Week 4

Question 1

Why do​ “bad cars drive out the good​ ones” in the market for used​ cars?

Answer 1

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.

Question 2

if moral hazard is a serious problem who is likely to win

Answer 2

Whoever has more to gain

Question 3

reasons why efficiency wages might mitigate moral​ hazard

Answer 3

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.

Question 4

In a free​ market, efficient firms will produce where X​ = Y.

Answer 4

In a free​ market, efficient firms will produce where MC​ = MR.

MC: Marginal cost

MR: Marginal revenue

Question 5

The three major examples of when the invisible hand fails​ are

Answer 5

externalities, public​ goods, and common pool resources. In each​ case, free markets do not maximize social surplus.

Question 6

Concept Question 9.3.2

Answer 6

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Question 7

Pure altruism

Answer 7

is a motivation solely to help others.

Question 8

Indoctrination

Answer 8

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.  

Question 9

Market failure

Answer 9

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)

Question 10

A number of types of market failure exist which correspond to violations of the assumptions of the model of the market.

Answer 10

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Question 11

Rationality

Answer 11

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.

Question 12

Information failure

Answer 12

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.

Question 13

Bounded rationality

Answer 13

The assumption that real people are homo sapiens and face imperfections in information and human reasoning and “satisfied” instead

Question 14

Bounded rationality, real people sometimes:

Answer 14

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.

Question 15

Bounded rationality, Real people also have inconsistent preferences:

Answer 15

are affected by their peers.
herding effects and information cascades

are affected by their past actions.

Question 16

Bounded rationality, public policy situations

Answer 16

governments provide information (awareness campaigns)

governments regulate firms to provide information

governments regulate consumption and production of certain goods and services

Question 17

Merit goods (bads)

Answer 17

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)

Question 18

Asymmetric information

Answer 18

Exists when one party to an economic interaction has more (market) relevant information than another.

Question 19

Asymmetric information

Adverse selection

Answer 19

(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

Question 20

Asymmetric information

moral hazard

Answer 20

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.

Question 21

Asymmetric information dangers

Answer 21

Asymmetric information can prevent mutually beneficial trades or cause shortages and surpluses in the market.

Question 22

Asymmetric information Private solutions

Answer 22

Signaling (informed party reveals private info to uninformed party)

Screening (uninformed party induces informed party to reveal private info)

Question 23

Asymmetric information Public policy solutions

Answer 23

Government provides information or regulates firms to provide information

Question 24

Externalities

Answer 24

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.

Question 25

Some examples of common externalities:

Answer 25

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Question 26

cost to society

Answer 26

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.

Question 27

A benevolent social planner in negative externalities of production

Answer 27

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.

Question 28

Negative externalities in production

Answer 28

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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.

Question 29

Spillovers

Answer 29

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.

Question 30

A benevolent social planner in positive externalities of production

Answer 30

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.

Question 31

Positive externalities in production

Answer 31

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Question 32

Negative externalities in consumption

Answer 32

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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Question 33

Positive externalities in consumption

Answer 33

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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Question 34

Solutions to externalities

Private solutions:

Answer 34

Moral codes and social sanctions

Charities

Self-regulation

Coase theorem

Question 35

Self-regulation

Answer 35

firms voluntarily agree to and monitor an industry code of conduct

Question 36

Coase theorem

Answer 36

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.

Question 37

Problems with the Private solutions to externalities

Answer 37

Transaction costs (monitoring, negotiation, compliance)

Break down in bargaining

Question 38

Solutions to externalities

Public policy solutions:

Answer 38

Regulation (command-and-control): forbidding, limiting or mandating certain activities;

Market-based policies: to align private incentives with social efficiency

Question 39

Market-based policies

Answer 39

Corrective taxes and subsidies: tax activities that have negative externalities and subsidise activities that have positive externalities;

Tradeable pollution permits

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Question 40

Problems with the Public policy solutions to externalities

Answer 40

Information (origin and value of externality, technology)

Regulatory capture

Question 41

Practice question about social marginal benefit

Answer 41

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Question 42

Traffic congestion is an example of a​ “broken” invisible hand​ because:

Answer 42

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.

Question 43

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.

Answer 43

b

Question 44

Examples of direct regulation include

Answer 44

laws restricting alcohol purchases.

fishing quotas.

price floors.

Question 45

What happens when there are negative externalities present

Answer 45

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.

Question 46

The social cost of producing a good that generates negative externalities is the sum of the

Answer 46

Private cost and external costs of production

Question 47

Free market

Answer 47

In a free market, efficient firms produce where marginal private cost equal marginal private benefit