at first set of graphs:

• Buyers willing to pay 4k for Lemons, 8k for plums (assume +-1k available)

Owners wiling to sell lemons for 3k and plums for 5k (case 1) or 7k (case 2)

Markets are clear in both cases, all cars are sold

Question 19

Imperfect by symmetric information in the car market

Answer 19

Buyers don’t know quality, 50% chance of lemon and 50% chance of plum

Now willing to pay 0.5(4000+8000) = 6000

Sellers also do not know quality
Case 1 - willing to sell for 0.5(3000+5000) = 4000
Case 2 - willing to sell for 0.5(3000+7000) = 5000

In both cases, market clears and all cars are sold

Market is inefficient - cars go to people who value them more than their original owners

Question 20

Imperfect and asymmetric information

Answer 20

Buyers cant observe quality so pay 6000

(look at second set of graphs on page 26)

Sellers can now observe the cars quality

Case 1: reservation value for high quality is 5000
- Willingness t pay > reservation value in both markets. All cars sold owners of lemons benefit and plums worse off

Case 2: reservation value for high quality is 7000
Owners of plums dont want to sell. If buyers realise, will only be willing to pay 4000 - the 1000 worse quality sell for 4000 and no plums will sell

Creates inefficient equilibrium because high quality cars remain in the hands of people who value them less than potential buyers do.

Question 21

How do reduce adverse selection:

Answer 21

Government intervention to rpevent opportunism by better infomred sellers:
- Product liability laws
-Standards and certification

Screening:
- Consumers avoi low quality goods if obtain good information

Signalling:
- Producers with high quality goods can distinguish themselves from other low quality produces:
- Brands, guarantees/waranties - only if signal is credible - often too costly for low-quality firms

Question 22

How is moral hazard in insurance market graphed?

Answer 22

Look at last set of graphs on page 26:

With moral hazards, infomred people take advantage of less infomred people through unobserved actions. Problem arises from the hidden action, not a hidden characteristic as with adverse selection

Without insurance, home owners balance MB of care against the marginal cost (assuming MC = 1 per unit)
- Set MC = MB

With insurance, the marginal benefit of care is reduced. A lower equilibrium level of care even though the total cost of the fire is still the same. Creates a welfare loss of the green area, since social MB > private MB

Moral hazards cause alignment of social and private incentives to breakdown, leading to welfare loss - arises from problem that decision maker actions cannot be properly monitored
- The policyholder would also benefit from absence of asymmetric information. even in perfect competition, insurance companies must cover cost and must increase premium with moral hazard

Question 23

Ways to reduce moral hazards? How does this differ from adverse selection?

Answer 23

• Insurance: co-insurance or excess/deductible
• Owner/employer: employee relationships: monitoring, performance based compensation (stock options, etc.)

Moral hazard requires different kinds of solutiosn than adverse selection

Adverse selection: needs to create mechanisms to transfer information to uniformed party

Moral hazard: need to create incentives for the informed party not to undertake harmful hidden actions