Topic 5 Market Imperfections

Chap 16, 17 & 20

Learning Objectives
Externalities and Coase Theorem Choice under uncertaintyInsurance Asymmetric informationadverse selection and moral hazard

The Missing Markets Externalities

Negative Externality/External Cost
A cost of an activity that falls on people other than those who pursue the activity
Examples?

Positive Externality/External Benefit

A benefit of an activity received by people other than those who pursue the activity
Examples?
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External Benefit
Discussion Questions (Part I): Does the honeybee keeper face the right incentives?
Bees pollinate the apple orchards. Q1: Who enjoys the external benefit generated by whom?
Answers: The orchard owner enjoys the external benefit generated by the honeybee keeper.

Q2: Is the number of hives more or less than the social optimal number?
Answers: The number of hives is less than the social optimal number.
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External Cost
Discussion Questions (Part II): Does the honeybee keeper face the right incentives?
If the hives are located near a school, people might to get stung by the bees.

Q3: Who bears the external cost produced by whom?

Answers: The students bear the external cost produced by the honeybee keeper.

Q4: Is the number of hives more or less than the social optimal number?
Answers: The number of hives is more than the social optimal number.

The Coase Theorem

When an activity generates external benefits/costs, the level of the activity will be less/greater than the socially optimal level.

The Coase theorem

If people can negotiate with one another at no cost over the right to perform activities that cause externalities, they can always arrive at efficient solutions to the problems caused by externalities, no matter who owns the right. Otherwise, the Coase solution of establishing property rights doesnt work and governments try to deal with externalities.
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The Coase Theorem

Discussion Questions:
Abercrombies company produces a toxic waste. If the waste is dumped into the river, Fitch cannot fish the river.

Will Abercrombie install a filter?

Part I
Assume that the law does not penalize Abercrombie for dumping toxins in the river. Also assume there is no communication between Abercrombie and Fitch.
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The Coase Theorem

With filter
Gains to Abercrombie Gains to Fitch

Without filter $130/day

$100/day

$100/day

$50/day

Q1: Which alternative will Abercrombie choose?

Answers: Not to install a filter because its gains is $30 more than that with a filter.

Q2: Which outcome will the society benefit the most?

Answers: Because the social gains with a filter is $20 more than that without a filter, the society will benefit the most if there were a filter.
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The Coase Theorem

With filter
Gains to Abercrombie Gains to Fitch

Without filter $130/day

$100/day

$100/day

$50/day

Q3: Whats the MC of the filter?

Answers: MC of a filter = $30.

Q4: Whats the MB of the filter?

Answers: MB of a filter = $50.

Q5: Whats the gain/loss in economic?

Answers: Economic gain of a filter is $20.
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The Coase Theorem

With filter
Gains to Abercrombie Gains to Fitch

Without filter $130/day

$100/day

$100/day

$50/day

Part II: Now assume Abercrombie and Fitch can communicate at no cost.
Q6: How much at most would Fitch like to pay Abercrombie to use the filter?
Answers: $50 at most which is equal to his MB of a filter.

Q7: Will Abercrombie accept Fitchs offer?

Answers: Abercrombie will accept Fitchs offer as long as he gets a payment greater than his MC of installing a filter, that is, $30.

Q8: Is this outcome socially efficient?

Answers: Yes, because the socially efficient outcome is to install a filter 10 which now is voluntarily reached by Abercrombie and Fitch.

The Coase Theorem

With filter
Gains to Abercrombie Gains to Fitch

Without filter $170/day

$100/day

$100/day

$50/day

Part III: Now continue to assume by law Abercrombie cannot dump without Fitchs approval.
Q9: Which outcome is socially efficient?
Answers: Not to install a filter is now socially efficient because the MB of a filter, which is $50, is smaller than its MC, $70.

Q10: Who will pay whom for that outcome?

Answers: Abercrombie will pay Fitch to avoid to install a filter.

Q11: How much at the most would someone like to pay?

Answers: Abercrombie would like pay at most $70.
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Legal Remedies for Externalities

When negotiation is not costless and not possible, legal remedies may be used to correct for externalities. Government action in the face of external benefits
public provision private subsidies

vouchers
patents and copyrights

Government action in the face of external costs

taxes

emission charges
marketable permits

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Legal Remedies for Externalities

Taxing a negative externality Subsidizing a positive externality

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Choices under Uncertainty

Discussion Questions: Tania, a student, is trying to decide which of two alternative summer jobs to take.
She can work as a house painter and have $2,000 in at the end of the summer and there is no uncertainty about the income from this job. The other job is working as a telemarketer. Tania thinks there is a 50 percent chance that she will earn $5,000 and a 50 percent chance that she will earn $1,000. Q1: Which job does she prefer?
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Choices under Uncertainty

Answers to Discussion Questions:
Benefits under uncertaintyexpected wealth
Tanias EW from the painting job = $2,000 Tanias EW from the telemarketing job = 0.5($5,000) + 0.5($1,000) = $3,000

Costs under uncertaintyrisks

The painting job is non-risky. The telemarketing job is risky.

Tanis will take a job that maximizes her expected utility, which depends on how much she dislikes riskdegree of risk aversion.
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Choice under Uncertainty

With uncertainty,
utility can be nonlinear to wealth.
Risk-averse: utility is concave to wealth. Risk-neutral: utility is linear to wealth. Risk-loving: utility is convex to wealth.
C E D F

Risk-neutral

So, choices are made to maximize expected utility.

Risk-averse
E

C B

Risk-loving

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Choices under Uncertainty

Risk aversion is the dislike of risk.
It is measured by using a utility of wealth curve. The marginal utility of wealth diminishes as wealth increases.
The faster the marginal utility of wealth diminishes, the more risk averse a person is.

