micro - market failure

Question 1

What is an externality and what does it cause?

Answer 1

This refers to the direct impact to the third party not involved in the economic transaction.
This causes markets to be inefficient, and thus fail to maximize total surplus which to reach social welfare due to under/over production / consumption

Question 2

When does a positive externality occur and what does the diagram look like and what are some examples?

Answer 2

This diagram is when MSB > MPB

For example, immunisations, network externalities, basic research, education

Question 3

When does a negative externality occur + equation and what does the diagram look like and what are some examples?

Answer 3

Negative externality = MSC = MPC + MEC (marginal efficiency of capital)

Diagram is when MSC > MPC

For example, raffic congestion, cigarette smoking, air pollution, loud stereos in a social setting

Question 4

Describe 2 market based policies + 1 Command and control policy to internalise a negative externality

Answer 4

1. Pigovian tax on carbon emissions that reduces the incentive to produce (market based)
2. Tradable pollution permits ( or a cap - and - trade system that is used by the ETS - emission Trading System of EU ) that allows firms to buy and sell permits of emission, with the goal of reducing greenhouse gas emissions (market based)
3. Pollution control regulation which is a regulated limit on the amount of pollutants than firms can emit, with the goal of reducing environmental damage and preserving public health that can be made by the Environment Agency

Question 5

What is a market based solution to internalising a positive externality and how would you add this subsidy to a demand equation?

Answer 5

A subsidy which is a grant of money from the state than reduces the price of a good and should encourage more consumption and production

In order to add this to a. demand equation you would use the add of tax method but instead of adding the amount of tax, you minus the amount of the subsidy

Question 6

What is the coase theorem negotiation method in terms of private solutions for an externality ?

Answer 6

Under ideal economic conditions with conflict of property rights, it stated that both parties will deliver an efficient solution, irrespective of allocation of rights due to a transaction cost - depending on the negotiation cost this will be mean the extenality will happen or not as someone will pay for it to occur or not.

Question 7

Misallocation of public goods can lead to market failure.
What is a public good and examples of privately provided and government provided public goods ?

Answer 7

This is a good that is non- excludable = meaning one cannot be prevented from using it. It is also non-rivalous = meaning that one persons use cannot diminish another persons use

For example, government can provide national defence or streetlights. Meanwhile privately provided goods can be charitable donations.

Question 8

There are other types of goods, define + how does it lead to market failure :
a) private good
b) common resource
c)club good

Answer 8

a) a good that the owner can exercise private property rights by excluding and is one rivalrous to other peoples usage ( e.g airplane rides, cellphones )

The absence of excludability and rivalry introduces market failure because the firms may not ensure than some goods and not efficiently provided because they are profit maximisers

b) a good that an individual or organization cannot lay claim to such public places so is rivalrous as someones use impact someone else’s ( e.g parks )

Overconsumption of a common resource can lead to tragedy of commons, where user self - interest leads to the destruction of resource in the long term, so will be a disadvantage. to everyone

c) a club good can exclude people but is not rivalrous, at least until reaching a point where congestion occurs ( e.g wireless internet)

Unless perfect / first degree price discrimination (when sellers sell the maximum price consumers are willing to pay with non difference in the product at all to maximise producer surplus), markets will not provide club goods at efficient levels which will lead to market failure

Question 9

What is the difference between private and club good?

Answer 9

They both exclude consumers from usage but the difference is that a private good can impacts someone else use if someone is already using it. For example an airplane ride or an iPhone.
But a club good does not interrupt someone else’s use for example wireless internet.

Question 10

Why would the coase theorem solution not work and then the good to be publicly produced?

Answer 10

1) The profit is not high enough for firms if unit cost is higher than the demands willingness to pay
2) Difficult to share the burden when the coase solution is used of the cost leading to free ride problem.

Question 11

How can the free rider problem or under - provision be solved ?

Answer 11

The government can decide to provide the public good if the total benefits exceed the costs + paying with its with tax revenue

To address the problem of the under-provision of public goods, by introducing restrictions that makes the public good excludable. (e.g intellectual property rights or encrypted TV programs )
This is done through (IPR) Intellectual property rights that argues that knowledge is public good as it is non rival and non excludable.

Question 12

What is intellectual property rights and an example of this?

Answer 12

Intellectual property rights - argues than knowledge is a public good as it is non rival and non excludable.

However IPR creates a temporary monopoly than makes knowledge excludable until paid for.
* For example, patents - (copyrights) that are typically temporary because it lasts up to 20 years in most countries
* IPR is alternative to secrecy ( as inventor must get the patent after disclosing the innovative knowledge)
* Patentability requirements =1) novelty 2) non - obviousness 3) utility

Question 13

How can asymmetric information cause market failure?

Answer 13

This causes market failure because buyers and sellers alike may distort pricing by withholding critical information about a products quality or risk.

Question 14

What is he difference between asymmetric information and uncertainty?

Answer 14

Uncertainty is not the same as asymmetric information which is when information is purposely not given in order for one agent to have a gain on top of another. Uncertainty is when the agents are unsure which of the many possible states will take place.

Question 15

What is a moral hazard in asymmetric infromation and what is an agent and principal in this situation?

Answer 15

Moral hazard is a hidden action and refers to the tendency of a person who is imperfectly monitored (e.g an employer ) to engage in dishonest or otherwise undesirable behaviour due to a incentive to increase its exposure because it doe not bear the full cost of that risk - therefore is protected from its consequences e.g by insurance

Question 16

What is adverse selection in asymmetric information?

Answer 16

Adverse selection is hidden information and refers to any situation where some information is hidden ( that is being held by one agent, or a subset of agents.)
It is the tendency for the mix of unobserved attributes to become undeniable from the standpoint of an uniformed party
In this case an agent is aware of what attribute they are making unobservable.

Question 17

How is Insurance, Credit Rationing and Involuntary Unemployment forms of Adverse Selection?

Answer 17

nsurance - people who are less careful are more eager to buy insurance so the people buying the insurance know more than those selling the insurance.

Credit Rationing - those who are willing to pay back the loans would buy loans when interest rates are low so the people borrowing the loan are the uninformed because they would not know if the people given the loan have intention to pay the loan back

Involuntary Unemployment - as in certain labour markets, if a firm reduces the wage its pays, high productivity

Question 18

What is the main difference between adverse selection and moral hazard?

Answer 18

Adverse selection is pre - contractual asymmetric information than means that there is a pre contract disclosure before the employer or consumer signs / approves an agreement
Meanwhile, moral hazard is post contractual asymmetric information which means the principal knows the result of the action, but does not know what part the agent played in this result and how much was due to exogenous ( environmental ) factors.

Question 19

What is one way to mitigate adverse selection

Answer 19

Signalling which is a theory developed by Michael Spence that stated that sellers send signals to consumers to assist them in judging the quality of products.

Can be signally employed in market places or for job market signalling for students with higher degrees so employers would send signals to employers with their education.

An example of signalling is guarantees and warranties which are used by many manufacturers of electronic goods as a signal to illustrate the reliability of the product.