EC 100
Week 2 LT
Last Micro Class Exercise
- This week: Public goods / Externalities.
- The result that decentralised markets with profit
maximizing firms and utility maximising individuals
maximises social welfare relies on the assumption that
there are no externalities.
- In case of externalities, the private benefit != social
benefit.
- Some examples: negative externalities, such as
pollution.
- Positive externalities: positive network externalities in
social networks (Linked In, Facebook,…)
Last Micro Class Exercise
- This week: Public goods / Externalities.
- Public goods: non rival in consumption and
non-excludable
Rival?
Yes
No
Yes
Private Goods
Natural
Monopolies
No
Common Pool
Resources
Public Goods
Excludable?
Question 1
Question 2
• Positive externalities: the more individuals get
vaccinated, the more useful is the vaccination to all
others.
• In competitive market, individuals only act “selfishly”
(assumption). So don’t consume enough.
• Government can encourage them to consume more, e.g.
lowering price, making it compulsory.
• In this case, the Marginal Benefit is increasing in the
number of consumers (# of individuals vaccinated).
Question 3
• Tube ride: you make life more uncomfortable
for everyone else
• Why is c) not a negative externality?
Question 4
• No assigned property rights – and if they belong
to the state, property rights need to be enforced
for them to be effective.
• Elephants are like a common pool resource
– Poachers don’t face a cost of killing elephants in the
way that farmers do
• Similar example in lecture.
Question 5
• In exam – start with a definition!
• Non-rival, non-excludable
– Aside: Excludability is determined by the level of
technology!
Question 6
Question 7
• Moral hazard occurs when there is asymmetric
information (or more generally, imperfect
information)
• “Moral hazard occurs when the behaviour of one
party to a contract cannot be trusted to carry out the
terms of the contract”
• i.e. the person carrying out the contract is not
perfectly monitored. May act “immorally”.
Question 8
Question 9
Suppose the government insists that profit-maximizing insurance companies
charge the same price for everyone to be insure themselves against the risk
of loss from an earthquake. It then finds the price is very high and take-up
very low. Why has this happened?
What is adverse selection?
Question 9
Suppose the government insists that profit-maximizing insurance companies
charge the same price for everyone to be insure themselves against the risk
of loss from an earthquake. It then finds the price is very high and take-up
very low. Why has this happened?
What is adverse selection?
Only sellers of poor quality products (e.g. in used car market), or high risk
individuals (e.g. in insurance markets) stay in the market. Because of
asymmetric information, it is not possible to tell what “type” of person
someone is. (If sellers and buyers could tell, the market would work
normally). This lack of information drives up prices and the market may
collapse completely.
Classic example is the used car market – George Akerlof (former LSE
professor) won Nobel prize for “analysis of markets with asymmetric
information”
Question 9
• A profit maximising insurance company must cover its costs
Profit = Q*(P-AC)
• The (main) cost is money paid out in insurance claims
• In locations with low risk, people will not pay a high price for insurance
cover
• If the firm has to charge a uniform price, they will not buy insurance
• This means that only people in high risk areas buy insurance
– i.e. “adverse selection”…only high risk people are in the market
• This drives up average costs, which drives up prices…
• This higher price reduces take-up even further, for the “low exposure”
individuals in the higher risk areas and so on…
Question 10
• Excludable: can exclude certain people (e.g. high risk
groups / individuals)
• Rival: there is a limited number of doctors/ nurses…
• So by that definition, healthcare is not a public good.
– But in general, there are positive externalities