For a loss of wealth or a gain of wealth of equal size, Tanias pain from the loss exceeds her pleasure from the gain.
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Choices under Uncertainty

Discussion Questions Revisited:
Tanias EU from the risky job is 70 units, which brings her an EW of $3,000. Her EU from the non-risky job is 70 units too, which ensures her $2,000 of wealth.
Certainty Equivalence (CE) is the ensured wealth that would generate the same utility level as the expected utility.
50 percent chance of this outcome

So, Tania is indifferent between these two jobs and her cost of bearing this risk is $1,000.
Cost of risk = EW - CE
Certainty Equivalence

and 50 percent chance of this outcome

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Choices under Uncertainty

Discussion Questions Revisited:
Q2: How about Tanias choice if her chance of success in the second job drops to only 20%?
Answers: With a low chance to success, Tanias EU from the risk job reduces to 55 units, which is lower than her utility from the non-risky job. So Tania should choose the first job.

Q3: How about Tanias choice if her chance of success in the second job increases to 80%?
Answers: With a high chance to succeed, Tanias EU from the risky job now increases to 85 units, which is higher than that from the non-risky job. So Tania should choose the second job.
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Buying and Selling Risk

Insurance
Insurance provides a goodrisk avoidance. Why do people buy insurance?
People values risk avoidance because they are risk averse generally. A buyer of insurance can gain because the value of avoiding risk is grater than the price that must be paid to get someone else to bear the riskpremium. Example:
Dan owns a car worth $10,000, and that is his only wealth. There is a 10 percent chance that Dan will have a serious accident that makes his car worth nothing. Would Dan buy insurance?
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Buying and Selling Risk

Answers to Example:
With no insurance,
Dan either has no utility if a car crash happens with a probability of 10%, or has 100 units of utility if there is no car crash with a probability of 90%.

His EU = 0.1(0) + 0.9(100) = 90 If Dan had $7,000 of wealth for sure, he would have the same utility as has with $10,000 of wealth and 10% risk of loss.
The CE to 90 units of EU is $7,000.
Certainty Equivalence

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Buying and Selling Risk

Answers to Example:
Buying an insurance which promises a full coverage, Dan sells all the risk he bears and so can lock his wealth to a certain level of $10,000 premium. Dan will like to pay $3,000 at most, in which he is at least as good as he would be without the insurance. The value of insurance to Dan is $3,000.
Value of insurance = Coverage of insurance CE

Wealth with fullcovered insurance

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Buying and Selling Risk

Insurance
Why does an insurance company sell insurance?
The seller of insurance faces a lower cost of risk than the price that people are willing to pay to avoid that risk.
Risk cost of the insurance company < Risk cost of an individual insured

An insurance company can reduce its cost of bearing the risk through pooling the risk.

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Buying and Selling Risk

Example Revisited:
If there are lots of people like Dan, the insurance company pays out $1,000 per person on average. So, the cost of insurance to an insurance company is only $1,000. Gain from trading risk is $2,000.
If the insurance market is a monopoly, the insurance company takes the $2,000 per insured person as economic profit. If the insurance market is competitive, each insured person enjoys a consumer surplus of $2,000.
Gain from insurance

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Private Information
Private information is information
possessed by a buyer or seller about the value of the item being traded that is not available to the person on the other side of a transaction.

When either buyers or sellers have private information, the market has asymmetric information.
Adverse Selection Moral Hazard
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Private Information
Adverse selection is the tendency for people to ENTER INTO agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.
Example:
If Jackie advertises jobs for salespeople at a fixed wage, she will attract lazy salespeople. Hardworking salespeople will prefer to work for someone who pays by results, rather than a fixed wage. The fixed-wage contract adversely selects those with private information about their work effort.
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Private Information
Moral hazard exists when one of the parties to an agreement has an incentive AFTER the agreement is made to act in a manner that brings additional benefits to himself or herself at the expense of the other party.
Example:
Jackie hires Mitch as a salesperson and pays him a fixed wage regardless of how much he sells. Mitch faces a moral hazard. He has an incentive to put in the least possible effort, benefiting himself and lowering Jackies profits.
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Market For Used Cars

Discussion Questions:
The market has two types of cars:
Lemons worth $5,000 each. Cars without defects worth $25,000 each.

Whether the car is a lemon or not is private information of the current owner. However, buyers are informed that half of the used cars sold turn out to be lemons. Q1: Whats the average price that a buyer would like to pay for a used care of unknown quality?
Answers: The average price for a used car of unknown quality should be equivalent to its expected value, that is, 0.5($5,000) + 0.5($25,000) = $15,000.
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Market For Used Cars

Discussion Questions:
Q2: Who would be likely to accept this offer, the owner of a good car, or the owner of a lemon?
Answers: The owner of a good car would be reluctant to accept this offer because the price is less than the value of that car. However, the owner of a lemon would be much happier to sell his lemon at such a high price.

Q3: What kind of cars, lemons or cars without defects, will exist in the market eventually?
Answers: Using the same logics, buyers are aware that only owners of lemons would take the offer. So, buyers would continue to lower his offer until the only possible offer is the value of a lemon, $5,000. Following that, the only kind of cars traded in the market would be lemons only. 29

Market For Used Cars

In the used car market,
Adverse Selection exists because of the Lemon Problem too many lemons and too few goods are traded in a market with asymmetric information. Moral Hazard also exists because the owner of a lemon has little incentive to take good care of the car, which probably worsens the lemon problem. Only one message is visible to buyers: all cars look the samepooling equilibrium

Solutions: Warranties
Through singing warranties, the car dealer, usually the informed person, sends a signal of information to uninformed buyers, which enables the market to trade good cars. Two messages are sent to buyers: cars with warranties are good cars and cars without warranties are lemons separating equilibrium.
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