Externalities
-> DEF: action made by an agent in order to maximize the object function, either utility or cost function, that has a reflection ot the cost or revenue functoin of another individual.
-> DEF 2: or spillover, is a cost (benefit) imposed upon someone by actions take by others (with no compensation)
- Externally imposed benefit (cost) is a positive (negative) externality
-> TYPE:
- Consumption externalities: Consumption of a good by agent A has an impact on agent B’s utility
-> E.g., smoking, loud music, tidy garden of neighbour.
-> Network externality (2° part of the course)
- Production externalities: Production actions by firm A have an impact on agent B’s utility/profit
-> E.g., bee-keeper and apple orchard, polluting firm and fisherman, etc.
| Pros | Cons | |
| Pros | Apple, Bee keeper | Vaccines |
| Cons | Water & Air Pollution | Loud music, Second hand smoke |
-> We can express aggregate demand (willingness to pay) & aggregate supply as
- Each unit of the good brings a private benefit to each single consumer.
- On the curve there are people.
-> CURVES:
- PMB/PMC: Private Marginal Benefit/ Cost
- SMB/SMC: Social Marginal Benefit/Costs
-> We shouldn’t produce more than the Quantity demanded.
-> PROBLEM: we can’t set any equality between PMB ≠SMB and PMC ≠ SMC.
Types:
-> Externalities cause welfare loss:
- Too much resources are allocated to an activity which causes a negative externality (overproduction)
- Too little resources are allocated to an activity which causes a positive externality (underproduction)
Production Externalities:
Negative
=> OVERPRODUCTION: the quantity supplied in the market is more than the optimal one.
=> Welfare loss (blue triangle)
-> The marginal private benefit exceeds marginal private costs, but is affected from marginal costs (which also includes external costs)
=> productin those units has a cost which is larger than the benefit from a social welfare perspective.
Positive
=> UNDERPRODUCTION: optimal quantity for society is reached thanks to the quantity supplied in the market and the external benefit.
-> Marginal private benefit of customers is below marginal private costs suffered from firms, but superior to the social marginal cost suffered from society.
=> Producing those units brings a benefit which is larger than the cost from a social welfare perspective.
Consumption Externalities:
Negative
=> OVERPRODUCTION
-> Marginal private cost of firms:
- Below marginal private benefits of consumers
- Superio to the social marginal benefits of society
=> Producing those units has a cost which is lager than the benefit from a social welfare perspective.
Positive
=> UNDERPRODUCTION
-> Marginal Private cost of firms is
- Above marginal private benefits of consumers
- Inferior to the social marginal benefits of society
=> Producing those units brings a benefit which is larger than the cost from a social welfare perspective.
Coase’s Theorem(s):
-> There is an inadequate specification of property rights, then an absence of markets in which trade can be used to internalize external costs or benefits.(Intuition of Ronald Coase)
Weak Version: Efficiency Proposition
When parties can bargain without cost (no transaction costs), the resulting outcome will be efficient, regardless of how the property rights are specified
Strong Version: Efficiency + Invariance Propositions:
When parties can bargain without cost, the resulting outcome will be efficient and the level of the externality generated the same, regardless of how the property rights are specified.
- This last is unlikely to appure in the real world.
=> Pareto improvements are always possible to the extent that there are ways that allow the economic system to internalize the externality through market mechanisms.
=> Firms make by following the profit firmal
-> MARKET MECHANISMS:
- Trade among consumers (Edgeworth box example)
- Merging of firms (steel mill vs fishery example)
Problem:
-> Assignment of property rights & trade (Coase theorem) or redistribution of property rights (merging) as a way to solve externality problems hinges upon:
- Small numbers involved,
- Absence of bargaining (transaction) costs &/or
- Ability of the firms to recognize profit market signals & act accordingly.
-> In real world
- Numbers involved are often very large,
- Bargaining costs are extremely high,
- Public policy has a more invasive role than just assigning property rights or leave the amrket exploit profit signals.
What do if Coase Theorem breaks down?
