Special Topics: Externalities & Imperfect Information

Professor WolframMBA201a - Fall 2009 Page 1 What is an externality? A transaction (or action) that affects parties that are not participating in the transaction. –Pollution, congestion, research Externalities cause economic inefficiency because they cause an inefficient level of transactions (too many or too few) to occur.

Professor WolframMBA201a - Fall 2009 Page 2 Examples of externalities Positive: my actions confer benefits on others. –Orchard and bees. –Voluntary contributions. Negative: my actions inflict costs on others. –Pollution. –Congestion.

Professor WolframMBA201a - Fall 2009 Page 3 Externalities imply economic inefficiencies. –Externalities imply a missing market. –In other words, there are potentially Pareto improving trades that could take place. –Consider two people sharing an office, a smoker and a non- smoker. Smoker’s valueNonsmoker’s cost 8 cigs per day cigs per day cigs per day-10 0

Professor WolframMBA201a - Fall 2009 Page 4 Why are there missing markets? –Property rights don’t exist or are difficult to enforce. –Transaction costs or other barriers to trading.

Professor WolframMBA201a - Fall 2009 Page 5 How to respond to externalities? Option 1: Adjust prices to reflect full social marginal cost and benefits, not just private. –Tax or subsidize to “internalize the externality.” –For instance, charge the smoker higher prices so that he chooses 2 cigs per day. Option 2: Adjust quantities to get to socially optimal level of economic activity. –Restrict production of a bad. –For instance, limit smoker to 2 cigarettes per day. –Government provision of a good.

Professor WolframMBA201a - Fall 2009 Page 6 Externalities and firms: network markets In network markets, your value of consuming a product is a function of the number of other people who are already consuming the product. Real networks: telephones, fax machines, railroads. Virtual networks: Computer OS’s, applications, yellow pages, languages. –The value of the network comes through secondary channels (e.g. file or knowledge sharing).

Professor WolframMBA201a - Fall 2009 Page 7 Network example If your surname begins with:Your value of the good is * : A B C12 D E F16 G H I20 J K L24 M N O28 P Q R32 STU36 VWY40 * Plus the number of other people buying the good.

Professor WolframMBA201a - Fall 2009 Page 8 Network markets –In a network market, your consumption of a product may create a positive externality for me, –… but if producers recognize this and sell to me at a low price (in order to encourage you to buy the same product), it’s not necessarily an externality. –Network products are distinct from bandwagon products or snob/Veblen products.

Professor WolframMBA201a - Fall 2009 Page 9 Sources of network effects –Demand-side: a product is more valuable if a number of other people are using it. Direct benefits (e.g. knowledge sharing). Complementary products. –Supply-side: a producer can achieve greater economies of scale selling to more people.

Professor WolframMBA201a - Fall 2009 Page 10 Asymmetric information and markets –We have been assuming that buyers and sellers have perfect information about all economic variables. –Consider cases where sellers have more information about a good than buyers. Market for used cars, labor markets, tradespeople.

Professor WolframMBA201a - Fall 2009 Page 11 Market for used cars - example –Consider the market for used Honda Insights. –Assume we’re looking at very similar vehicles—same year, mileage, color, interior condition, etc. –BUT, half of the cars have had major body work and half have not.

Professor WolframMBA201a - Fall 2009 Page 12 Market with perfect information With perfect information, there would be two markets: 12,500 10,000 10,000 PP Q Q High Quality CarsLow Quality Cars DHDH DLDL SLSL SHSH 8,500

Professor WolframMBA201a - Fall 2009 Page 13 Market with imperfect information With imperfect information, buyers would only be willing to pay based on their expectation of the type of car they would get: 12,500 6,000 10,000 10,000 13,000 PP Q Q High Quality CarsLow Quality Cars DHDH DLDL SLSL SHSH 8,500 DMDM DMDM

Professor WolframMBA201a - Fall 2009 Page 14 Mechanisms for overcoming imperfect information -In the extreme, in markets with imperfect information, low quality goods can drive high quality goods out of the market. -Several mechanisms are used to overcome this problem: -Independent quality certification. -Reputation. -Warranties.