20 Negative Externalities

Question 1

What are each firm’s profit function?

Answer 1

Question 2

How can we find a better approach?

Answer 2

MERGE THE FIRMS

Question 3

What is Coase’s theorem (1960)?

Answer 3

If there is an externality such as that of public goods and public bads, then it is because there is no market for them. What you need to do is create a market, permit trade.

Question 4

How can the government get us to r*? (2)

Answer 4

Question 5

Issues with each of these methods?

Answer 5

Question 6

What is the principle behind Cap and Trade?

Answer 6

As total quantity is fixed, free rider problem eliminated. Normal market mechanisms now ensure price of permits will be MEC_r(r*) = MB_r(r*).

Question 7

What is a Pigouvian tax?

Answer 7

The other intervention: polluter pays principle.

Question 8

What is “grandfathering”?

Answer 8

!! Both interventions are subject to this !!

As we do not know MEC, we start of with more lax regulation and make them stricter on regular intervals (such as reducing permit quantities or increasing the tax).

Question 9

What is the farm’s profit maximisation function under a Pigouvian tax?

Answer 9

Question 10

Normal taxes vs Pigouvian taxes

Answer 10

Normally taxes cause DWL, but, with externalities, Pigouvian taxes eliminate DWL.

Question 11

Tragedy of the commons diagram

Answer 11

Question 12

How can we address this? (3)

Answer 12

• Property rights: remove this problem if the field belongs to one person.
• Taxes: so the equilibrium output is equal to the efficient output
• Quantity constraints: agree as a village on the number of cows.

Question 13

Price mechanism supremacy !

Answer 13

Consumers only need to know the prices of goods and their personal preferences in order to make a sensible decision on purchases. Producers only need to know prices of goods to decide what to produce.

Question 14

What does adverse selection refer to?

Answer 14

Hidden attributes/information

Question 15

Examples of adverse selection situations?

Answer 15

• Buyers of second-hand cars do not know all the attributes of the car e.g. quality, but the sellers do.
• Health insurance: people who expect to have the highest demand for insurance, will be most keen to buy it.

Question 16

How does this information asymmetry cause a problem?

Answer 16

The informational asymmetry of the informed seller, and uninformed buyer, produces a “lemons” problem. At any given price:

• all lemons are offered
• a small fraction of the cars for sale are actually worth that price

The buyers understand the situation above but does not know the quality of the car. So the buyer isn’t willing to pay the actual value of a high value car offered for sale. The market collapses. Only the “lemons” trade, at a price around zero.

Question 17

Main examples of adverse selection

Answer 17

One of the main examples of this is health care. Individuals know more about their health risks than insurance companies. In this situation, hidden information causes an incentive for bad risks to sign up.

Question 18

How could adverse selection not be a problem?

Answer 18

One policy could then be to coerce people into making choices. If the “good risks” cannot opt out of the market, as is in UK car insurance, can safely base premia on average risk characteristics and stay in business.

Question 19

What does moral hazard refer to? Where does it arise from?

Answer 19

Hidden actions/behaviour.

Arising from incomplete contracts.

Question 20

Examples of moral hazard situations?

Answer 20

• Involuntary unemployment because employers cannot observe employees’ exact work effort.
• If the government will bail out banks that are “too big to fail”, this incentivises risk-taking behaviour.

Question 21

Partial or imperfect solutions to the asymmetric information problem

Answer 21

1. Buyers/sellers can be informed and hire inspectors or experts to evaluate. Reduces the asymmetry but is costly.
2. Intermediaries offer warranties and certification to mitigate the lemons problem.

The existence of these solutions shows the reality and significance of the lemons problem. Sometimes it may be more efficient for the government to step in e.g. health.

Question 22

NHS and the moral hazard problem

Answer 22

If everyone is pooled, then the good risks essentially pay for the bad risks (NHS, the ill are supported by the healthy). This, as a result, can exacerbate moral hazard. People can indulge in more risky behaviour or be likely to make excessive use of medical services.

To deal with this, NHS can require referrals, quotas and queuing as an allocation system.