Economics 100B Microeconomics

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Economics 100BMicroeconomics
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Announcements

• Solution to Problem Set 6 has been posted on the
  course website
• I will hold extra office hours this week
• Friday, June 8, 10-12pm

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Course Outline
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Todays Plan

• Adverse selection
• Externalities and inefficiency

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I. Adverse Selection

• Adverse selection occurs when individuals know
  more about their types than insurers do
• an individuals type is her probability of
  experiencing a loss

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Adverse Selection

• Assume that there are two types of individuals
• both types have the same initial wealth (W) and
  face a potential financial loss of L
• one type has a higher probability of loss than
  the other pH gt pL

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Case with Perfect Information
L
Wb
certainty line
H
W - L
E
Wg
W
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Case with Perfect Information
UL
Wb
Low-risk individuals will maximize utility at
point F, while high-risk individuals will choose G
UH
certainty line
F
G
W - L
E
Wg
W
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Unstable with Imperfect Info.
UL
Wb
The high-risk individuals will want to purchase
the policy designed for the low risk individuals
UH
certainty line
F
G
W - L
E
Wg
W
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Pooling Contract
A
Wb
One possible solution would be for the insurer to
offer premiums based on the average probability
of loss
certainty line
W - L
E
Wg
W
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Pooling Contract
Wb
The amount of coverage offered will be that most
preferred by the low-risk person (M)
certainty line
F
M
UHp
G
W - L
ULp
E
Wg
W
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Pooling Contract
An insurance policy like N would not attract
high-risk individuals, but would attract low-risk
individuals and be profitable for insurers
Wb
certainty line
M
N
UHp
W - L
ULp
E
Wg
W
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No Stable Pooling Equilibrium

• If a market has asymmetric information, the
  equilibrium must be separated
• high-risk individuals must have an incentive to
  purchase one type of insurance, while low-risk
  purchase another

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Separating Equilibrium
Wb
UH
certainty line
The policies G and J represent a separating
equilibrium
F
J
G
W - L
ULs
E
Wg
W
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II. Externalities

• An externality occurs whenever the activities of
  one economic agent affect the activities of
  another economic agent in ways that are not
  reflected in market transactions

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Examples

• Negative externalities
• People are safer in SUVs, but they inflict
  greater harm on the drivers of smaller vehicles
• Estimate (White 2002) 3,700 additional
  fatalities per year against 1,400 fatalities
  avoided for SUVs drivers
• Positive externalities
• Michael Jordan raised sales throughout the NBA
• Estimate (Hausman and Leonard 1997) 40.3
  million for the 1991-1992 season

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Production Externalities

• The production of x will have an external effect
  on the production of y if the output of y depends
  on the level at which x is produced

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Consumption Externalities

• Externalities can also occur if
• the activities of an economic agent directly
  affect an individuals utility
• the utility of someone else affects an
  individuals utility

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A. Externalities and Inefficiency

• Externalities lead to inefficient allocations of
  resources because market prices do not accurately
  reflect the additional costs imposed on or the
  benefits provided to third parties

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Negative Production Externality

• Steel mill up river
• s units of steel produced
• ps competitive price
• cs(s) cost function
• h(s) pollution
• Fishery downstream
• f units of fish produced
• pf competitive price
• cf(f,h) cost function

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Negative Production Externality

• Assume

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Negative Production Externality

• Competitive market equilibrium

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Negative Production Externality

• Pareto efficient outcome

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Negative Production Externality

• Pareto efficient outcome

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Negative Production Externality
Price
MC
Market equilibrium will occur at ps, s
MCs
If there are external production costs, social
marginal costs are represented by MC
D
ps
Quantity of steel
s
s
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Numerical Example

• Consider an upstream firm (x) and a downstream
  firm (y)
• x20lx0.5
• y20ly0.5-(1/200)x2
• pxpy1 and w5

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Example Splitting the Bill See Gneezy, Haruvy
and Yafe (2004), Economic Journal

• Consider two undergrads, Bob and John, who go to
  the restaurant
• If each pays individually
• V(CB)lnCB-pCB
• V(CJ)lnCJ-pCJ
• What happens if they split the bill?

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Assignment

• Read Nicholson Chapter 20