Market Failure: Asymmetric info and Public Goods

Question 1

What is meant by asymmetric info?

Answer 1

Asymmetric info is a situation in which the buyer knows more than the seller - or the seller knows more than the buyer - about the thing they’re bargaining over.

ex. when it comes to selling used cars, sellers are much more knowledgable about the true quality of the vehicles than the buyers.

on the other hand, when it comes to home insurance, the buyers of the insurance policies are much better informed because they know all about their homes, and the security methods they employ to safeguard them.

Question 2

What is symmetric info?

Answer 2

Info can be incomplete but SYMMETRIC when each party is equally in the dark about the other.

Question 3

What does asyymetric info limit?

Answer 3

It limits exchange in a market.

If you know that the other person is better informed than you, you’re afraid that he may use his info to take adv of you.

Similarly, if you cannot expect their honesty in the deal, you will be less likely to make one.

Question 4

How can asymmetric info lead to MARKET FAILURE (or even market collapse)?

Answer 4

It depends on how bad the asymmetric info is.

If you have huge worries that that the seller of the used car may be exagerating the value of the vehicle she’s trying to sell you, you probably aren’t going to buy it. This sounds logical, but it prevents the sale of good cars because everybody’s worried about bad cars.

If insurance co.’s can’t figure out a way to tell the good insurance risks from the bad insurance risks, they may charge high rates to everybody as though everyone is a high risk. And that typically causes the low risk people not to buy insurance because they know they’re being overcharged.

Question 5

Who is George Akerloff?

Answer 5

berkely economist. Received the nobel prize in economics in 2001 for his paper called ‘the market for lemons’ - which is about asymmetric info and market failure in the used cars market.

Question 6

Why was Akerloff interested in the used car market?

Answer 6

Because it suffered from an interesting form of market failure: almost all the used cars for sale are lousy (lemons).

Akerloff explained that poor-quality cars, dominate the market because asymmetric info drives away almost all SELLERS who want to part with high-quality used cars.

Question 7

In akerloff’s model what are the 3 types of used cars available for buyers?

Answer 7

3 types: good, okay and bad.

they all look and drive the same but they all have major differences in terms of how much longer they’re going to last until the engine dies.

Because of the difference in engine quality the good cars are worth: £15G, the okay = 10G and the bad = 5G

What causes the market failure? asymmetric info between buyers and sellers - in particualr, although each seller knows how good their own car’s engines are, they buyers have no way of knowing.

Question 8

How much is a buyer willing to pay for a used car?

Answer 8

Because sellers have no way of proving to buyers how good their cars are, a sensible thing to do when presented with a used car is to assume its of average quality - therefore the buyer offers 10G

Question 9

What are the different reactions of the seller to the 10G offer?

Answer 9

depending on the true quality of their cars

1) if the seller knows its a bad car (worth 5G) he happily accepts your offer
2) if the seller knows its an ok car he accepts because you’re offering what the car’s worth
3) if the seller knows its a good car he doesnt accept (unless he’s desperate)

Question 10

What happens to all the good cars because of the 10G offer from buyers?

Answer 10

the result is that all the good cars on the market are withdrawn, leaving only bad and ok car.

Question 11

How does taking all the good cars off the market change what the buyer is willing to offer?

Answer 11

so now a 50/50 chance exists that a car is ok or bad.

So now the buyer offers the seller 7.5G.

Question 12

How does the seller react to a 7.5G offer for an ok car?

Answer 12

remember ok cars = worth 10G

Now the market becomes even more dysfunctional.

becaus ethe seller is going to reject your offer and withdraw all their ok cars from the market as well.

Question 13

How does the used car market end up as a market for lemons?

Answer 13

Because the good and okay cars are all withdrawn the only cars left are the bad ones - the lemons.

Question 14

Are buyers aware that the used car market ends up as a market for lemons?

Answer 14

Yes.

And so they only off 5G for any car on the market.

And because only bad cars are offered, the sellers accept the 5G.

So although the bad cars end up being priced correctly in the used car market, no market exists for good or even ok used cars.

Question 15

How is Akerloff’s model related to the credit crunch?

Answer 15

Following the Lehman Brothers’ bankrupcy filling in sept 08, crediors began to wonder whether Lehan was the only poor debtor in town (as we no know, they weren’t).

Soon, the financial sector began to withdraw credit from the market as the sums were done and exposures calculated. Lenders could not be confident that borrowers were not lemons, and so they began to withdraw their custom from the market - just like Akerloff predicted.

This withdrawal of credit from the market is what we now call - the credit crunch.