-> The only possible solution with externalities, in case of coase theorem breaks down, is the invasive role of the state.
-> There are three public policy intervention that can happen:
- Command & Control
- Pigouvian Taes (subsidy)
- Treadable permits (“artificial” markets in the spirit of Coase)
Comand & Control:
-> DEF: direct regulation of an industry or activity by legislation that states what is permitted and what is illegal.
- Government set a thershold and agents can’t surpass it.
- Focused on negative production estrernalities.
-> EX: there are threshold for pollution, it is set and the agents cant surpass it. If thy do they have to pay! Government have to control that they don’t surpass it.
Pigouvian Taxes:
-> DEF: is a tax assessed against businesses and private individuals that engage in activities that create adverse side effects for society.
- Government make visible to the private agents the curve of social marginal costs.
- G change the pov of the PA from the Private Marginal Cost curve to a Social Welfare pov.
-> PROBLEMS:
- In reality is difficult to draw those curves in a precise way <= Is difficult to define the right amount of taxes and subsidy
- You never know how the PA will react
- Each polluter of the externality burn the same costs in terms of taxes (command & Control and Pigouvian Taxes don’t acocunt the differences between firms)
Tradable Permits:
-> DEF: is the artificial markets in the spirit of Coase. Are quotas for pollution that can be exchanged to create a market in the right to pollute, and thereby create a tax on polluting.
- Some social bundaries are settled, once reached we can trade permissions.
-> We can apply it when the externality is not strongly localized in terms of geography.
Take a look to Edgeworth Box Example
Public & Common Goods:
Public Goods:
-> DEF: It’s a good that is non-excludable & non-rival in consumption
- Once provided none can be excluded from consumption.
- It’s a positive externality, bcse the action of one agent has the same effect on the objective function of all the individuals involved.
-> CHAR:
- NON-EXCLUDABILITY for CONSUMTPION: Does not prevent other for not consuming that good
- NON-RIVALRY in CONSUMPTION: doesn’t allow rivalry.
- One Size should fit all: Has to be provided in the same quantity for all individual (even if they have different preferences)
-> EX:
- Street lights: all citizens are lighted, Defense: military defense is for all citizens; fireworks: just looking in the sky we can enjoy them and we can’t exclude other people from enjoing them.
-> NOTE:
- It’s economically grounded, it’s not a political concept, even if they are provided by the state.
- It’s technically impossible to elude non-excludability.
- Everyone consume the same ammount (one side shold feed all)
Taxonomy:
| RIVAL | NO RIVAL | |
| EXCLUDABLE | PRIVATE GOODS -> EX: ticket for concert | CLUB GOODS -> DEF :Are those goods that are provided just to some people that pay a subscription -> EX: netflix |
| NON EXLUTABLE | COMMONS -> EX: fields feeding cows | PUBLIC GOODS -> EX: light house |
-> EXAMPLE: public good game
-> GIVEN:
- Two player with 1€ each one
-> STRATEGIES:
- Keep the euro
- Put the euro in a public fund.
-> Whethever is in the pblic fund will be multiplied to 1.5 and then will be split in equal terms for the two players
| 1\2 | Contribute | Don’t Contribute |
| C | 1,5 ; 1,5 | 0,75 ; 1,75 |
| DC | 1,75 ; 0,75 | 1 ; 1 |
=> Dominant Strategy: don’t contribute.
-> Similar to the game of the prisoner.
-> PROBLEM:
- With the government intervention we can have problem of Free Riding.
FREE RIDING: when an individual is using a public good without paying it.
-> Government can provide the public good & paying it with tax revenues (there could still be the problem in free riders in paying taxes).
RESERVATION PRICE: willingness to pay.
- Reservation price of each person depends on its personal wealth => Provide or not a Public Good depend on reservation prices (willingness to pay) and to turn on the distribution of wealth among members of a community.
-> EXAMPLE: the TV Rommates:
-> Two roomates have to decide if to buy a tv or not.
| -> Reservation price for person 1: | for person 2 is equal. |
-> Each plave to free-ride on the expenditure of the other, but if both think in this way => the good will not be provided.
