Public Good, Externality and Market

Imperfections

Doç. Dr. Sezgin Polat

Political Economy Course

Political Science Department
Galatasaray University

Fall, 2016
Outline

Public Good

Externality
The Coase Theorem
Pigouvian Taxation

Market Imperfections
Imperfect Information
Adverse Selection (Antisélection)
Moral Hazard (Aléa Moral)
Signaling
Market Power
Natural Monopoly
Reference Chapters
I Public Good Provision ([Varian, 2014] chapter 36)

I Externalities ([Hindriks and Myles, 2013] chapter 7)

I Asymmetric Information ([Varian, 2014] chapter 37)

I Asymmetric Information ([Hindriks and Myles, 2013] chapter 9)

Sub-optimal Pareto Cases

I Public Good
I Externality
I Market Imperfections
Public Good Provision
Efficient Level of Public Good Provision ([Varian, 2014] ch. 36,
Public Good)
I Let x1 and x2 measure the private consumption of each
person and x1 and x2 be their contributions to the TV G now
measures the ”quality” of the TV they buy, and let the cost
function for quality be given by c(G)
I The constraint facing the roommates is that the total amount
that they spend on their public and private consumption
I x1 + x2 + c(G) = w1 + w2
I Pareto efficient allocation is one where consumer 1 is as
well-off as possible given consumer 2’s level of utility. If we fix
the utility of consumer 2 at u2 , we can write this problem as
Public Good Provision

M ax(x1 ,x2 ,G) u1 (x1 , G)

such that u2 (x2 , G) = ū2 (pareto optimality condition)
and p1 x1 + p2 x2 + c(G) = w1 + w2
such that prices are equal to 1 for each good p1 = p2 = 1

First Order Conditions

Γ = u1 (x1 , G) + λ(ū2 − u2 (x2 , G)) + γ(w1 + w2 − (x1 + x2 + c(G)))

∂Γ ∂u1
= −γ =0
∂x1 ∂x1
∂Γ ∂u2
= −λ −γ =0
∂x2 ∂x2
∂Γ ∂u1 ∂u2 ∂c(G)
= −λ − =0
∂G ∂G ∂G ∂G
Arranging first order conditions gives
∂u1 ∂u2
∂G ∂G ∂c(G)
∂u1
+ ∂u2
= ∂G
∂x1 ∂x2

[Samuelson, 1954]) states that Pareto efficient provision of the

public good occurs when the marginal rate of cost
(transformation) (MC) between the public good and each private
good is equated to the sum, over all households, of the marginal
rates of substitution (MRS).

M Ug M Ug
+ = M RS1 + M RS2 = M C(G)
M Ux1 M Ux2
Samuelson Rule
What does the condition for Pareto efficiency mean ? We can think of the
marginal rate of substitution as measuring the marginal willingness to pay
for an extra unit of the public good. Then the efficiency condition just
says that the sum of the marginal willingnesses to pay must equal the
marginal cost of providing an extra unit of the public good.

Efficient Provision of Public Good

Externality
Externality
Definition of Externality (1)
An externality is present whenever some economic agent’s welfare (utility
or profit) is ”directly’” affected by the (unintended) action of another
agent (consumer or producer) in the economy.

I Non-pecuniary externality
I Production externality occurs when the effect of the externality

is on a profit relationship.
I Consumption externality whenever a utility level is affected.

I Pecuniary externality is present in any competitive market but

creates no inefficiency (since price mediation through competitive
markets leads to a Pareto-efficient outcome)

Definition of Externality (2)

An externality is present whenever there is an insufficient incentive for a
potential market to be created for some good and the nonexistence of
this market leads to a non-Pareto optimal equilibrium. This can also be
called ”market failure”.
Externality Examples ([Hindriks and Myles, 2013], chapter 7)
I Pollution
Example
I Congestion - e.g. Traffic Jams
Example
I Pecuniary Externality
Example
I The Rat Race Problem
I The Tragedy of the Commons
Example
I Bandwagon Effect
I Anti-commons
Example :Commuting by train always takes 40 minutes regardless of the number of
travelers. The commuting time by car increases as the number of car users increases.
This congestion effect, which raises the commuting time, is the externality for
travelers. Individuals must each make decisions to minimize their own transportation
time.
The number of car users will adjust until the travel time by car is exactly equal to the
travel time by train. For the travel time depicted in the figure, the equilibrium occurs
when 40 percent of commuters travel by car. The optimum occurs when the aggregate
time saving is maximized. This occurs when only 20 percent of commuters use a car.