Question 16

What is one way a seller can convince a buyer that she’s really got a good car?

Answer 16

Offer the buyer a warranty.

A warranty is convincing because only the seller of a good car is willing to offer one - the seller knows the car won’t break down after the sale, meaning she’s never going to have to pay for repairs.

On the other hand, the seller of a bad car would never offer a warranty because he knows that his car is likely to break down and that he’s going to have to pay for the repairs.

Also known as ‘signalling’ - signal = a way to indicate that your product is high quality.

Question 17

What is another way of solving the lemons problem?

Answer 17

Building a reputation.

Compare a used car dealership with an individual selling her car online.

She has much more of an incentive to lie about the quality of the car than the dealer who has to worry about his reputation - think what happens to him if he lies.

As a result, most good used cars are sold through used car dealers.

Question 18

What asymmetric info problem do insurance co’s face?

Answer 18

The people buying the insurance know more than the co. aboout the risks they face.

Question 19

What is ADVERSE SELCTION?

Answer 19

Even good drivers need insurance as they’re sometimes involved in accidnets which were not their fault. But bad drivers want insurance EVEN MORE to help pay for all the accidnets they know they’re going to cause because of their poor driving. Economists call this situation ADVERSE SELECTION.

An asymmetric info proble, faces the insurance co because although individual drivers know they’re good or bad, the insurance co can’t easily tell them apart. If they could, they’d simply charge the good drivers a low rate for insurance and the bad drivers a high rate.

Question 20

Since the insurance co’s can’t tell good and bad drivers apart, what risks do they face?

Answer 20

Therefore they face the risk of going bankrupt.

Imagine that the insurance co’s offer the same low rate to everyone, as though they were ALL good drivers. This strategy soon leads to bankruptcy because the insurance co’s aren’t collecting enough in premiums to pay off all the damage caused by the bad drivers.

Question 21

What do the insurance co’s do to avoid bankruptcy?

Answer 21

They go to the other extreme and charge everyone the high rates as though they were ALL bad drivers.

But then the good drivers stop buying insurance because for them it’s overpriced. The result is that only bad drivers sign up for insurance.

Question 22

How do insurance co’s tell whether an individual is a good or bad driver?

Answer 22

They look for clues about the individual based on the groups to which he or she belongs.

ex. malesunder 25 get into more car accidents than females uner 25. So if a 23 yo male and 22 yo female walk into an insurance co, chances are the male is the worse driver out of the 2 and so you charge him a higher rate.

Question 23

What is the benefit to society when insurance co’s group individuals to tell them apart?

Answer 23

This situation has the nice result of making sure that everybody can get insurance at what is LIKELY to be a fair price given the fact that, on average, males under 25 get into more accidents than females under 25.

Question 24

In reality, what is the real reason why insurance companies group individuals to tell them apart?

Answer 24

The real reason they do so is because they have no choice; competition forces them to do so.

Imagine 2 insurance co’s, only 1 of which uses group-membership info to help set rates. The co that doesn’t use group info has to set very high rates because of the fear that all its customers might be bad drivers - and this drives away all the good drivers who don’t want to pay bad driver rates for insurance.

Question 25

What unfair conclusions are made by insurance complanies using group-membership info?

Answer 25

Sometimes, good-driving yound males end up paying higher rates than bad driving young females because the only thing insurance co’s have to go on is gender.

Still though, this system is better than the even more unfair alternative in which ALL good drivers ahve to pay bad-driver rates - which is what would happen if insurance co’s were banned from using group-memebership info.

Question 26

What is the group for which insurance co’s have the greatest need to use group-memebership info?

Answer 26

New drivers.

Because insurance co’s don’t have any accident or violaion records for new drivers, a pressing need exists to try to separate the good from the bad drivers using group-memebership info.

As drivers get more experience, the insurance co’s can get increasingly accurate accident and violation info that ditinguishes the good from the bad.

Question 27

Give an example of ADVERSE SELECTION.

Answer 27

Obviously, any group still features lots of individual variation.

ex. even if young women are, on average, better drivers than young men, some young women are bad drivers. If an insurance co sets a premium for young women on the basis of how often young women ON AVERAGE get into accidents, insurance is more attractive to young women who are really bad drivers than to young women who are really good drivers.

As a result, bad-driving yound women are more prone to sign up for insurance than good-driving young women. This is known as adverse selection because the bad, or adverse, insurance risks seem to self-select into buying insurance policies. The result is a customer pool that contains a disproportionately high no. of bad drivers.