Arrow’s Impossibility Theorem:
-> DEF: if a social decision mechanism satisfies properties 1, 2, 3 then it must be a dictatorship: all social rankings arre the rankings of one individual.
-> PROPERTIES:
- Given any set of complete, reflexibe & transitive individual preferences, the social decision mechanism shoul result in social performances that satisfy all the same properties
- If everybody prefers alternative x to alternative y => the social preferences should rank ahead of y.
- The preferences between x and y should depend only on how people rank x versus y, and not onhow they rank other alternatives.
📌 Vaccines are not public good, is a public good with a lot of positive externalities.
- You can easily exclude people from being vaccinated
- They are rivarly in consumption
-> The effect of vaccines is a public good.
Common Goods
-> DEF: goods that are rivalrous and non-excludable. Thus, they constitute one of the four main types based on the criteria:
- RIVALROUSNESS: whether the consumption of a good by one person precludes its consumption by another person.
- EXCLUDABILITY: whether it is possible to prevent people (consumers) who have not paid for it from having access to it.
->CHAR:
- Accessible by everybody,
- They are at risk of being subject to overexploitation which leads to diminished availability if people act to serve their own self-interests.
-> PROBLEM: excludabilit:
-> EXAMPLE: in a commmon grazing land, villagers graze their cows on a comon field => Individuals are free to graze their cows in the field with no restrictions.
TRAGEDY of the COMMONS: the presence of common goods may lead to the overexploitation of the common goods:
=> Could occur the Over-Exploitation of the field.
-> REMEDIES:
- Transforming the common into a private good with precise definition of property rights-> Private Property provide such mechanism..
- Keep them as public but allocate the right to enter.
⚠PROBLEM: there are situations where excludability mechanisms are not implementable & law is ambiguous/ difficult to enforce => tragedy of commons can eeasily arise.
- Overfishing in international waters.
📌When commons remain commos & formal institutions are unable to enforce restrictions => theirs survival will crucially depend on whether informal instituctions characterizing a society.
Asymmetric Information:
-> DEF: imperfectly informed markets
- One side is better informed than the other
- Purely competitive markets all agents are fully informed about traded commodities and other aspects of the market.
- May be reduced with Digital Technologies.
-> EX: doctor knows more about medical services
| -> PROBLEMS: | -> REMEDY: |
| Adverse selection Moral hazard | Signaling Inventives Final remarks. |
Problems:
Adverse Selection:
-> DEF: situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality.
- Can also occur when producers do have the option to produce low-quality or high-quiality goods and face different costs for producing the two.
- Oblem of hidden information.
-> To understand what kyind of product is sold we have to:
- Compute Expected Value
- Compute the willingness to pay
- Comparing those two, thanks to the assumption of neutrality to risk, we’ll undestand the products that will be sold.
Case: Adverse Selection.
-> In a usedd car market:
- 100 people want to sell their used car
- 100 want to buy.
- 2 type of car: Lemon: bad product (sell between 1 000 – 1 200$), Plums: good product (sold between 2 000 – 2 400$)
📌Gains-to-trade are generated when buyers are well informed.
-> No buyer can tell a plum from a lemon before buying.
=> EV = 0.5*1200+0.5*2400=1800
MKT for Finance of Innovation:
-> There are good & bad innovation project (bad = high risk failure)
- Those who provide external finance can not perfectly discern good vs bad => the shiedl from the risk are high condition for lending to everybody.
=> Only kamikaze innovators will ask for money while capable innovators may prefer to give up searching fro external debt finance or search for other alternative financig sources.
- Good innovation may risk not to be financed.
Moral Hazard:
-> DEF: occurs in a transaction when the party with more information about its actions/ intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
- Problem of hidden action.
- Less trade than optimum.
Case: Bike
-> If one has full bike insurance what are the probabilities that he will leave the bike unlocked?