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Example : The number of economists will adjust until the earnings of an economist are
exactly equal to the earnings of a lawyer. The equilibrium is given by the percentage of
economists at point E.
To the right of point E, lawyers would earn more and the number of economists would
decrease.
Alternatively, to the left of point E economists are relatively few in number and will
earn more than lawyers, attracting more economists into the profession.

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Example : Assume that performance is judged not in absolute terms but in relative
terms so that what matters is not how much is known but how much is known
compared to what other students know.

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Example : The bandwagon effect studies the question of how standards are adopted
and, in particular, how it is possible for the wrong standard to be adopted. The
standard application of this is the choice of arrangement for the keys on a keyboard.

F Klâvyenin Mucidi, Intersteno Onursal Başkanı, İhsan Sıtkı Yener

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Coase Theorem
[Coase, 1960] Ronald Coase “The Problem of Social Costs,” The
Journal of Law & Economics, 3 (October 1960)
Coase gives the example of a Baker and a Doctor sharing an office
building.
Externality : baker’s loud machinery disturbed the doctor’s medical
practice. (inputs for production)
Options : The baker could buy a quiter machinery for $50. the
doctor could soundproof his walls for $100.
Assignment of property right regime does not change the efficient
outcome. Consider following cases :
I Noise level limit then the baker spends the money.
I No Noise limit then the doctor pays the money.

The Coase theorem

In the absence of transaction and bargaining costs, affected parties
to an externality will agree on an allocation of resources that is
both Pareto optimal and independent of any prior assignment of
property rights.
Externalities and Negociations
Suppose that firm’s total costs c are c = 4q 2 where q is the level of
output. It can sell any number of units of output at a price of 64.
However, production inflicts damage on the firm’s neighbours. The
total damage D inflicted depends on the firm’s output :
D = 4q + q 2
I Questions ([Leach, 2004], ch 6)
1. Assume that the firm has the property rights. In the absence of an
agreement with its neighbours, what would its level of output be ?
Suppose that the neighbours negotiate with the firm. To what level
of output would the negotiations lead ? What is the minimum
payment that the neighbours must make to the firm to achieve this
change in output ? What is the maximum payment ?
2. Assume that the neighbours have the property rights. In the
absence of an agreement between the firm and its neighbours, what
would the level of output be ? If an agreement between the firm and
its neighbours is negotiated, what are the smallest and largest
payments that the firm would have to pay ?
3. Assume that the firm has the property rights. If the government
wishes to control the externality by imposing a tax, what should the
tax be ? How much revenue does it collect ?
I Profit is defined as sales minus cost which is
π = price ∗ quantity − cost = 64q − 4q 2
I Cost of damage or externality is D = 4q + q 2
I Private marginal cost is the derivative of cost function implying what will
∂c(q)
be the cost of producing one unit more ∂q
= 8q
I Marginal Damage is the cost of externality of producing an extra unit
which is ∂D(q)
∂q
= 4 + 2q
I Social marginal Cost is the sum of private marginal cost + marginal
damage which is M SC = 8q + 4 + 2q = 10q + 4
I M SC = price which is 10q + 4 = 64 −→ q = 6
Pigouvian Taxation
The government wishes to control the externality by imposing a
tax, tax will be 64 − 48 = 16
Tax revenue will be G = t ∗ q −→ 16 ∗ 6 = 96
Market Imperfections
Market for Lemons 1
Akerloff (1970) ”The Market for Lemons : Quality Uncertainty and the
Market Mechanism”
Example :[Varian, 2014], ch. 37
I Consider a market with 100 people who want to sell their used cars
and 100 people who want to buy a used car. Everyone knows that
50 of the cars are “plums (good quality)” and 50 are “lemons (bad
quality).” The current owner of each car knows its quality, but the
prospective purchasers don’t know whether any given car is a plum
or a lemon.
I The owner of a lemon is willing to part with it for $1000 and the
owner of a plum is willing to part with it for $2000.
I The buyers of the car are willing to pay $2400 for a plum and $1200
for a lemon.
I The lemons will sell at some price between $1000 and $1200 and
the plums will sell at some price between $2000 and $2400.
I But what happens to the market if the buyers can’t observe the
quality of the car ?
Market for Lemons 2

