Chapter 5: Market Failure

Question 1

Define the term externality

Answer 1

Costs imposed on third parties

Question 2

Name the conditions that violate the assumption of PC

Answer 2

1. Imperfect Information
2. Externalities
3. Market power

Question 3

How can an externality be eliminated?

Answer 3

Transferring the cost back to the parties involved in the transaction i.e a tax, the imposition of a fee through the need to purchase permits, fee-driven property rights etc.

Question 4

Describe the method of calculating the value of a pigou tax

Answer 4

At equilibrium, P = MC.

MSC, however, is neglected.

Accounting for MSC, P-MSC=MC.
Substituting P-MSC for P yields the new supply equation.
Finding the new equilibrium price and quantity, substitute P-t for P in the old supply equation and then, using the new equilibrium quantity and price, calculate t (the pigou tax).

Question 5

What are some alternative solutions to the issue of externalities?

Answer 5

1. Coase’s theorem: if property rights are assigned and negotiations are costless, then externalities will eventually be internalised.
2. Social norms.
3. Direct regulation i.e bans

Question 6

How can imperfect information lead to the collapse of a market?

Answer 6

Suppose a consumer wants to buy a used car, and is oblivious to whether a car on the market is a lemon or a peach. Only sellers know.

Given this informational asymmetry, the consumer is only willing to pay a price that is equivalent to his expected payoff.

This causes sellers with peaches to exit the market, since they cannot secure a price that is equal to the value of a peach.

As sellers exit, the market price decreases but so does the expected value. Since the two continually diverge, eventually there will be no sellers left in the market except for those with lemons.

Question 7

What happens at equilibrium in an adverse selection afflicted market?

Answer 7

The good is under-provided since firms have no way of distinguishing between consumers that are more costly to service and those that are less costly. Hence, P is set higher (think health insurance firms).

Question 8

Describe some examples of adverse selection

Answer 8

Buying of CDS protection from oblivious parties, health insurance, all you can eat buffets etc.

Question 9

The degree of monopoly power is…

Answer 9

inversely related to price elasticity, which is related to the margin condition (firms with lower elasticity tend to price higher than marginal cost)

Question 10

Define the capture theory of regulation

Answer 10

Firms demanding governments to regulate markets i.e prevention of dumping