Externalities Flashcards
externality
a cost or benefit external
to a market transaction,
and is thus not reflected
in market prices
CBA
method of decision making that takes into account all social costs and benefits involved with economic activity. If social benefits exceed costs, suggests activity will be beneficial to the public and should proceed
what is a project that CBA has been used on?
major transport projects like UK’s High Speed 2 railway
how is CBA different from private sector investment appraisal?
- includes ALL costs and benefits, not just private ones
- will assign a shadow price for costs and benefits without a market value for e.g. time savings due to a transport project or easier access to healthcare due to a hospital
shadow price
one applied when there is no market price available
implications of CBA for economic efficiency
can be an alternative means of allocatively efficient resource allocation and dealing with the basic economic problem when the market mechanism would fail to account for all costs and benefits
this is because it allocates scarce resources like govt funds only to projects with a net social benefit
benefit cost ratio
net benefits as a porportion of net costs
asymmetric information
one party has more or better information than another in a business transaction, leading to a misallocation of resources
can be either adverse selection or moral hazard
adverse selection
sellers have information that buyers do not have on product quality or vice versa
e.g. buyers of used cars may end up purchasing more low quality cars because they do not know the true quality of what they are buying and hence only prepared to pay an average price, which will not be enough for the legitimately good quality cars
thus good quality cars driven out of the market
A person choosing to purchase a health insurance policy has a history of family illness. They decide to withhold that information when buying insurance because they know it may result in a higher premium. Since the health insurance company doesn’t have this information, they offer the individual a policy with the same premium as a healthy person with no family medical history. In the end, the unhealthy individual is more likely to benefit because they may use their insurance more than the healthy individual
moral hazard
someone takes more risk knowing that their actions are insured by a third party - e.g. a driver in possession of a car insurance policy may exercise less care while operating their vehicle than an individual with no car insurance