I The probability of a car being plum is q = 1/2.

I Expected (average) value of a car will be
Ec = qpl + (1 − q)ph = (1/2)1200 + (1/2)2400 = 1800
I At a price of $1800 only lemons would be offered for sale.
I No market for good quality cars. Lemons will dominate the market.
I Gresham’s Law ”La mauvaise monnaie chasse la bonne” ”Bad
money drives out good”
I failure. The problem is that there is an externality between the
sellers of good cars and bad cars ; when an individual decides to try
to sell a bad car, he affects the purchasers’ perceptions of the
quality of the average car on the market.
I Market Failure due to information asymmetry. (Sellers know the
quality of their car while buyers do not know the quality of car on
the market.)
I
Market for Lemons 3
I No Market Failure Condition (perceptions of buyers)
I Ec ≥ psh = qpl + (1 − q)ph
2000 = q1200 + (1 − q)2400 −→ q ≤ 1/3
Adverse Selection
I Adverse Selection : In the model we just examined the low-quality
items crowded out the high-quality items because of the high cost
of acquiring information.
I Example : Insurance
I Suppose that an insurance company wants to offer insurance for
bicycle theft.
I In some areas there is a high probability that a bicycle will be
stolen, and in other areas thefts are quite rare. Suppose that the
insurance company decides to offer the insurance based on the
average theft rate.
I the insurance claims will mostly be made by the consumers who live
in the high-risk areas. Rates based on the average probability of
theft will be a misleading indication of the actual experience of
claims filed with the insurance company.
I The insurance company will not get an unbiased selection of
customers ; rather they will get an adverse selection. In fact the
term “adverse selection” was first used in the insurance industry to
describe just this sort of problem.
Moral Hazard
I Consider the bicycle-theft insurance market again and suppose for
simplicity that all of the consumers live in areas with identical
probabilities of theft, so that there is no problem of adverse selection. On
the other hand, the probability of theft may be affected by the actions
taken by the bicycle owners.
I If a consumer can purchase bicycle insurance, then the cost inflicted on
the individual of having his bicycle stolen is much less. If the bicycle is
stolen then the person simply has to report it to the insurance company
and he will get insurance money to replace it. In the extreme case, where
the insurance company completely reimburses the individual for the theft
of his bicycle, the individual has no incentive to take care at all.
I This lack of incentive to take care is called Moral Hazard (Aléa Moral).
I Tradeoff (quid pro quo) : too little insurance means that people bear a lot
of risk, too much insurance means that people will take inadequate care.
I If the amount of care (action) is observable, then there is no problem.
The insurance company can base its rates on the amount of care taken.
I In general, the insurance companies will not want to offer the consumers
“complete” insurance. They will always want the consumer to face some
part of the risk.
I Free Parking lots in Yıldız park (Galatasaray University) bearing some
cost reveal the hidden actions
Hidden Actions/Informations

I Moral hazard refers to situations where one side of the market can’t
observe the actions of the other. For this reason it is sometimes
called a hidden action problem.
I Adverse selection refers to situations where one side of the market
can’t observe the “type” or quality of the goods on other side of the
market. For this reason it is sometimes called a hidden information
problem.
I Equilibrium in a market involving hidden action typically involves
some form of rationing—firms would like to provide more than they
do, but they are unwilling to do so since it will change the
incentives of their customers.
I Equilibrium in a market involving hidden information will typically
involve too little trade taking place because of the externality
between the “good” and “bad” types.
I Example : Deposit Insurance in 1990s
I In a system without deposit insurance (bail-out), depositors would
have a strong incentive to monitor their bank’s actions.
Signaling

