Welcome to BA201a.

Welcome to BA201a.

Special Topics: Externalities & Imperfect Information 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 Wolfram MBA201a - 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 Wolfram MBA201a - 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 nonsmoker. Smokers value Nonsmokers cost 8 cigs per day

80 150 2 cigs per day 60 50 0 cigs per day -10 0 Professor Wolfram MBA201a - Fall 2009

Page 4 Why are there missing markets? Property rights dont exist or are difficult to enforce. Transaction costs or other barriers to trading. Professor Wolfram MBA201a - 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 Wolfram MBA201a - 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 OSs, applications, yellow pages, languages. The value of the network comes through secondary channels (e.g. file or knowledge sharing). Professor Wolfram

MBA201a - Fall 2009 Page 7 Network example If your surname begins with: Your value of the good is*: ABC 12 DEF 16 GHI

20 JKL 24 MNO 28 PQR 32 STU 36 VWY

40 Professor Wolfram MBA201a - Fall 2009 * Plus the number of other people buying the good. 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), its not necessarily an externality.

Network products are distinct from bandwagon products or snob/Veblen products. Professor Wolfram MBA201a - 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 Wolfram MBA201a - 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 Wolfram MBA201a - Fall 2009 Page 11 Market for used cars - example Consider the market for used Honda Insights. Assume were looking at very similar vehiclessame year, mileage, color, interior condition, etc.

BUT, half of the cars have had major body work and half have not. Professor Wolfram MBA201a - Fall 2009 Page 12 Market with perfect information With perfect information, there would be two markets: High Quality Cars P Low Quality Cars SH P DH

12,500 SL DL 8,500 10,000 Professor Wolfram Q MBA201a - Fall 2009 10,000 Q

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: High Quality Cars P Low Quality Cars SH P DH 12,500 SL D

M 8,500 6,000 10,000 Professor Wolfram Q MBA201a - Fall 2009 DM DL 10,000 13,000Q 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. Professor Wolfram MBA201a - Fall 2009 Page 15

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