Question 28

Why is adverse selection a difficult problem?

Answer 28

Because it feeds on itself. The insurance co. has to raise rates to take account of the fact that bad drivers are more likely to sign up than good drivers.

But when it raises rates, the problem just gets worse because the higher ratesmake insurance even less attractive to good drivers, meaning that the pool of applicants is going to be even more disproportionately dominated by bad drivers.

Question 29

What is a solution for adverse selection?

Answer 29

One solution is for insurance co’s to offer a large group of people one rate - on the condition that nobody can opt out.

ex. at one U.S uni, a health insurance co. offers the uni one low rate for every employee on the condition that every employee must be enrolled.

by enrolling everyone, there’s no chance that the less healthy are going to dominate the insurance pool because the healthy have declined to be enrolled.

Question 30

Explain the MORAL HAZARD problem faced by insurance co’s.

Answer 30

Moral hazard arises because buying insurance tends to change people’s behaviour.

ex. if you don’t ahve car insurance, you’re likely to drive much more slowly, knowing that you have to use your own money to pay for any damages. But becuase you do have insurance, you may driver faster and more recklessly knowing that if something were to go wrong, the insurance co. will pay the bill.

Question 31

How do insurance co’s deal with moral hazards?

Answer 31

By offering discounts in exchange for high excesses.

ex. if you get into an accident, the £1,000 excess that you’ve chosen means that you have to pay the first £1,000 of any bills resulting from the accident.

The excess serves as a strong inducement for you not to give into moral hazard and drive recklessly.

And because the insurance co. knows that your high excess gets rid of most of your moral hazard problem, they’re willing to offer you insurance at a lower rate than if you opt for ONLY £100 excess.

Question 32

What is a public good?

Answer 32

Public goods are things that private firms can’t profitably produce because no way exists to exclude non-payers from using them.

The inability of private firms to produce public goods profitably derives from the fact that public goods have two very special characteristics: they are non-rival and non-excludable.

Question 33

What does non-rival mean?

Answer 33

It means that one person using the good doesn’t diminish another person’s ability to enjoy the good.

Think of a fireworks display, a statue in a park or a tv show broadcast over the airwaves. Your consumption doesn’t in any way diminish that of others.

This situation stands in stark contrast to most goods, where if you consume more, less remains for others (think of cookies).

Question 34

What does non-excludable mean?

Answer 34

It means that preventing non-payers from consuming a good or service is difficult.

ex. when you produce a fireworks display, everyone in the vicinity gets to see it for free, no matter how much you may want to charge them for it.

a more serious example is an army: when an army is in place to provide national defence, it provides national defence for everybody, including those who don’t want to contribute to the cost of maintaining it.

Question 35

What is the most common solution to the problem of how to provide public goods?

Answer 35

The most common solution is for gov’s to step in and use tax revenues to pay for them.

ex. fireworks, because everyone likes fireworks, there’s no problem getting enough political support for spending tax money on displays. And after taxpayers have funded them, everyone can enjoy the fireworks.

Question 36

Give examples of how philanthropy is sometimes enlisted to provide public goods.

Answer 36

Although gov taxs pay for most public goods, some goods are paid for privately.

ex. in Dundee lots of public parks were originally donated to the city by the Jute Barons like the Cox bothers - who gained their wealth in the thriving textiles industry of the 19th century.

In ancient Greece and Rome, rich aristocrats used to pay for new roads, aqueducts and temples for public use. Some even paid for entire armies to be sent out to defend countries in times of war.

Question 37

Are gov’s absolutely necessary for the provision of public goods?

Answer 37

No

But they are a much more relaibale way to provide public goods because you don’t have to rely upon the philanthropic largess of the rich, who are under no obligation to spend their wealth on public rather than private goods.

Question 38

Are public goods called public goods because the gov rather than the private sector typically provides them?

Answer 38

No.

Economists call them public goods because private firms can’t profitably produce them, not because they have to be produced by the gov. Private philanthropy can produce public goods without any help at all from the gov.

Question 39

Given that tv programming is very much a public good, why are lots of tv programmes produced by privately owned and operated tv stations?

Answer 39

The answer is that the US broadcast industry figured out that although TV itself is a public good, the adverts that accompany TV programmes are very much PRIVATE goods for which they can charge a lot of money.

ex. if a car maker wants its ad to be shown to millions of viewers who tune in for free to the public good known as TV, that company has to pay for commercial air time.

Question 40

What si the trick behind TV?

Answer 40

The trick is that the privately sold good called advertising pays for the freely provided public good called TV.