I One sensible signal in this context would be for the owner of a good
used car to offer a warranty/insurance. This would be a promise to
pay the purchaser some agreed upon amount if the car turned out
to be a lemon. Owners of the good used cars can afford to offer
such a warranty while the owners of the lemons can’t afford this.
I This is a way for the owners of the good used cars to signal that
they have good cars.
I But there are other cases where signaling can make a market
perform less well.
Signaling
Michael Spence, Market Signaling (Cambridge, Mass : Harvard University
Press, 1974). Example : [Varian, 2014], ch. 37
I Suppose that we have two types of workers, able and unable. The able
workers have a marginal product of a2 , and the unable workers have a
marginal product of a1 , where a2 > a1 . Suppose that a fraction b of the
workers are able and 1 − b of them are unable.
I If worker quality is easily observable, then firms would just offer a wage of
w2 = a2 to the able workers and of w1 = a1 to the unable workers. That
is, each worker would be paid his marginal product and we would have an
efficient equilibrium.
I But what if the firm can’t observe the marginal products ? If a firm can’t
distinguish the types of workers, then the best that it can do is to offer
the average wage, which is w = (1 − b)a1 + ba2 .
I However, suppose now that there is some signal that the workers can
acquire that will distinguish the two types. For example, suppose that the
workers can acquire education. Let e1 be the amount of education
attained by the type 1 workers and e2 the amount attained by the type 2
workers.
I Suppose that the workers have different costs of acquiring education, the
total cost of education for the able workers is c2 e2 and the total cost of
education for the unable workers is c1 e1
Signaling

I Suppose that c2 < c1 . This says that the marginal cost of acquiring
education is less for the able workers than the unable workers.
I Let e∗ be an education level that satisfies the following inequalities :

a2 − a1 a2 − a1
< e∗ <
c1 c2

I Note that the choice of the education level of a worker perfectly signals
his type.
I a2 − a1 < c1 e∗ for will choose zero education for unable worker.
I a2 − a1 > c2 e∗ for will choose education for able worker.
I This pattern of wages is an equilibrium : if each able worker chooses
education level e∗ and each unable worker chooses a zero educational
level, then no worker has any reason to change his or her behavior.
Signaling - Equilibria

Separating equilibrium
The equilibrium involves each type of worker making a choice that allows him
to separate himself from the other type.

Pooling equilibrium
each type of worker makes the same choice

I The separating equilibrium is especially interesting since it is inefficient

from a social point of view. Each able worker finds it in his interest to pay
for acquiring the signal, even though it doesn’t change his productivity at
all.
I It is worth thinking about the nature of this inefficiency. As before, it
arises because of an externality. If both able and unable workers were paid
their average product, the wage of the able workers would be depressed
because of the presence of the unable workers.
I Thus they would have an incentive to invest in signals that will
distinguish them from the less able.
I This investment offers a private benefit but no social benefit.
Signaling- Examples

Wage Labor
The problem with wage labor is that it requires observation of the
amount of labor input. The wage has to be based on the effort put in to
production, not just the hours spent in the firm. If the owner can’t
observe the amount of labor input, then it will be impossible to
implement this kind of incentive scheme.

