Answers to Problem Set 10 - PROBLEM SET 7

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					Markets and Market Failure with Cases                                     HKS API-105B/GSD 5203B

                                    PROBLEM SET 10
                            PUBLIC GOODS AND EXTERNALITIES

1. Moral Hazard and Adverse Selection
    Explain in one sentence how each of the following relates to, or is an example of, moral
    hazard or adverse selection:

    a. Insurance companies write policies with deductibles.
       Answer: Deductibles reduce moral hazard since individuals must pay a part of any
       claim, which discourages them from engaging in the risky behavior leading to the claim
    b. Incompetent motorists buy a lot of accident insurance.
       Answer: When the insurance companies do not know whether a person engages in a risky
       behavior (such as riding a motorcycle), this is an example of adverse selection. People
       doing risky things are more likely to purchase accident insurance
    c. Workers in states with mandatory worker’s compensation insurance are more prone to
       Answer: Knowing they have worker’s compensation insurance, the workers in those
       states are more careless, which is an example of moral hazard
    d. New cars lose much of their resale value shortly after they are purchased.
       Answer: This is a result of adverse selection. Car owners know more about the condition
       of their own cars than prospective buyers. People who own cars with hidden defects
       (“lemons”) are more likely to want to sell their cars. The fact that an almost new car is
       being sold, therefore, implies that it is more likely than the average car to be a “lemon.”
       Car buyers know this and, therefore, are willing to pay much less for an almost new car
       than for a new one. This, in turn, makes it even more likely that only owners of lemons
       will sell their used cars (the owners of good cars will sell them at such a huge discount
       only in rare circumstances), so the effects of seller actions and buyer expectations are
       mutually reinforcing

2. Identifying Externalities
Answer the following questions for each of the examples below:
   (i) Does the example involve externalities, and if so, are they positive or negative? Explain
        your answer in one sentence or less.
   (ii) If positive, who confers the external benefit and who enjoys it? If negative, who imposes
        the external cost and who suffers from it?
   (iii)What is the particular good (product or service) being consumed or produced?

      a. A resort owner uses a spray to reduce the mosquito population. The spray is toxic
          only to mosquitoes and not to humans or other forms of life.
          i) Yes, the consumption of the spray generates positive externalities in that it
              reduces the mosquito population of the resorts neighbors as well. If the
              spray sickened humans as well then that would be a negative externality.
          ii) The externalities are conferred by the users of mosquito spray. The
              benefit of fewer mosquitoes is enjoyed by all those in the local area..

Markets and Market Failure with Cases                                       HKS API-105B/GSD 5203B

           iii) The good being consumed is the toxic spray.
        b. Sam drives his car onto a crowded expressway.
           i) Yes, Sam’s use of the expressway confers negative externalities by
                increasing congestion.
           ii) The external cost is imposed by Sam and suffered by other users of the
           iii) The good being consumed is expressway use.
        c. Seaside Electric Inc. discharges hot water directly into the bay and fish are killed as a
           i) Yes, Seaside Electric’s production of electricity generates a negative externality
                by killing fish.
           ii) The external cost is imposed by Seaside Electric and suffered by
                fishermen, and to the extent that it forces an increase in the price of fish,
                by consumers.
           iii) The good being produced is electricity.
        d. In an oil field, each owner of a well tries to pump out oil relatively fast, to
        capture as much oil as possible before the reserves are exhausted.
           i) Yes, each oil well owner’s activity reduces the quantity of reserves
                available to other well owners
           ii) Each well owner imposes the cost on the other well owners. (Note that the
                fact that the harmful effect is reciprocal does not mean that it is not an
           iii) The good being produced is oil.

        e. A rug dealer dumps his inventory and lowers prices.
           There is no externality here. The impact of his expanded supply is felt entirely
              through market prices.

Markets and Market Failure with Cases                                      HKS API-105B/GSD 5203B

3. Painting for Dollars (OPTIONAL)
    More than 100 small companies provide house-painting services and all of them advertise
    “First Class Quality”. Homeowners know, however, that painters can easily substitute low-
    quality for high-quality paints and that the homeowner won’t discover which quality was
    used until the paint ages, years after the painter has been paid. Moreover, painters go in and
    out of business and change the names of their companies frequently. Painters charge about
    $5,000 to paint a typical house. Experts estimate that doing a really high quality job would
    cost fully $10,000 for the typical house but it would last three times as long. By tradition, no
    painting company offers guarantees (partly because they come and go so frequently).
        a. Despite all of the complaining, no painting services are offered for more than $5,000.
            How do you explain this outcome?
            Answer: This is a classic information asymmetry problem that creates a “market for
            lemons”. Since homeowners have no way of knowing until too late whether the paint
            job is high quality and painters go in and out of businesses too often to establish a
            reputation or offer a credible guarantee, homeowners will assume all paint jobs are
            low quality and will only pay accordingly. No painter will offer a high quality job
            because they will be undercut by a competitor offering a low quality job. And since
            the market for painting is competitive, prices will be driven down to the MC for a low
            quality paint job, or $5000.
        b. A new paint company advertises high-quality work for $11,000 and it offers a 10-year
            guarantee on the work backed up by an independent bank. Do you think the new
            company will be able to get any business? Explain your answer.
            Answer: The fact that a high quality paint job lasts three times longer but costs only
            three times as much suggests that at least some, if not many, people would prefer it.
            If so, then there is an information market failure in the sense that the “lemons” are
            tarnishing every suppliers’ offerings and the market is unable to sustain supplying
            high quality painting at $10,000 even though some would prefer it. By the same
            reasoning, it looks likely that the new company could survive – the guarantee backed
            by an independent party looks like it creates property rights upon which someone
            could sue if the guarantee is violated and this would tend to make the new company’s
            offering distinguishable from the “lemons” offered by others. Over the long run,
            others might well offer the same guaranteed high quality service and drive the price
            back toward $10,000 for the high quality service.