Newspapers work in the same way - although they raise some money from subscriber fees or from the newstand price, a huge chunk of their revenue comes from the advertising they sell.

Question 41

Is advertising the sole reason why TV is provided as a public good?

Answer 41

No.

In most countries a balnce exists between state sponsorship and private provision.

ex. in the uk, the BBC, funded from a license fee, is a solution to the non-excludabilty condition.

Question 42

Give an ex. of how new technologies are public goods.

Answer 42

Consider the invention of the moveable-printing press by Gutenberg in 1435. Before Gutenberg, books were copied by hand. But after he invented the printing press, printing new copies became incredibly easy.

Question 43

How does the invention of the printing press satisfy the characteristics of a public good?

Answer 43

1) The invention is non-rival because building and using a printing press doesn’t in any way lessen anyone else’s ability to build and use a printing press.
2) The invention is basically non-excludable because the cost of communicating the idea to another person is so low - just a short conversation does the trick.

And so, gutenberg never received any payment in spite the fact everybody copied his idea.

The result: unless you come up with a way to reward the creaion of new inventions financially, you’re unlikely to get many new inventions.

Question 44

What can be used to ensure new inventions are created?

Answer 44

The solution has been the creation of patents.

The fact that the industrial revolution took off only after gov-enforced patents became widely available in western europe in the 18th century is not coincidental.

Question 45

Can every new innovation be patented?

Answer 45

No

because you can patent only something you create, not something you discover.

ex. if you think up a new chemical and then synthesis it, you can patent it.

but if you merely discover an eexisting chemical thats been floating around the sea or lying in the soil, you can’t patent it.

Question 46

Why does this situation (discovering a new chemcial as opposed to creating a new chemical) create big issues for cancer research?

Answer 46

because many potential cures are chemicals derived from plants and animals - chemicals which have been in existence for eons.

These chemicals have huge potential benefits, but because they can’t be patented, nobody has a strong financial incentive to try to discover them.

Question 47

How do we get past the public goods problem which would otherwise limit research?

Answer 47

Govs and philanthropic groups fund research into areas of science where the public goods problem would otherwise limit research.

This solution is very important to an economist because providing public goods is an economic problem that markets and the invisible hand can’t fix.

remember: other types of market failure, like asymmetric info, have pretty decent private sector solutions i.e. ‘making lemonade: solutions to the lemons problem’

Question 48

What happens if a society can’t come up with good ways of providing public goods?

Answer 48

That society is permanently deprived of their benefits.

For public goods like firework displays, this hardly matters.

But for technological innovations like curing cancer, the situation is literally a matter of life and death.

Question 49

How do the owners of a large business know that managers work to build shareholder value?

Answer 49

This lack of information is known as the principal-agent problem or the “agency problem.

The principal agent problem revolves around how best to get your employees to act in your interests rather than their own

aka Possible conflicts of interest that may result between shareholders (principal) and the management (agent) of a firm

Question 50

How are private sector companies normally owned?

Answer 50

The owners of a private sector company normally elect a board of directors to control the business’s resources for them. However, when the owner sells shares, or takes out a loan or bond to raise finance, they may sacrifice some of their control.

Other shareholders can exercise their voting rights, and providers of loans often have some control (security) over the assets of the business

This may lead to conflict between them as different stakeholders can have varying objectives.

Question 51

Give an example of a principle agent problem

Answer 51

Shareholders tend to want strong returns in the form of dividend payments and a rising share price.

Managers may have objectives such as power, bonuses, large expense accounts, prestige and status. The problem is the many shareholders have no day-to-day control over managers.

i.e 1) Pension fund managers cannot dictate what CEOs and CFOs of businesses decide to do and 2) senior executives may have little knowledge of what their managers are doing.

Question 52

how might a business overcome the principle agent problem?

Answer 52

One way to overcome the agency problem is to provide employee-share ownership schemes i.e. the John Lewis model where all 85,500 permanent staff are Partners who own 50 John Lewis shops across the UK.

the effects of this might be to improve the incentives for employees to increase their productivity and help the business make higher profits

Question 53

How else might a business overcome the principal agent problem?

Answer 53

Another approach could be to offer long-term employment contracts for senior managers.

This might help them to make decisions more in tune with the long-term strategic objectives of the business.

Question 54

Describe Apple’s long term stock commitment policy

Answer 54

Apple’s new policy (2013) requires senior executives at Apple to hold three times their annual base salary in stock, and executives have to keep this salary in stock for a minimum of five years to satisfy the requirement

Question 55

Tackling binge drinking.