- Without Insurance: consumers have incentive to take the maximum possible amount of care
- With Insurance: consumers woudn’t have the incentive to take any care. => MORAL HAZARD
-> NOTES:
- Hidden action problem (if the amount of care is observable=>there is no problem)
- Insurance company faces a trade-off: higher immediate returns = higher risk of bearing great costs later.
- Market inefficiency: Going to insurance company => we take care about the product. But the more we pay, the less we care about the good.
MKT for Financial of Innovation:
-> For outsider may be difficult to monitor stategies, choices, decisions taken by innovative managers & enterpreneurs => they may put in place actions not in the interest of the investors
Remedies:
Signaling:
-> DEF: act on information and find a way to through which high-quality sellers may signal credibility of high quality.
- Involve information in market
- Involves cost => the equilibrium is sub-optimal compared to a full information scenario.
-> EX: in the car example we can introduce a warranty, given by the seller, that cover damage if the car breaks down. Good cars break down very rarely => the good seller would rarely pay the money. It would be convenient just for those who sell plum.
-> CHAR:
- Has to be costly & higher for bad sellers.
- Has to be intentionally taken
- Has to be observable.
Government in Signaling:
-> The rule of gov is limited byt with one notable expectation.
SEARCH GOOD: no asymmetric information between seller & buyer.
-> EX: bic, the pen.
EXPERIENCE GOOD: asymmetric information just before to buy.
CREDENCE GOOD: asymmetric information, but infor are not known also ex post
-> EX: vaccines: person don’t know if works neither befor or after.
Case: Job Market Signaling, Spence, 1974:
-> In a labour market there are two types of workers: high-ability, low-ability.
- In a fraction h all workers are HA. 1-h are LA.
- Worker are paid differently, given their ability.
- Firms cannot tell workers’ type => have to pay the expected marginal product Wp=(1-h)LA+ h*H
-> EDUCATION (signal) can be acquired by workers: HA has lower cost for it while LA has higher costs for education.
Incentives:
-> DEF: actions that incentive people to don’t occur in hazard.
- If a person make a warranty and has to pay a bit if he lost the bike => inventive.
Principal-Agent Theory:
When the principal possesses less information than the agent, the two have different objective functions, principal can not monitor perfectly agent’s behavior and resulting performance of agent’s action is noisy.
-> AGENCY THEORY: area of economics that deals with all situations where there is a principal who wants an agent to act in the principal’s interest to achieve some goals.
Problems:
- Agent can indulge in moral hazard, making suffering the principal => introducing incentives we re-alligning objective functions.
- Perfomance of principal depend on his effort and random variables that are in function of the agent.
-> Two Scenarios:
Full Info Scenario:
-> DEF: Any possibility of randomness: principal can fully monitor agent or performance depend just on effort of principal.
-> Wages works perfectly:
Hidden Action Scenario:
-> DEF: Principal cannot monitor the agent.
=> Wages don’t work:
📌Also the Agent wouldn’t enter in this kind of relation: he know that the final performance wouldn’t depend just on him and if the principal don’t pay him if the performance is reached => Agent would spend an effort for nothing.
Flexible Remuneration Schemes:
-> DEF: make the agent partecipate to the sharing of the performance.
-> TYPE:
- Sharecroping in agriculture: the land owner lend the land to the farmer and let him take a percentage.
- Stoke options: possiblity to buy the shares of the company people are managing to a predefined price => if the effort of the agent is enogh he would increase his payback.
-> NOTE: again it’s not a full remedy: the effort of the agent that have a portion of the pie would be less than the one that have all the pie.
MKT fo Finance of Innovation
Sort of “Signals”
-> Established firms may exhibit their track record
-> Innovative start-ups may show their goodness ot external investors.
- Are not pure signals
- Like patenting or endorsment by a reputable alliance partner
Sort of “Incentives”:
-> Banks: collateral secre debt
-> Venture Capital: active investors co-investment with enterpreneurs as a guarantee of high effort, use milestones.
Education as Signal:
-> DEF: human capital play important rule in the determinatio of wages.
- Pure signal
SHEEPSKIN EFFECT: way thorugh which signals are called in the education
- Pergamena.
