Week 4 Flashcards
Why do “bad cars drive out the good ones” in the market for used cars?
Buyers are not able to tell the difference between good cars and bad cars, and so they are not willing to pay a high price for a used car because of the significant chance it will be lemon, which makes owners of good cars unwilling to sell them.
if moral hazard is a serious problem who is likely to win
Whoever has more to gain
reasons why efficiency wages might mitigate moral hazard
A.
Higher-paid workers risk being fired from the job if they shirk and thus would have to take a lower-paying job.
B.
Higher pay might reduce employee turnover and therefore reduce the recruiting and training costs to employers.
C.
Higher wages may increase employee tenure and thus increase productivity because of the effects of experience.
D.
All of the above might mitigate moral hazard.
In a free market, efficient firms will produce where X = Y.
In a free market, efficient firms will produce where MC = MR.
MC: Marginal cost
MR: Marginal revenue
The three major examples of when the invisible hand fails are
externalities, public goods, and common pool resources. In each case, free markets do not maximize social surplus.
Concept Question 9.3.2
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Pure altruism
is a motivation solely to help others.
Indoctrination
Indoctrination is the process by which organizations imbue society with their ideology or opinion. In other words, it is the process of providing information in order to change people’s preferences. While some preferences are determined by biological or chemical processes, socialization, access to information, and indoctrination can also determine and affect people’s preferences.
Market failure
A situation in which the market on its own faults to allocate resources efficiently. A number of types of market failure exist which correspond to violations of the assumptions of the model of the market. When markets fail, sometimes they correct themselves (private solutions); sometimes, government needs to intervene (public policy solutions) (lectures 5.2, 6)
A number of types of market failure exist which correspond to violations of the assumptions of the model of the market.
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Rationality
The assumption that people are “homo economicus” i.e. gather information and carefully weigh costs benefits to choose the optimal course of action. The model of the competitive market assumes that decision makers (consumers and firms) are rational.
Information failure
Information failure arises when people fail to be rational.
This arises due to people
having insufficient or incorrect information.
do not have the capability to rational, limited cognition.
have preferences which are not stable.
Bounded rationality
The assumption that real people are homo sapiens and face imperfections in information and human reasoning and “satisfied” instead
Bounded rationality, real people sometimes:
fail to understand information and make mistakes;
act against their own self interest;
take excessive risks or act overconfidently;
give too much weight to small no. of vivid observations;
are reluctant to change their minds.
Bounded rationality, Real people also have inconsistent preferences:
are affected by their peers.
herding effects and information cascades
are affected by their past actions.
Bounded rationality, public policy situations
governments provide information (awareness campaigns)
governments regulate firms to provide information
governments regulate consumption and production of certain goods and services
Merit goods (bads)
Goods or services that government thunks people ought (ought not) to consumer irrespective of tastes or incomes. In the free market people under (over) consume merit goods (bads). Government enforces or subsidises (prohibits or taxes) the consumption of merit goods (bads)
Asymmetric information
Exists when one party to an economic interaction has more (market) relevant information than another.
Asymmetric information
Adverse selection
(hidden characteristics): the seller knows more about the attributes of the good than the buyer who runs a risk of being sold a good of low quality. For e.g. used car, labour, insurance markets
Asymmetric information
moral hazard
hazard (hidden action): an “agent” performs a task on behalf of a “principal” who cannot perfectly monitor the agent’s behaviour. The agent tends to undertake less effort than the principal considers desirable. For e.g. shirking, lack of reasonable care.
Asymmetric information dangers
Asymmetric information can prevent mutually beneficial trades or cause shortages and surpluses in the market.
Asymmetric information Private solutions
Signaling (informed party reveals private info to uninformed party)
Screening (uninformed party induces informed party to reveal private info)
Asymmetric information Public policy solutions
Government provides information or regulates firms to provide information
Externalities
Exist when the production or consumption of a good has positive or negative side-effects on third parties which are not accounted for in the price of the good. Externalities are the uncompensated impact of one persons actions on the wellbeing of a bystander. Positive externalities make bystanders better off; negative externalities make bystanders worse off.
Some examples of common externalities:
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cost to society
The cost to society of producing a unit of the good is the private costs of sellers plus the costs to bystanders who are adversely affected by the pollution.
A benevolent social planner in negative externalities of production
A benevolent social planner maximises the value to consumers minus the cost of production, including the external costs.
The planner would choose the level of production at which the demand curve crosses the social cost curve.
Negative externalities in production
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Below QOpt the value of the good to consumers exceeds the social cost of producing it. Above QOpt the social cost exceeds the value to consumers.
Spillovers
A production process gives rise to a chance that the producer will make a technological advance. Such advances create benefits for society as a whole, known as spillovers, because they add to our pool of knowledge. Because of these spillovers, the cost to society of producing a unit is less than the private cost of sellers.
A benevolent social planner in positive externalities of production
Once again, a benevolent social planner maximises the value to consumers minus the cost of production.
In this case the planner would want to increase production until the social cost is equal to the private benefit.
Positive externalities in production
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Negative externalities in consumption
The consumption of alcohol can yield negative externalities if consumers drive under the influence or engage in violent or antisocial behaviour.
Because of the external costs associated with such consumption, the social value is less than the private value.
The planner would want to lower the quantity produced and consumed to QOpt.
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Positive externalities in consumption
Vaccines yield positive externalities because they lower the risk of catching diseases for everyone in the population, even those who are not vaccinated.
Because of the external benefits associated with such consumption, the social value is greater than the private value.
The planner would want to increase the quantity produced and consumed to QOpt.
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Solutions to externalities
Private solutions:
Moral codes and social sanctions
Charities
Self-regulation
Coase theorem
Self-regulation
firms voluntarily agree to and monitor an industry code of conduct
Coase theorem
The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
Internalising externalities via contracting (the Coase theorem): private parties can negotiate a payment from one to the other, achieving the socially optimum outcome.
Problems with the Private solutions to externalities
Transaction costs (monitoring, negotiation, compliance)
Break down in bargaining
Solutions to externalities
Public policy solutions:
Regulation (command-and-control): forbidding, limiting or mandating certain activities;
Market-based policies: to align private incentives with social efficiency
Market-based policies
Corrective taxes and subsidies: tax activities that have negative externalities and subsidise activities that have positive externalities;
Tradeable pollution permits
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Problems with the Public policy solutions to externalities
Information (origin and value of externality, technology)
Regulatory capture
Practice question about social marginal benefit
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Traffic congestion is an example of a “broken” invisible hand because:
True
Surplus is not maximized.
False
Market outcomes are efficient.
True
Drivers impose a cost on others that is not reflected by the price they pay.
False
The marginal private benefit of driving an extra mile exceeds the marginal social cost.
Which of the following is not likely to be subject to the tragedy of the commons?
A. Donuts brought to the office. B. National defense. C. A public area for grazing cattle. D. Coral reefs.
b
Examples of direct regulation include
laws restricting alcohol purchases.
fishing quotas.
price floors.
What happens when there are negative externalities present
When there are negative externalities present, this market outcome is no longer efficient. In cases where there are negative externalities, markets (if left alone) will produce too much.
The social cost of producing a good that generates negative externalities is the sum of the
Private cost and external costs of production
Free market
In a free market, efficient firms produce where marginal private cost equal marginal private benefit