Sharecropping
This is something of a happy medium. The payment to the worker
depends in part on observed output, but the worker and the owner share
the risk of output fluctuations. This gives the worker an incentive to
produce output but it doesn’t leave him bearing all the risk.
Market Power
Market Power
I As the Two Theorems of Welfare Economics showed, they do this so well
that Pareto-efficiency is attained. Imperfect competition arises whenever
an economic agent has the ability to influence prices.
I This requires that the agent must be large relative to the size of the
market in which they operate.
I Imperfect competition can take many forms. It can arise due to monopoly
in product markets and through monopsony in labor markets.
I Firms with monopoly power will push price above marginal cost in order
to raise their profits. This will reduce the equilibrium level of consumption
below what it would have been had the market been competitive and will
transfer surplus from consumers to the owners of the firm.
I The assumption of price-taking behavior used to prove the Two Theorems
is violated, and an economy with imperfect competition will not achieve
an efficient equilibrium
I If the influence on price can be exercised by the sellers of a product, then
there is monopoly power. If it is exercised by the buyers, then there is
monosony power, and if by both buyers and sellers, there is bilateral
monopoly. A single seller is a monopolist and a single buyer a
monopsonist. Oligopoly arises with two or more sellers who have market
power, with duopoly being the special case of two sellers.
Market
I Market consists of the buyers and sellers whose interaction determines the
price and quantity traded. Two sellers will be considered to be in the
same market if their products are close substitutes.
I Markets are also defined by geographic areas, since otherwise identical
products will not be close substitutes if they are sold in different areas
and the cost of transporting is large.
Pricing of Monopoly

I Let us use p(y) to denote the market inverse demand curve and c(y) to
denote the cost function. Let r(y) = p(y)y denote the revenue function
of the monopolist. The monopolist’s profit-maximization problem then
takes the form

M axy π = r(y) − c(y)

π = p(y)y − c(y)

∂p ∂c
p+y =
∂y ∂y
∂p
< 0 (price falls as output increases), implies that
∂y
p>c
Monopoly Pricing > Marginal Cost of Production
Competition

I Three distinct dimensions of competition.

I The first dimension is contestability, which represents the freedom of
rivals to enter an [Link] monopoly rights (patent protection,
operating licenses, etc.) or other barriers to entry (economies of scale and
scope, the marketing advantage of incumbents, entry-deterring strategies,
etc.).
I A second dimension is the degree of concentration that represents the
number and distribution of rivals currently operating in the same market.
The performance of a market depends on whether it is concentrated or
unconcentrated.
I The third dimension of the market structure is collusiveness. This is
related to the degree of independence of firms’ strategies within the
market or the possibility for sellers to agree to raise prices in unison.
Collusion can either be explicit (e.g., a cartel agreement) or tacit (when it
is in each firm’s interest to refrain from aggressive price cutting).
Natural Monopoly

[Leach, 2004], chapter 14

A production process displays increasing returns to scale if output more than
doubles when the use of every input is doubled. The cost curves of a firm that
produces under increasing returns to scale have two important properties :
I Average cost falls as output rises.
I Marginal cost is everywhere below average cost.
I A market in which production is characterized by increasing returns to
scale is said to be a natural monopoly because only one firm can survive
in such a market. Initially, a number of competing firms will “race to get
big.” The larger firms will have lower average costs than their smaller
competitors and will be able to charge lower prices. The smaller firms will
be unable to earn profits and will be driven from the market. Ultimately,
only one firm will remain in the market.
I Not a contestable market (rivals can not enter into the market)
Natural Monopoly

I Regulation : A regulator would require the monopolist to raise its output

from q o so that the welfare cost of the monopoly is reduced. Raising
output from q o to q̂ will reduce the welfare cost of the monopoly by an
amount equal to the area ABDE. A welfare cost equal to the area BCD
would remain.
I Government ownership : A government-owned firm does not need to earn
profits. The government-owned firm should therefore operate at the
socially optimal output q ∗ and charge the price p∗ .
References I

Coase, R. H. (1960). The problem of social cost. In Classic Papers in Natural

Resource Economics, pages 87–137. Springer.

Hindriks, J. and Myles, G. D. (2013). Intermediate public economics. MIT

press.

Leach, J. (2004). A course in public economics. Cambridge University Press.

Samuelson, P. A. (1954). The pure theory of public expenditure. The review

of economics and statistics, pages 387–389.

Varian, H. R. (2014). Intermediate Microeconomics : A Modern Approach :

Ninth International Student Edition. WW Norton & Company.