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Learning Objectives
Externalities and Coase Theorem Choice under uncertaintyInsurance Asymmetric informationadverse selection and moral hazard
External Benefit
Discussion Questions (Part I): Does the honeybee keeper face the right incentives?
Bees pollinate the apple orchards. Q1: Who enjoys the external benefit generated by whom?
Answers: The orchard owner enjoys the external benefit generated by the honeybee keeper.
Q2: Is the number of hives more or less than the social optimal number?
Answers: The number of hives is less than the social optimal number.
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External Cost
Discussion Questions (Part II): Does the honeybee keeper face the right incentives?
If the hives are located near a school, people might to get stung by the bees.
Q4: Is the number of hives more or less than the social optimal number?
Answers: The number of hives is more than the social optimal number.
$100/day
$100/day
$50/day
$100/day
$100/day
$50/day
$100/day
$100/day
$50/day
Part II: Now assume Abercrombie and Fitch can communicate at no cost.
Q6: How much at most would Fitch like to pay Abercrombie to use the filter?
Answers: $50 at most which is equal to his MB of a filter.
$100/day
$100/day
$50/day
Part III: Now continue to assume by law Abercrombie cannot dump without Fitchs approval.
Q9: Which outcome is socially efficient?
Answers: Not to install a filter is now socially efficient because the MB of a filter, which is $50, is smaller than its MC, $70.
vouchers
patents and copyrights
emission charges
marketable permits
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Tanis will take a job that maximizes her expected utility, which depends on how much she dislikes riskdegree of risk aversion.
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Risk-neutral
Risk-averse
E
C B
Risk-loving
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For a loss of wealth or a gain of wealth of equal size, Tanias pain from the loss exceeds her pleasure from the gain.
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So, Tania is indifferent between these two jobs and her cost of bearing this risk is $1,000.
Cost of risk = EW - CE
Certainty Equivalence
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Q3: How about Tanias choice if her chance of success in the second job increases to 80%?
Answers: With a high chance to succeed, Tanias EU from the risky job now increases to 85 units, which is higher than that from the non-risky job. So Tania should choose the second job.
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His EU = 0.1(0) + 0.9(100) = 90 If Dan had $7,000 of wealth for sure, he would have the same utility as has with $10,000 of wealth and 10% risk of loss.
The CE to 90 units of EU is $7,000.
Certainty Equivalence
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An insurance company can reduce its cost of bearing the risk through pooling the risk.
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Private Information
Private information is information
possessed by a buyer or seller about the value of the item being traded that is not available to the person on the other side of a transaction.
When either buyers or sellers have private information, the market has asymmetric information.
Adverse Selection Moral Hazard
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Private Information
Adverse selection is the tendency for people to ENTER INTO agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.
Example:
If Jackie advertises jobs for salespeople at a fixed wage, she will attract lazy salespeople. Hardworking salespeople will prefer to work for someone who pays by results, rather than a fixed wage. The fixed-wage contract adversely selects those with private information about their work effort.
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Private Information
Moral hazard exists when one of the parties to an agreement has an incentive AFTER the agreement is made to act in a manner that brings additional benefits to himself or herself at the expense of the other party.
Example:
Jackie hires Mitch as a salesperson and pays him a fixed wage regardless of how much he sells. Mitch faces a moral hazard. He has an incentive to put in the least possible effort, benefiting himself and lowering Jackies profits.
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Whether the car is a lemon or not is private information of the current owner. However, buyers are informed that half of the used cars sold turn out to be lemons. Q1: Whats the average price that a buyer would like to pay for a used care of unknown quality?
Answers: The average price for a used car of unknown quality should be equivalent to its expected value, that is, 0.5($5,000) + 0.5($25,000) = $15,000.
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Q3: What kind of cars, lemons or cars without defects, will exist in the market eventually?
Answers: Using the same logics, buyers are aware that only owners of lemons would take the offer. So, buyers would continue to lower his offer until the only possible offer is the value of a lemon, $5,000. Following that, the only kind of cars traded in the market would be lemons only. 29
Solutions: Warranties
Through singing warranties, the car dealer, usually the informed person, sends a signal of information to uninformed buyers, which enables the market to trade good cars. Two messages are sent to buyers: cars with warranties are good cars and cars without warranties are lemons separating equilibrium.
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