Chapter 5

Question 1

Important sources of “market failure” (3)

Answer 1

Externalities
Imperfect information
Market power

Question 2

Free riding problem

Answer 2

An agent’s decision does not take into account the costs imposed on other agents (splitting the bill)

Question 3

Types of externalities (3)

Answer 3

Tragedy of commons: a situation where a common resource is overused with respect to the socially optimal level

Congestion: excessive congestion results from an externality

Public goods: positive externalities (parks, defence, health, education)

Question 4

Why social cost and Pigou taxes?

Answer 4

In markets with externalities, the fundamental theorem fails to hold: market price is no longer the right guide for consumers and producers –> apply Pigou tax.

Question 5

The Coase Theorem

Answer 5

If property rights are properly assigned and negotiations are costless, then all externalities will be internalized so that the market solutions (cum negotiations) leads to an efficient solution.

Question 6

Adverse selection + cost lines & equilibrium

Answer 6

A market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expense of other parties who do not have this information (Lemon problem)

qe is lower than at social optimal where (p=mc)

Question 7

Advantageous selection + cost lines & equilibrium

Answer 7

Opposite of adverse selection. MC > AC (so AC increasing)

equilibrium output is greater than social optimal (qe > q*)

Question 8

Moral Hazard

Answer 8

Occurs when an entity has an incentive to increase exposure to risk because it does not bear the full costs of that risk.

Question 9

Why do monopolies exist?

Answer 9

Patents/copyright
Network effects
Leading the industry in terms of quality and efficiency (economies of scale)

Question 10

Monopoly and efficiency

Answer 10

Harberger triangle (excess burden) = loss of surplus due to missing efficient trades
allocative inefficiency
productive inefficiency because an inefficient firm manages to survive
Rent seeking

Question 11

Dominant firms

Answer 11

industry where one of the firms command a market share of 50% or more and the smaller firms divide the rest

Question 12

Residual demand

Answer 12

Market demand - the total capacity of (small) competitors –> optimal pricing MR=MC (behave as a monopoly)

Question 13

Monopoly power and elasticity

Answer 13

The degree of monopoly power is inversely related to the demand elasticity faced by the seller

Question 14

Types of regulation (4)

Answer 14

“Government intervention in economic activity using commands, controls and incentives”

Market regulation
Entry regulation
firm regulation
social regulation

Question 15

Normative theory of regulation

Answer 15

consumers faced with the negative effects of market failures demand regulation from political leaders

Question 16

Capture theory of regulation

Answer 16

market regulation is a tool employed by firms to better serve their interest –>
regulation demanded by firms rather than by consumers

Benefits from regulations are highly concentrated in few agents, whereas the costs are spread through a large number of consume

revolving-doors problem: the personnel turnover between regulatory agencies and regulated firms

Question 17

Regulatory Capture

Answer 17

Situation whereby firms invest resources into influencing the regulator’s decisions, to the point that regulation reflects the objective of profit maximization rather than that of welfare maximization

Question 18

Average cost pricing

Answer 18

Forces the firm to set the lowest price consistent with making non-negative profits

Question 19

Natural monopoly

Answer 19

When the cost structure is such that costs are minimized with one supplier only

Question 20

Rate-of-return regulation

Answer 20

A mechanism whereby prices are set to allow the firm a fair return on the capital it invests

Major issue: little incentive to reduce costs, as fixed rate of return

Question 21

Regulatory lag

Answer 21

A gap between when the firm reduces cost and the time when the new regulated prices take effect, provide transitory gains

Question 22

Low-power incentive mechanism

Answer 22

price varies in the same measure as cost, which minimizes the incentives for cost reduction

Question 23

High-power incentive mechanism

Answer 23

Price is set beforehand and does not change at all even if cost changes, providing maximal incentives to reduce costs.

Little incentive to focus on quality
Could allow for allocative inefficiency if the gap between p and mc becomes substantial

Question 24

The efficient component pricing rule (ECPR)

Answer 24

the wholesale price offered to an independent downstream firm cannot be higher than the difference between p, the final price set by the integrated firm, and the marginal
cost of the integrated firm at the downstream stage.

If ECPR is applied than production efficiency is maximized