market imperfections_econ notes

7/27/2019 Market Imperfections_econ Notes

1/30

Topic 5

Market ImperfectionsChap 16, 17 & 20


2/30

2

Learning Objectives

Externalities and Coase TheoremChoice under uncertainty Insurance

Asymmetric information adverseselection and moral hazard


3/30

3

The Missing Markets Externalities

Negative Externality/External Cost A cost of an activity that falls on people otherthan those who pursue the activity

Examples?

Positive Externality/External Benefit

A benefit of an activity received by people otherthan those who pursue the activity

Examples?


4/30

4

External BenefitDiscussion Questions (Part I): Does the honeybee keeper facethe right incentives?

Bees pollinate the apple orchards.

Q1: Who enjoys the externalbenefit generated by whom?

Answers: The orchard ownerenjoys the external benefitgenerated by the honeybee keeper.

Q2: Is the number of hives moreor less than the social optimalnumber?

Answers: The number of hives isless than the social optimalnumber.


5/30

5

External CostDiscussion Questions (Part II): Does the honeybee keeper facethe right incentives?

If the hives are located near a

school, people might to get stungby the bees.Q3: Who bears the external costproduced by whom?

Answers: The students bear theexternal cost produced by the

honeybee keeper.Q4: Is the number of hives moreor less than the social optimalnumber?

Answers: The number of hives ismore than the social optimalnumber.


6/30

6

The Coase TheoremWhen an activity generates externalbenefits/costs , the level of the activity will beless/greater than the socially optimal level.

The Coase theorem If people can negotiate with one another at no cost overthe right to perform activities that cause externalities,

they can always arrive at efficient solutions to theproblems caused by externalities, no matter who owns the right .Otherwise, the Coase solution of establishing propertyrights doesnt work and governments try to deal with

externalities.


7/30

7

The Coase TheoremDiscussion Questions:

Abercrombies company produces a toxic waste. If the waste is dumped into the river, Fitchcannot fish the river.Will Abercrombie install a filter?Part I

Assume that the law does not penalize Abercrombie fordumping toxins in the river.Also assume there is no communication betweenAbercrombie and Fitch.


8/30

8

$100/day $130/day

$100/day $50/day

With filter Without filter

Gains to

Abercrombie

Gains toFitch

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 thanthat without a filter, the society will benefit the most if there were afilter.

The Coase Theorem


9/30

9

$100/day $130/day

$100/day $50/day


Gains to

Abercrombie

Gains toFitch

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.

The Coase Theorem


10/30

10

$100/day $130/day

$100/day $50/day


Gains to

Abercrombie

Gains toFitch

Part II: Now assume Abercrombie and Fitch can communicate atno 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 apayment 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 filterwhich now is voluntarily reached by Abercrombie and Fitch.

The Coase Theorem


11/30

11

$100/day $ 170 /day

$100/day $50/day


Gains to

Abercrombie

Gains toFitch

Part III: Now continue to assume by law Abercrombie cannotdump 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.

The Coase Theorem


12/30

12

Legal Remedies forExternalities

When negotiation is not costless and not possible, legalremedies may be used to correct for externalities.Government action in the face of external benefits

public provisionprivate subsidiesvoucherspatents and copyrights

Government action in the face of external costs

taxesemission chargesmarketable permits


13/30

13

Legal Remedies forExternalities

Taxing a negative externality Subsidizing a positive externality


14/30

14

Discussion Questions : Tania, a student, istrying to decide which of two alternativesummer jobs to take.

She can work as a house painter and have$2,000 in at the end of the summer and there isno uncertainty about the income from this job.

The other job is working as a telemarketer.

Tania thinks there is a 50 percent chance thatshe will earn $5,000 and a 50 percent chancethat she will earn $1,000.Q1: Which job does she prefer?

Choices under Uncertainty


15/30

15

Answers to Discussion Questions :Benefits under uncertainty expected 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 uncertainty risks The painting job is non-risky. The telemarketing job is risky.

Tanis will take a job that maximizes herexpected utility, which depends on how muchshe dislikes risk degree of risk aversion.



16/30

16

With uncertainty ,utility can be nonlinear towealth.

Risk-averse: utility isconcave to wealth.Risk-neutral: utility is linearto wealth.Risk-loving: utility is convexto wealth.

So, choices are made tomaximize expected utility .

Choice under Uncertainty

B

C

D

E

F

Risk-averse

Risk-neutral

B

C

D

E

F

Risk-loving


17/30

17

Risk aversion is thedislike of risk.

It is measured by using autility of wealth curve.

The marginal utility of wealth diminishes aswealth increases.

The faster the marginalutility of wealth diminishes,the more risk averse aperson is.

For a loss of wealth or again of wealth of equal size,

Tanias pain from the lossexceeds her pleasure fromthe gain.



18/30

18

Discussion QuestionsRevisited:

Tanias EU from the risky jobis 70 units, which brings heran EW of $3,000.Her EU from the non-risky

job is 70 units too, whichensures her $2,000 of wealth.