Answer 55

The Scottish government sees cut-price drink as a major factor in widespread abuse of alcohol that results in huge social and health costs. It has introduced legislation to bring in a minimum retail price for alcohol in supermarkets of 50 pence per unit.

Question 56

What action might gov’s takes to correct market failures suffering from lack of/assymetric info?

Answer 56

Government action can have a role in improving information to help consumers and producers value the ‘true’ cost and/or benefit of a good or service. Examples might include:

Compulsory labelling on cigarette packages with health warnings to reduce smoking

Improved nutritional information on foods to counter the risks of growing obesity

Anti-speeding television advertising to reduce road accidents and advertising campaigns to raise awareness of the risks of drink-driving

Information campaigns on the dangers of smoking addiction and binge-drinking

Businesses in England and Wales that allow under-18s to use sun beds can now be fined up to £2,000. The Sunbed (Regulation) Act 2010 stops young people using sun beds in places including salons, gyms and hotels

Consumer protection laws e.g. right for refunds of faulty goods

Industry standards / guarantees for selling used products such as second hand cars

Question 57

How might a moral hazard arise as a result of the principal agent problem?

Answer 57

The agent behaves in a manner that is damaging to the principal.

Ex. Employees of investment firms make trades that ultimately, cause financial damage to the firm

Question 58

Name one solution to the moral hazard problem arising through principal agency.

Answer 58

Incentive compatible payment schemes.

if the principal can design a way to reward the agent that incentivizes the agent to engage in the type of behaviour that the principal desires, we say that the reward system is incentive compatible.

Question 59

Name another solution to the moral hazard problem arising through principal agency.

Answer 59

Monitoring.

Mutual monitoring in which memebers of a group monitor each others’ performance, is often used in microfinance to ensure loan repayment.

Question 60

Name Fishing policy in scotland

Answer 60

Most stocks exploited by Scottish fishermen are managed under the Common Fisheries Policy (CFP) by the European Commission.

Question 61

One important part of CFP

Answer 61

An important part of the management procedure is the use of Total Allowable Catches (TACs). These are intended to allocate fish resources to different member states and to control the amount of fish removed each year.

Most TACs are set on an annual basis and are the result of a cycle of events ending in the December Council of Fisheries Ministers, which decides on the final TACs for the following year

Question 62

name one issue with fixing the level of fishing quotas that can be caught:

Answer 62

Fixing the level of fish quotas that can be caught by EU member states is a complex process and EU fisheries ministers have the final say on the quotas to be allocated for the next 12-month period

sometimes scientific advice on how much of a certain species should be caught is followed to the letter, but it is not unusual for ministers to agree on levels which are very different from the European Commission’s initial proposals.

Different quotas are applied to different areas for different species, the so-called TAC areas. For example, the TAC area for North Sea whiting comprises various divisions of the International Council for the Exploration of the Sea (ICES).

Question 63

How might SG help consumers decide which sources to buy their fish?

Answer 63

The Scottish Government believes that independent sustainability certification schemes, such as that of the Marine Stewardship Council, can be a useful tool in helping consumers decide which sources to buy their food from. The MSC blue eco-label provides assurance that the product comes from a sustainable fishery.

There are a number of certification schemes around the world but the Scottish Government is particularly involved with two: those of the Marine Stewardship Council and the Responsible Fishing Scheme.

Question 64

What is the stronger incentive compatible degree?

Answer 64

dominant-strategy incentive-compatibility (DSIC)

It means that truth-telling is a weakly-dominant strategy, i.e you fare best or at least not worse by being truthful, regardless of what the others do

Question 65

What is the weaker incentive compatible degree?

Answer 65

A weaker degree is Bayesian-Nash incentive-compatibility (BNIC)

It means that there is a Bayesian Nash equilibrium in which all participants reveal their true preferences. I.e, if all the others act truthfully, then it is also best or at least not worse for you to be truthful

Question 66

1) name an example DSIC mechanism

Answer 66

majority voting between two alternatives

‘Majority rule’ is a decision rule that selects alternatives which have a majority, that is, more than half the votes. It is the binary decision rule used most often in influential decision-making bodies, including the legislatures of democratic nations

Question 67

2) name an example DSIC mechanism

Answer 67

second-price auction.

A generalized second price auction (GSP) also known as a Vickrey auction is used to sell multiple items in an auction to multiple bidders, where each item auctioned has a different value. … The winner, who has the highest bid, takes the highest valued item, but pays the bid of the secondhighest bidder.