Certainty Equivalence (CE) is the ensured wealth thatwould generate the same

utility level as the expectedutility.So, Tania is indifferentbetween these two jobs andher cost of bearing this risk is$1,000.

Cost of risk = EW - CE


and 50

percentchance of

thisoutcome

50 percentchance of this

outcome

CertaintyEquivalence


19/30

19

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 fromthe risk job reduces to 55 units, which is lower than herutility from the non-risky job. So Tania should choose thefirst 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 EUfrom the risky job now increases to 85 units, which ishigher than that from the non-risky job. So Tania shouldchoose the second job.



20/30

20

InsuranceInsurance provides a good risk avoidance.Why do people buy insurance?

People values risk avoidance because they arerisk averse generally.A buyer of insurance can gain because thevalue of avoiding risk is grater than the pricethat must be paid to get someone else to bear

the risk premium .Example :

Dan owns a car worth $10,000, and that is his onlywealth. There is a 10 percent chance that Dan willhave a serious accident that makes his car worthnothing. Would Dan buy insurance?

Buying and Selling Risk


21/30

21

Answers to Example: With no insurance,

Dan either has no utility if a car crash happens with aprobability of 10%,

or has 100 units of utility if there is no car crash with aprobability of 90%.

His EU = 0.1(0) + 0.9(100) =90If Dan had $7,000 of wealthfor sure, he would have thesame utility as has with$10,000 of wealth and 10%risk of loss.

The CE to 90 units of EU is

$7,000.


CertaintyEquivalence


22/30

22

Answers to Example: Buying an insurance whichpromises a full coverage,Dan sells all the risk he

bears and so can lock hiswealth to a certain level of $10,000 premium.Dan will like to pay $3,000at most, in which he is at

least as good as he wouldbe without the insurance. The value of insurance toDan is $3,000.

Value of insurance =

Coverage of insurance

CE


Wealthwith full-covered

insurance


23/30

23

InsuranceWhy does an insurance company sellinsurance?

The seller of insurance faces a lower cost of risk than the price that people are willing topay to avoid that risk.

Risk cost of the insurance company < Risk cost of an

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



24/30

24

Example Revisited: If there are lots of peoplelike Dan, the insurancecompany pays out $1,000per person on average.

So, the cost of insurance toan insurance company isonly $1,000.Gain from trading risk is$2,000.

If the insurance market isa monopoly, the insurancecompany takes the $2,000per insured person aseconomic profit.If the insurance market iscompetitive, each insuredperson enjoys a consumersurplus of $2,000.


Gain frominsurance


25/30

25

Private InformationPrivate information is informationpossessed by a buyer or seller about thevalue of the item being traded that is notavailable to the person on the other side of a transaction.

When either buyers or sellers have private

information, the market has asymmetricinformation .Adverse SelectionMoral Hazard


26/30

26

Private InformationAdverse selection is the tendency forpeople to ENTER INTO agreements inwhich they can use their private

information to their own advantage and tothe disadvantage of the less informed party.Example:

If Jackie advertises jobs for salespeople at a fixedwage, she will attract lazy salespeople.Hardworking salespeople will prefer to work forsomeone who pays by results, rather than a fixedwage.

The fixed-wage contract adversely selects those withprivate information about their work effort.


27/30

27

Private InformationMoral hazard exists when one of theparties to an agreement has an incentiveAFTER the agreement is made to act in a

manner that brings additional benefits tohimself or herself at the expense of theother party.

Example: Jackie hires Mitch as a salesperson and pays him afixed 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 .


28/30

28

Market For Used CarsDiscussion 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 privateinformation of the current owner. However,buyers are informed that half of the used carssold turn out to be lemons.

Q1: Whats the average price that a buyerwould like to pay for a used care of unknownquality?

Answers : The average price for a used car of unknown quality should be equivalent to its expectedvalue, that is, 0.5($5,000) + 0.5($25,000) = $15,000.


29/30

29

Market For Used CarsDiscussion Questions :

Q2: Who would be likely to accept this offer, theowner 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 thevalue of that car. However, the owner of a lemonwould be much happier to sell his lemon at such ahigh price.

Q3: What kind of cars, lemons or cars without

defects, will exist in the market eventually?Answers : Using the same logics, buyers are awarethat only owners of lemons would take the offer. So,buyers would continue to lower his offer until theonly possible offer is the value of a lemon, $5,000.Following that, the only kind of cars traded in themarket would be lemons only.


30/30

30

Market For Used CarsIn the used car market,

Adverse Selection exists because of the Lemon Problem too many lemons and too few goods are traded in a marketwith asymmetric information.Moral Hazard also exists because the owner of a lemonhas little incentive to take good care of the car, whichprobably worsens the lemon problem.Only one message is visible to buyers: all cars look thesame pooling equilibrium

Solutions: Warranties

Through singing warranties, the car dealer, usually theinformed person, sends a signal of information touninformed buyers, which enables the market to tradegood cars.

Two messages are sent to buyers: cars with warranties aregood cars and cars without warranties are lemons

separating equilibrium

market imperfections_econ notes

Documents